An option is simply a contract that provides the buyer the right — but not the obligation — to buy or sell a given asset at a specified price within an fixed amount of time.
For instance, one might buy an option to buy 100 shares of AMZN at $750 per share anytime within the next month. To do this, one pays the price of an option — which is a function of numerous factors — plus a commission.
If one is buying the right to BUY an asset at a fixed price, this is referred to as a call option. If one is buying the right to SELL an asset at a fixed price, this is referred to as a put option.
In addition to buying strategies, traders can also sell, or write, options. For instance, you may sell a call option — which is selling someone the right to buy shares at a fixed price. In such a scenario, you must sell the shares to the buyer of the option if/she chooses to exercise the option before the expiration. However, you can also charge for options, and thus earn money for writing options.
The price of an option depends on a few factors, such as:
1. The volatility of the underlying asset. Options on more volatile assets are more expensive.
2. Duration — the amount of time until the option expires. Options with longer durations are usually more expensive.
Uses of Options
There are many uses of options:
1. Insurance policy to protect against assets. If one owns a volatile asset, one can buy an option to lock-in a potential price, which can protect them from price movements that do not move in their favor but still allow them to capture the upside.
2. Speculation. Just like traders trade stocks and commodities, they can also trade options on these instruments as well.
3. Hedging. As is the case with futures, options can be used to lock prices in in the future, and thus allow current producers to hedge production.
Options can be traded with little money, allow use of leverage, and are conducive to a variety of risk management strategies.