Characteristics of an option
Options derive their value from an underlying security.
Unlike the forward or future, an option is conditional and therefore doesn’t have to take place. Same as a future, also an option depends on a base value. Options are also standardized financial instruments. You can choose your amount, term, and exercise price.
Options are sold from a seller (short) to a buyer (long). In this trade, one investor thinks the underlying security price will increase, while the other thinks the price will decrease.
The buyer of an option
The buyer of the option pays a premium to the seller and therefore receives the right to buy or sell a security to the seller. The buyer of an option (long) can choose between the following 2 kinds of options:
Either a right to buy (call option) -> The option buyer would buy a call option if he thinks the underlying price will rise.
or a right to sell (put option) -> The option buyer would buy a put option if the thinks the underlying price will fall.
The seller of an option (short)
The seller of an option sells the kind of option that he thinks will not be exercised. If the option buyer exercises his option, the seller must buy or sell a security at a specified point in the future. For selling that right to the option buyer, the option seller receives a premium from the buyer.
That could be either a put (short) or a call (short). So in case, the seller sells a call (short), he expects that the underlying (e.g., stock) prices fall or stay the same. On the other hand, if he sells a put (short), he expects that prices of the underlying will increase or stay the same (e.g., the stock will increase) cause the buyer of the option wouldn’t sell then at the lower strike price of the option.
But remember, as it is an option, contrary to the buyer, the seller has an obligation to fulfill the contract if the buyer exercises his option.
Example Stock vs Call on a stock
As you can see, if the stock price falls below the option’s strike price, you can’t lose money (except for the premium you paid for the option). So while buying an option limits your downside risk, writing (selling) an option (especially a call option) exposes you to many risks.