What are options?

When you purchase an options contract, you’re not buying an asset — rather, you’re buying a contract that gives you the right to buy or sell an asset at a specific price by a fixed date, depending on the type you choose. Note that we said it gives you the right to buy an asset; this isn’t an obligation.

Therefore, options fall under the derivatives category, because their value depends on the value of something else (the asset you’ll have the right to buy or sell). The asset in question could be a commodity, a currency, an index, or a range of other securities.

There are two parties involved in this arrangement: The person who buys the contract, also known as the holder, and the person who sells it (called the writer).

Options in their current form date all the way back to 1973, when they were introduced by the Chicago Board Options Exchange. However, they’ve been diffused into the rest of the world gradually. For instance, in India, the National Stock Exchange (NSE) only launched them in 2001.

Options contracts contain the following six features:

  • Contract size. Size demonstrates how many units of the underlying asset are included in an options contract, and ensures a fixed quantity is delivered. For instance, if the contract specifies 50 shares, exercising one option contract means the holder must buy or sell 50 shares.
  • Strike price. As mentioned, an option contract comes with a fixed price for buying or selling the underlying asset. This price remains the same for the duration of the contract, no matter how much the market price fluctuates.
  • Intrinsic value. Since the market price and strike price can differ drastically, the intrinsic value exists to express the difference between them. If you have the option to sell something for more than it’s actually worth, it has a greater intrinsic value.
  • Expiration date. Options contracts are only valid for a limited period of time, after which they expire. The contract can only be executed before this date.
  • No obligation to buy or sell. Buying an option contract doesn’t mean the investor has to exercise it. If they don’t want to buy or sell before the expiration date comes, the option will simply expire, with no consequences.
  • Option settlement. An option settlement takes place when somebody decides to exercise their contract by buying, selling, or exchanging the securities involved. If this doesn’t happen before the expiration date, no settlement takes place.