An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (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, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.
Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices – whether to buy or sell and whether to choose a call or a put – based on what you want to achieve as an options investor.
Options can be used to generate added income from securities, like stocks that you already own. The most common of these are “covered call options.” They can also be used as a temporary insurance policy against a decline in the price of a stock or the market as a whole. The most common of these are known as “protective puts.”
Options are complex instruments that require a sophisticated understanding of securities, and while some options can be used to reduce risk, others can create large amounts of risk.
Arie J. Korving, a CERTIFIED FINANCIAL PLANNER™ professional, has been delivering customized wealth management solutions to his clients for more than three decades. Prior to co-founding Korving & Company, he was First Vice President with UBS Wealth Management and held management positions with General Electric.