Definition
An option is a derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed strike price on or before an expiration date. The buyer pays a premium to the seller, who takes on the obligation.
How it works
The two basic types are calls, which give the right to buy, and puts, which give the right to sell. A buyer's maximum loss is the premium paid, while the seller keeps the premium but must perform if the buyer exercises, so a seller's loss can be much larger.
Exchange-listed options are standardized by strike, expiry and contract multiplier, which is the number of units one contract covers. The quoted premium is per unit, so the cash cost is the premium times the multiplier times the number of contracts. Time to expiry, the underlying price and volatility all affect the premium.
Formula / convention
Total premium = Quoted premium per unit × Contract multiplier × Number of contracts
Illustrative example
A fictional listed option covers 500 units of Sample Co and is quoted at a premium of HK$1.20 per unit, so the buyer pays 1.20 × 500 = HK$600 up front. That HK$600 is the most the buyer can lose, while the seller receives HK$600 but carries the obligation if the option is exercised.
What to watch for
Buyers can lose the entire premium if the market does not move enough before expiry, and sellers can face losses far larger than the premium they collected.