An option, sometimes called a derivative, is an agreement between a buyer and a seller to sell an asset at an agreed upon and fixed price, at some specified future date. The asset is usually of the financial kind — a stock or a futures value. As the name suggests, the agreement is optional — the buyer is not obligated to buy the asset, whether or not it decreases or increases in value. The seller, however, is obligated to carry out the transaction if the buyer so chooses.
The concept of options trading is much easier to understand when applied to a common scenario. Suppose a buyer who wants to make an offer on a house in cash, won't have the needed cash for another six months. He might negotiate a deal with the seller whereby he will buy the house in six months, at an additional cost of 1% of the sale price. The buyer in this scenario is paying extra for the convenience of being able to buy the house when it suits him.
There are two types of options — call options and put options. A call option gives the buyer the right to buy the asset, at the previously agreed upon price and on the designated date. A put option gives the buyer the right to buy the asset and then immediately sell it to a third party. In the United States, but not in Europe, an option can also be exercised before the designated date, if both the buyer and seller agree to it.
Like most financial transactions, options trading has its advantages and disadvantages. One disadvantage, for the buyer, is that an investor may end up paying a fee for an option, the trade for which is never transacted. That is, a potential buyer may pay a fee now for an option to buy in the future. However, since buyer doesn't have to complete the transaction in the future, if the buyer chooses not to complete the transaction, he will lose that fee which secured the option to buy. Options trading generally benefits the buyer, rather than the seller, who is also known as the writer of the option. In addition, some trades require a middle man, or broker, who will also charge a fee.
On the other hand, options trading is advantageous in that it is flexible, offering the opportunity to withdraw an offer. The buyer can also hold on to his or her money for a longer period of time, allowing that money to be earning interest. An option can also act as a form of insurance to ensure that the buyer makes a profit if he or she is buying a stock or asset that is somewhat risky.