Options belong to a special class of financial instruments called derivatives. As its name implies, derivatives have a price that is derived from other assets. This allows investors to participate in the price movements of the underlying asset without actually owning the asset. Common assets underlying derivatives include stocks, bonds, commodities, currencies, interest rates and index futures.
Without actual ownership of the asset, investors benefit by being able to control their exposure and position in a versatile and dynamic manner. Market participants can use derivatives as a tool for hedging to protect their position, as an instrument for speculation, or as part of an arbitrage strategy.
The flexibility of options arises from their very nature; options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price – the strike/exercise price. If the buyer has the right to buy an asset, it is a call option. If the buyer has the right to sell an asset, it is a put option.
An option which has underlying stock price equal to the exercise price at the time of expiry is an ‘at the money’ (ATM) option. An option with stock price greater than the exercise price is an ‘in the money’ (ITM) option, while an option with stock price less than exercise price is an ‘out of the money’ (OTM) option.
Options also come with an expiry date – the last date whereby the option holder may exercise the contract. Options can be classified into American or European options. European options can only be exercised on the expiry date while American options can be exercised any time up to expiration.