Option

Posted in Finance, Accounting and Economics Terms, Total Reads: 648
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Definition: Option

Option is a derivative instrument that provides the opportunity to buy or sell an underlying asset with a specific expiration date. Buying an option gives the right, not the obligation, to buy or sell an underlying asset. There are two types of options, a call and a put.

A call is an option granting the right to buy the underlying; a put is an option granting the right to sell the underlying.

Example:

Farmer A grows corn. Currently the market price of corn is Rs.50 per kg. But the farmer is not sure what will be the market price of corn after 6 months when his crop is ready for harvest. If the market price falls below from 50 to 40 then the farmer will be at a loss. So to reduce this price risk the farmer will buy a put option at a price of 50.  In this option the underlying asset is the crop. This option grants the farmer the right to sell his corn but not an obligation to sell his crop at 50 irrespective of what is the market price. Suppose if the market price is below 50 after 6 months then the farmer will exercise his option to sell at 50. If the market price is above 50 then the farmer will not exercise his option. In this way Option is used to reduce the risk.

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