An option is a contract between two parties. The first party, who purchases the option, has the right but not the obligation to buy or sell at a stated price, who we call the “writer” of that option.
The second party is obligated to do whatever its writer says if its counterparty chooses to exercise his rights under the terms and conditions of that contract. That means if you own an options contract for 100 shares on IBM stock, you can’t pick its strike price and timing; those are determined by your counterparty (the writer). But as long as it’s profitable for him (or her), you will make money whether he means it or not.
It sounds more complicated than it is. Let’s look for example at this September 2019 put option on Apple stock (AAPL) by a Saxo FX broker UAE:
Expiration date: Sep 19,2019
Option type: Put Option
Strike Price: 600 Bid/Ask : 2.18 / 2.20 Volume OI: 0 Open Interest: 0
This contract gives its buyer the right to sell 100 shares of Apple Incorporated (AAPL) on Friday, September 20th, 2019. The buyer has the “right” but is not obligated to do that. The buyer has the right to sell (or write) it, and anybody who takes possession of this contract can also exercise its rights if he wants.
The seller of this option (counterparty) is obligated to purchase 100 shares from “the buyer” if he decides to exercise his right on September 19th. Stay with me now, don’t get confused by what you read above. Sellers have an obligation, but they also have a choice! Let’s assume today is Monday, September 10th, 2019, I own one put option for AAPL at strike price 600 expiring on September 19th.
What happens next? First, I need to be correct in assuming that Apple Inc will fall below $600 a share before September 19th, 2019. Otherwise, I will have to buy 100 shares of Apple for $60,000 no matter the current price! And that’s why it’s called an obligation. But let’s assume you are right, and after two weeks, AAPL will be down at 540$ per share on the expiration date. You can sell your options contract at a value much higher than the one you bought it, i.e. 2.18$ per share. If that happens, the writer of this option has an obligation to buy 100 shares from me for 60,000$. So even though he was unwilling to initiate this transaction before today, i.e. write this option in the first place, now at least he doesn’t have any choice but to trade with me.
In this example, I bought a put option on AAPL at the strike price of 600 expiring on September 19th, 2019, for 2.18$ per share, which is also its bid price today. This option gives me the right but not the obligation to sell 100 shares of Apple Inc on September 19th, 2019, at 600$.
If, on the expiration date, AAPL will be below $600 a share, then my put options will be “in the money”, and its value will be higher than 2.18$ per share, i.e. let’s say 3$. In that case, I can sell it for 3$ per share and keep the difference as my profit. If it won’t, if after two weeks from now, AAPL will still be at 605$ per share on September 19th, 2019, then my put options will expire worthless.
Let’s assume I am not correct, and AAPL will stay above the strike price of 600$. In this case, I will never exercise my contract, and it will expire worthless, i.e. its value at the expiration date is equal to 0$.
If you ask yourself, “why would anybody sell me an option if he knows that his obligation is more important than mine?” Well, there are several reasons: It might be that he’s bullish on Apple Inc, meaning that he thinks it’s going up in the next two weeks before September 19th but not above $600 a share (strike price). If you were wrong, meaning AAPL went down, he still has the choice not to buy 100 shares from you at the strike price of 600$. He might have another reason to sell options.