Derivatives — Options

An option is a derivative contract between two parties over an underlying asset (a share, index, currency, commodity or futures contract). Its value is DERIVED from that underlying.

The BUYER (holder) pays a premium and gains a RIGHT; the SELLER (writer) receives the premium and takes on an OBLIGATION to perform if the buyer exercises.

Two basic types: a CALL option gives the buyer the right to BUY the underlying at the strike price; a PUT option gives the buyer the right to SELL the underlying at the strike price.

Key terms: the strike (exercise) price is the fixed price at which the underlying can be bought/sold; the premium is the price of the option itself; the expiry (expiration) date is the last day the option is valid; the contract size is the quantity of underlying per contract.

The buyer's downside is limited to the premium paid — they simply let a worthless option lapse. Their upside can be large (a call) or substantial (a put).

The writer's position is the mirror image: their maximum GAIN is the premium received, while their potential LOSS can be large. A writer of a naked (uncovered) call has THEORETICALLY UNLIMITED loss because the underlying price can rise without limit.

Because the buyer holds a right and the writer an obligation, only the buyer decides whether to exercise; the writer must comply if assigned.