Basics - What is an Option?
Len Yates

Suppose you agree to sell something. And suppose you and the other party has agreed on a price and a time to complete the sale. In such a case, you have what is called, in the realm of finance, a forward contract.
 
However, if you agree to let someone have the privilege of buying something from you at a stated price and for a limited time, if and when the other party decides to do so, you have sold an option.
 
The holder of the option possesses the right, but not an obligation, to buy something at a stated price for a limited time. The party who sold the option is obligated to deliver the goods if the options holder decides to exercise his option.
 
The asset that would be delivered is called the ‘underlying asset”, or just “the underlying”.  The price agreed to is called the “strike price” or “exercise price” of the option.
 
For example, let’s say I have a piece of real estate worth $100,000. I could agree to let someone have an option to buy the property from me for, say, exactly $100,000 at any time during the next two years. The option’s strike price is therefore $100,000, the underlying is the property itself, and the expiration date is two years from today.
 
Now, why would I enter into such an agreement? After all, if the property increases in value over the next two years, that appreciation would be lost to me because I have agreed to sell the property for $100,000. Furthermore, I am locked into owning the property, and may not sell it to anyone for the next two years – because if the option holder decides to exercise, I am obligated to deliver the property. So why should I put myself in such a constrained position?
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