What are options?

Option markets have been operating through the major stock
exchanges in many countries since the 1970s. In most cases,
these markets have experienced significant growth since
then in both the number of options traded and the range
of options available. Why? Because options are an amazing
trading tool that can be used in a wide range of strategies.
Option strategies can vary in time frame, risk and purpose to
suit the needs of a wide range of investors and traders. In this
chapter we will define what options are, how they work and
some of the many ways in which they can be used to enhance
your trading outcomes.
In this book, we will be referring to exchange traded
options over stocks or shares, unless specified otherwise.
These are options that can be bought and sold through a
central exchange such as the Australian Securities Exchange
(ASX), and are the most commonly traded type of option.
This allows us to simplify the discussion as we introduce the
various components and attributes of options.
Options also exist over exchange traded funds (ETFs),
indices and currencies. There are also company issued
options that have different terms and conditions from
exchange traded options.

What are options?
Options are exactly as their name suggests: they provide
the purchaser with an option to buy or sell an underlying
financial security. Although this may sound limiting, options
are amazing tools that can provide both the seller of the
option and the buyer of the option with the ability to protect
or hedge current stock positions, reduce their market risk, or
generate additional income.

Options can be issued over a range of financial securities,
including stocks, indices and foreign currency. In order to
simplify the discussion, for the most part we will refer to options
issued over stocks. However, the same concepts generally apply
to options issued over other underlying financial securities.
An option is defined by a contract between the seller of
the option and the buyer of the option. The contract gives
the buyer of the option the right (or option) to buy or sell a
set amount of stock at a specific price on or before a specific
date. The buyer pays the seller a premium in order to acquire
this right. If the buyer decides to use their option, this is
referred to as ‘exercising’ their option. When an option buyer
exercises their option, they are taking action to buy or sell the
stock as specified in the option contract.

The buyer of an option is referred to as the taker, as they are
taking up the right to buy or sell the underlying stock.
The seller of the option is providing the buyer with the
right to buy or sell the underlying stock. The seller has no
control over whether the option they sold will be exercised
or not. They have created an obligation to fulfil the option
contract if the buyer decides to exercise the option. The seller
of the option is referred to as a ‘writer’, as they underwrite or
accept the obligation contained in the option.