Option Definition and Legal Meaning
On this page, you'll find the legal definition and meaning of Option, written in plain English, along with examples of how it is used.
What is Option?
It refers to the right or priviledge or a contract where a person has paid a value to purchase the stock, real estate or commodities at a fixed agreed price and at a specified time.
History and Meaning of Option
The concept of options can be traced back to ancient Greece, where philosopher Thales of Miletus famously used options to profit from a good olive harvest. However, the modern option market did not emerge until the 17th century, when Dutch traders began trading options on shares of the Dutch East India Company. Since then, options have become a popular tool for investors and traders to mitigate risk and generate returns.
An option is a type of financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (such as a stock, real estate, or commodity) at a predetermined price and time. The price is called the strike price and the time period is called the expiration date. There are two types of options: call options and put options. A call option gives the buyer the right to buy the underlying asset, while a put option gives the buyer the right to sell the underlying asset.
Examples of Option
John buys a call option for 100 shares of Apple stock with a strike price of $150 that expires in 2 months. If Apple's stock price goes above $150 before the expiration date, John can exercise his option and buy the 100 shares at $150, even if the current market price is higher. If the price does not go above $150, John can choose not to exercise the option and it will expire worthless.
Sarah sells a put option for 500 barrels of crude oil with a strike price of $60 that expires in 1 month. If the price of oil falls below $60 before the expiration date, the buyer of the put option can exercise their right to sell to Sarah at $60, even if the market price is lower. If the price stays above $60, the put option will expire worthless and Sarah will keep the premium she received for selling the option.
Tom buys an option to sell his house to Mary for $300,000 in 6 months. If the housing market falls and Tom's house is only worth $250,000 in 6 months, Tom can exercise his option and sell to Mary at $300,000. If the house is worth more than $300,000, Tom can choose not to exercise the option and sell on the open market.
Legal Terms Similar to Option
- Futures contracts - Similar to options as they allow the trader to buy or sell an asset at a predetermined price, but futures obligate traders to fulfill the contract at expiration.
- Swaps - A derivative contract in which two parties exchange financial instruments or cash flows based on a predetermined set of rules.
- Warrants - A type of security that gives the holder the right, but not the obligation, to buy shares of a stock at a predetermined price and time.