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Option Basics: A Crash Course in Option Mechanics

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What is an option? What is a derivative? What is an underlying asset? The authors of "Commodity Options " explain the basics.

The concept of options has been around for a long time. Ancient Romans, Greeks, and Phoenicians traded options based on outgoing cargoes from their local seaports. When used as a derivative of a financial instrument, an option is generally defined as a contract between two parties, a buyer and a seller, in which the buyer has the right but not the obligation to buy or sell the underlying asset at the denoted strike price. In the world of finance and trading, a derivative is defined as any asset in which its value is derived, or resulting, from the value of another asset. Likewise, the underlying asset is an asset on which the value of the derivative is dependent.

What Is an Option?

There are two types of options, a call option and a put option. Understanding what each of these is and how they work will help you determine when and how to use them. The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to take delivery of the underlying futures contract (exercise). This financial value is treated as an asset, although eroding, to the option buyer and a liability to the seller.

There are two sides to every option trade, a buyer and a seller. Traders willing to accept considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known belief that more options than not expire worthless. The premium collected by a seller is seen as a liability until the option either is offset (by buying it back) or expires.

  • Call options—Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time. Conversely, the seller of a call option is obligated to deliver a long position in the underlying futures contract from the strike price should the buyer choose to exercise the option. Essentially, this means that the seller would be forced to take a short position in the market upon expiration.
  • Put options—Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time. The seller of a put option is obligated to deliver a short position from the strike price (accept a long futures position) in the case that the buyer chooses to exercise the option. Keep in mind that delivering a short futures contract simply means being long from the strike price.

Call

Put

Buy

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Limited Risk

Sell

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Unlimited Risk

To understand what an option is, you need to know the various components that comprise it. This next section explains the following:

  • Strike price
  • Intrinsic and extrinsic value
  • Time value, volatility, and demand
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