1. WHAT IS AN OPTION CONTRACT?
An option contract is a contract between a buyer and a seller. The option is connected to something, such as a listed stock, an exchange index, futures contracts, or real estate. Options have one feature that sets them apart from all other existing financial instruments: the holder of an option has the right, but not the obligation, to buy or sell an underlying asset at a predetermined price during a specified period. Thus, the option holder will exercise his or her option (i.e. take up the rights granted by the option) only if it is profitable to do so. The maximum possible loss to the holder of an option is limited, but the potential profit is unlimited.
Every stock option is designated by:
name of the associated stock
strike price
expiration date
the premium paid for the option, plus broker’s commission.
Using the example of a three-month option to buy a house for $100,000, the holder of the option has the right to purchase the house for $100,000 at any time during the next three months. The option price, or premium, can be mutually agreed upon by buyer and seller, and may for instance be $ 5,000 in this example. Should house prices increase above $100,000 during this time, the option holder can obviously exercise his or her option and, if they have risen above $105,000, he can buy and resell the house for a net profit. Should he no longer require the house, he can at least resell it at the higher price. However, should house prices fall to say, $90,000, he can now "abandon" the option and buy the house at the current market value of $90,000 (i.e. for a total cost of $95,000).
An option can therefore be considered as a type of insurance against unfavorable price movements and, as in the insurance industry, the amount paid for an option is called the premium.
The date on which an option becomes void if not exercised is called the expiration date, while the date on which an option is exercised is called the declaration date or