What is an option?

Option definition
Options are financial derivatives of stocks, exchange traded funds (ETFs), financial indices, like the S&P 500 (symbol SPX), and futures. (Stocks and ETFs are referred to as equities).
Each option is a contract between buyers and sellers. Most option contracts represent 100 shares of stock. And every option has a specified contract expiration date. Instead of buying or selling a stock or an ETF, an option trader buys and sells option contracts by paying or receiving option premium, where premium is the current value of an option contract at a given option price.
The premium values are mathematically derived from the current market price of the underlying equity, current trading volume (or buying and selling volatility), and the amount of time remaining until the option contract expires.
The premium values are mathematically derived from the current market price of the underlying equity, current trading volume (or buying and selling volatility), and the amount of time remaining until the option contract expires.
Options Profit chart
Option P&L chart
Options profit/loss chart
Option premiums increase and decrease as the price of the underlying equity fluctuates up and down. Option premiums are also sensitive to buying and selling volatility in addition to the amount of time remaining in the option contract, i.e., until expiration.
Therefore, an option is a depreciating asset. If held to expiration, the option becomes worthless. It follows that option traders, just like stock traders, want to buy low and sell high. Or, the option seller wants to sell high and buy back low and keep the difference as profit.
Option sellers who wish to keep a portion of the premium received from selling one or more options contracts can buy back their option for less that they originally received, i.e., sell for a dollar and buy back for a dime.
Many option sellers retain their positions until the contract expires worthless for even more profit. But as you will see, a seller can be forced to close their position for a loss if market conditions turn against them. Consider the premium homeowners pay for an insurance policy.
A homeowner may pay $2,000 each year for homeowner's insurance on a $300,000 house. The insurance company is essentially selling the homeowner an option that has a 1-year duration. If the house is destroyed by a storm during the life of the insurance contract, the homeowner exercises the option and the insurance company delivers $300,000 less deductibles. But if the same storm strikes the day after the policy expires without the homeowner's renewal, the insurance company is "off the hook," the insurance policy expires worthless, and the homeowner receives nothing.
The $2,000 premium is based on calculations that determine the statistical probability of the insured asset being damaged or lost.
The computation includes the volume of insurance policies being written in a given geographical region. The insurance company bases the premium on its exposure to risk.
Another dynamic of insurance policy premium is how it drops in value with time. Six months after a homeowner pays $2,000 in premium the homeowner decides to sell the insured house and move to another state.
The insurance company returns the value that remains in the policy, which would be around $1,000. The insurance company keeps the $1,000 as profit.


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