STSM112010 - Derivatives: introduction to options: what is an option?

An equity option is a financial contract between the issuer of the option and the ultimate option holder which gives the holder the right, but not the obligation, to buy or sell a stock or share at a given price per share (often referred to as the ‘strike’ price) on or before a given future specified date.

Options are a means of minimising losses at times of company share price fluctuations. Options are a form of protection for stocks and shares held by a person and a gamble on shares that an investor might want to purchase.

For example, an investor may want to wait and see if it was advantageous to buy or sell a particular number of shares at a future date. In other words, an investor would like the right but not the obligation to buy or sell if the market conditions were right. An option contract differs from other sorts of derivatives because it gives the holder a choice.

One important difference between stocks and shares and equity options is that:

• the purchase of stocks and shares give the holder the right to share in the company’s profitability through dividend payments, a degree of control and general meeting voting rights
• in contrast options are contracts that give the holder the right, but not the obligation, to buy or sell shares in an underlying company at a specific share price by a specific date. The holder of an option has no rights to dividend payments and no degree of control or voting rights in the company.

When a person issues an option, this effectively creates a security that did not exist before. This is known as writing an option.

See STSM112030 for the meaning of ‘specified date’.

See STSM112040 for the meaning of ‘contract’.