Options

An options contract is an agreement between two parties to facilitate a potential transaction on the underlying instrument at a pre-set price, referred to as the strike price, prior to the expiration date.

An option is considered a call when a buyer enters into a contract to purchase the underlying instrument at a specific price by a specific date. An option is considered a put when the option buyer takes out a contract to sell the underlying instrument at an agreed-on price on or before a specific date.

The idea is that the purchaser of a call option believes that the price of the underlying instrument will increase, while the seller of the option thinks otherwise. The option holder has the benefit of purchasing the underlying instrument at a discount from its current market value if the price of the underlying instrument increases prior to expiration. If, however, the purchaser believes the underlying instrument will decline in value, he enters into a put option contract that gives him the right to sell the underlying instrument at a future date. If the underlying instrument loses value prior to expiration, the option holder is able to sell it for a premium from current market value.

The strike price of an option is what dictates whether or not it's valuable. The strike price is the predetermined price at which the underlying instrument can be bought or sold. Call option holders profit when the strike price is lower than current market value. Put option holders profit when the strike price is higher than the current market value.

American options, can be exercised any time between the date of purchase and the expiration date of the option. European options are slightly less common and can only be redeemed at the expiration date.

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