An option is a contract to buy or sell a specific financial product, which is called the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, ETF or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised. And it has an expiration date. When an option expires, it no longer has value and no longer exists. Options are most frequently used to remove market risk in owning or trading in an individual security or market segment.
A certain number of trading decisions will inevitably be unsuccessful—because of unlucky timing, incorrect information, unforeseen events and just plain getting it wrong. Options are a useful tool for limiting potential loss and maximizing potential gain—in other words, improving the risk-reward ratio of your trading.
With options, it is possible to trade for profit in a rising, falling, or even static market. You can:
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Participate in short-term price movements with limited capital outlay—an option is a "geared" investment, putting less capital at risk.
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Participate in short-term price movements with limited downside risk—an option can have a pre-determined, fixed level of maximum potential loss.
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Hedge against a fall in the price of an asset—an option can be used like an insurance policy to make short term adjustments to your portfolio's exposure.
