What options are. Examples of options hedging.
An option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option
Hedging means reducing risk exposure in the market. A hedge is an investment that is taken out speciafically to reduce or cancel out the risk in another investmnt, is a strategy designed to minimize exposure to unwanted business risk, while still allowing the busness to profit from an investment activity, In effect is a similar to purchasing an insurance policy on your financial security
An option can be a ‘call’ option or a ‘put’ option.
A call option gives the buyer, the right to buy the asset at a given price. This ‘given price’ is called ‘strike price’. It should be noted that while the holder of the call option has a right to demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have a right.
A ‘put’ option gives the buyer a right to sell the asset at the ‘strike price’ to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy.
So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as ‘premium’. Therefore the price that is paid for buying an option contract is called as premium.