Definition

An option contract is the right to buy or sell an underlying security for a specific price for a set period of time. The underlying asset can be individual stocks, stock indexes, exchange-traded funds (ETFs) or futures contracts.

Function

A call option is the right to buy the underlying security and a put option is the right to sell the security. The option holder has the right to exercise the option and a seller must fulfill the contract by delivering or buying the underlying security if a contract is exercised.

Features

Option contracts are for a specific price of the underlying security called the strike price. Options expire according to a standard schedule. Options can have expiration dates from one month and up to two years. Options will trade over a range of strike prices and expiration dates for a specific underlying asset.

Considerations

Option traders can buy or sell or use combinations of contracts to achieve a specific trading strategy. Strategies range from very conservative to extremely risky. A significant amount of study is required to understand the possible ramifications of option trades.

Potential

The purchase of call or put options allow traders to earn significant profits with a small capital outlay if the underlying security makes a big price move in the right direction. Option sellers can generate extra income from their securities holdings.

Expert Insight

The Chicago Board Options Exchange and Options Clearing Corp. provide a detailed document that explains in detail how options function. The Characteristics and Risks of Standardized Options linked is in the Resources section.

Source:

Options Industry Council: What is an Option?

More Information:

CBOE: Characteristics and Risks of Standardized Options