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An option gives the buyer or holder the right, but not the obligation, to buy or sell an underlying financial asset at a pre-determined price. Unlike the sale or purchase of a futures market contract where the holder has to fulfil the contract at some future date an option gives holder the choice of whether to exercise or not. An option contract specifies a future date on or before which it can be exercised, the expiry date. An option's strike price or exercise price is the price at which the underlying asset can be bought or sold. Options are very flexible instruments. They allow investors to benefit from favourable price movements while limiting the consequence of unfavourable price movements. Option holders have to pay a premium for this protection as with any insurance contract. There are two kinds of option; a call option, which gives the holder the right to buy the underlying instrument at the strike price and a put option, which gives the holder the right to sell it at the strike price. More than one option transaction can be combined to create a spread. These strategies usually involve the simultaneous purchase and sale of options with different prices, or expiry dates, within the same class. American options can be exercised at any time before the expiry date, whereas European options can be exercised only at the expiry date and not before. Options can be traded on exchanges or they can be traded over the counter (OTC).
See also: Derivatives, In the Money, Out of the Money, At the Money, Option Holder, Option Writer, Option Premium, Omega, Barrier Option, Trigger Option, Look Forward Option, Straddle, Strangle, Butterfly Spread, Binary Option, Combined Option