An option is a contract that provides a right, but not an obligation, to purchase or sell an underlying asset at a specific price within a specific time frame in exchange for a one-time option premium payment. Options are often used in financial markets with the underlying asset being an instrument such as a futures contract. But they can also be used in physical markets with the underlying asset being a commodity or the right to utilize an asset. Here is an example of each type of underlying asset:
Financial options are offered through financial exchanges and similar products may be offered as over-the-counter (OTC) instruments. The terms “put” and “call” are used to specify whether the entity holding an option has a right to buy the underlying asset or a right to sell that asset. A call option grants the buyer the right to purchase a future at a specific price while a put option grants the right to sell a future at a specific price.
For the buyer, the risk of an option is limited to the option premium since if the option price is not supported by the market (“in the money”), the buyer will simply allow the option to expire. The seller, however, has an unlimited risk unless she has hedged the risk in some other way. One advantage to an option is that it is lower cost than using futures or physical means of hedging risks. They are often used to create price ceilings or to otherwise hedge risks of adverse price movement.