Unlike futures or forwards, which confer obligations on both parties, an option contract confers a right on one party and an obligation on the other.

The seller of the option grants the buyer of the option the right to purchase from, or sell to, the seller a designated instrument at specified price within a specified period of time. If the option buyer exercises that right, the option seller is obligated.

The seller (known as the writer) grants this right to the buyer in exchange for a sum of money called the option premium. The option premium is effectively the price of the option.

The price at which the underlying instrument may be bought or sold is called the exercise or strike price. The date after which the option is no longer active is called the expiration date.

An ‘American-style’ option may be exercised at any time up to and including the expiration date. A ‘European-style’ option may be exercised only on the expiration date. These terms have nothing to do with geography in the sense that both American and European options are traded in all the world’s major markets.

When an option writer grants the buyer the right to purchase the designated underlying instrument the option granted is called a call option.

When the option buyer has the right to sell the underlying instrument to the writer, the option is called a put option.

The buyer of an option is said to be long the option; the writer of an option is said to be short the option.

Consider the following example:

An American-style option on a stock with three months to expiration has an exercise price of $15. The option price (the premium) is 25 cents. If the option is a call option the buyer has the right to purchase the stock for $15 at any time before expiry. The writer of the option (the seller) must sell the stock to the buyer for $15 if they exercise the option.

Suppose now that the stock’s price rises to $16. If the option buyer exercises the right to buy at this price they buy a stock for $15 that is currently worth $16. After taking account of the cost of buying the option in the first place – 25 cents – the option buyer realises a profit of 75 cents. The writer of the option, on the other hand, has lost 75 cents.

If instead, the stock’s price falls below $15 the option buyer will not exercise the option and will lose the price they paid to buy the option in the first place; namely, the 25 cent premium. Here, the writer of the option will realise a profit of 25 cents.

If the option on this stock was a put rather than a call the buyer will benefit if the stock’s price falls rather than rises.

From these two examples we can draw the following important conclusions:

• The maximum amount that an option buyer can lose is the option price. 
• The maximum profit that the option seller can realise is the option price.

In other words: an option buyer has a lot of upside potential and limited downside risk; whereas an option writer has limited upside potential and a lot of downside risk.