An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a set price before a set date. The buyer pays a premium for that right. The seller receives the premium and takes on the obligation. Options trade on exchanges and over the counter. They are used to hedge risk and to speculate on price movements.

Two main types exist. A call option gives the right to buy. A put option gives the right to sell. The strike price is the price at which the asset can be bought or sold. The expiration date is when the contract ends. If the option is not exercised by then, it expires worthless. American options can be exercised anytime before expiration. European options only on the expiration date.

Options are versatile and complex. A farmer can buy puts to guarantee a minimum price for crops. An investor can sell covered calls to generate income from stocks they own. A trader can buy calls hoping for a price surge. Leverage is built in: a small premium controls a large position. That leverage amplifies gains and losses. Options can expire worthless, wiping out the entire premium. They are not suitable for everyone. Understanding the mechanics is essential before trading them.

Key terms

• Call option
• Put option
• Strike price
• Expiration date
• Premium