What Exactly Are Options?
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What Exactly Are Options?

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Options are contracts that give an option buyer the right to buy or sell a specific underlying asset at a set price either on or before a specific date in time. Similar to a stock or bond, an option is considered to be a security. Options are also binding contracts with strictly defined terms and properties.

An option is technically considered to be a derivative on an underlying security. Therefore, options are essentially contracts that deal with an underlying asset, meaning that they derive their value from something else.

There are various types of options. Some strategies for investing in options have more risk than others. Essentially, there are four primary types of options, divided into two general categories – calls and puts. Of these, there are two types of call options and two types of put options.

A call option gives the holder of that contract the right to purchase an underlying asset at a certain price within a set time period. Each call option gives an investor the right to buy 100 shares of the underlying stock. Therefore, if an investor purchases a call option on ABC stock for $25 per share, and the stock share price rises to $40 per share, then the investor would be allowed to purchase 100 shares of ABC stock for $15 less than the underlying share price at that time.

In this manner, calls can be considered as having a type of long position in a stock. Buyers of calls are hoping that the price of the underlying stock will rise substantially before their option expires.

Conversely, a put option gives an investor the right to sell an underlying asset at a specified price within a set period of time. Therefore, if an investor purchases a put option, they have the right to sell the underlying stock at a certain price prior to the options expiration date. As an example, if an investor buys a put option that allows them to sell certain stock shares for $50 per share, but the actual stock was only trading at $35 per share on a given day, then the investor could sell those shares for $15 per share over the actual price of that underlying stock.

Therefore, puts can be considered as being similar to having a short position in a stock. Buyers of put options are hoping that the price of the underlying stock will drop before their option contract expires.
In the case of buying either a call or a put option, the investor also has the right to sell the option contract itself to another investor up until the time of the options expiration date. Or, the investor could simply allow their option contract to expire worthless if they do not either exercise or sell it.

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