An investment contract that provides a buyer the right to buy or sell an underlying asset on or before a specified date, for a specific price, is called an option. With an option, the buyer or seller is under not obligation to buy or sell the asset. It is a binding contract. There will be very well defined terms written into an options contract.
The attraction of options contracts is their versatility. They make it possible for an investor to adjust or adapt their position based on any situation that may occur. Some options are based on risky and speculative investments. Others are based on extremely conservative investments. An investor can prevent their position from declining as well as bet on the movement of the index or market. They are also complex securities that can provide significant rewards with extreme risk.
When an investor anticipates a stock price to rise or lower in value, they can call an option that would enable them to pay for the stock at a fixed price at a later date. This makes it possible for them to avoid paying for the stock outright. This would require the investor to pay a premium. They would not have to purchase the stock; the investor only has the right to buy or sell it at or before the determined expiration date. The risk of loss would be limited to the premium paid. The profit or loss could be significant if market performance is unanticipated.
An investor who anticipates a stock price to go lower can purchase a put option. This would enable them to sell the stock at a fixed price at a future date. The investor does not have to sell the stock. Should the stock price be less than the exercise price at its expiration, and the value is more than the premium paid by the investor, profit will be realized. Should the stock price be above the exercise price, the investor can let the options contract expire. They will then only lose the amount of the premium they paid.
When an investor anticipates a stock’s price to rise, they can buy the stock. They can also write a put option. The investor has an obligation to purchase the stock at a fixed price. If the price of the stock is higher than the fixed price, the investor who wrote the put will make a profit in the amount of the premium that was provided. Should the stock price at expiration be below the fixed price, in excess of the premium provided, the investor will lose money. They could lose up to the fixed price less the premium.
When an investor anticipates a stock will become lower in price, they can sell the stock short or write a call. The investor is obligated to sell the stock to the call buyer at an established fixed price. Should the investor not own the stock at the time of the option being exercised, he is required to purchase the stock from the market at the current market price. Should the price of the stock go lower, the investor who wrote the call will make a profit in the amount of the premium paid. The seller could lose money, and the amount of such a loss could have no limitations.