Concept of Options

An option is a financial derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) on or before a specific date (the expiration date).

Think of it like this: An option is similar to a reservation or a down payment. You pay a small fee (the premium) for the right to do something in the future (buy or sell an asset), but you are not obligated to do it. If the deal becomes unfavorable, you can simply let the option expire, and your loss is limited to the premium you paid.

Key Differences from Futures/Forwards:

• Obligation vs. Right: Futures and forwards obligate both parties to transact at a future date. Options only obligate the seller (writer) if the buyer chooses to exercise.
• Premium: Option buyers pay a premium to the seller for the right to buy or sell. This premium is the maximum loss for the buyer. Futures and forwards typically do not involve an upfront premium (they are entered into at zero cost initially).

In essence, options provide flexibility and limited downside risk for the buyer, while offering the seller income (the premium) in exchange for taking on the potential obligation to buy or sell the underlying asset.