An option is a financial derivative. Options are based on the value of their underlying security, such as stocks, indexes, currencies, ETFs, etc. By buying an options contract, a trader earns the right to buy and sell the underlying asset at a specific price and within a specific time frame. Contrary to futures, holders do not have the obligation to sell or buy the asset if they decide not to. There are two types of options: puts and calls.
An options contract has a specific expiration date. The price of an option is called the strike price.
Options are mostly traded through online trading platforms.
How do options work?
There are two parties involved: the buyer and the seller. The options buyer pays a premium for the rights to buy or sell an asset. Call options give the buyer the right to buy the underlying asset at a predetermined price up to the expiration date. Put options give the buyer the right to sell the underlying asset at a predetermined price up to the expiration date.
An options contract represents 100 shares. The seller of the contract offers the contract for a premium. The buyer of the contract chooses to pay a premium to have the option of buying or selling the contract for a predetermined strike price by or on a specific date.
For example, if a contract accounts for 100 shares and the premium on those shares is $3, the contract will be worth $300. If we assume that this is a call options contract, the buyer will now have the option to buy stock but won’t be able to sell it.
If the strike price for this contract is $50 and the contract matures a month later, at some point before the contract matures, the stock might be valued at $70. The trader is up $20 per share ($70 – $50). So, if you multiply the 100 shares by $20, the trader would have $2000. If you subtract the initial investment of $300, the trader would’ve made $1700 in profits.
Benefits of Options
Options are an excellent way for investors to hedge their risk and leverage their positions. For example, if an investor is bullish and wants to buy $10,000 worth of stocks, he could get a better return by buying $10,000 worth of call options on the stock.
In a way, options leverage the position by increasing the buying power.
Hedging with options works by taking an opposite position. For example, if an investor holds a position in a company, he could hedge and reduce exposure by selling put options against the same company.
Drawbacks of Options
One of the main drawbacks of options is that they are complex, difficult to price, and can lead to substantial losses. We have seen a trend of more retail traders trading options in recent years due to the potential for high returns and losses. Options are suitable for knowledgeable and experienced investors due to their complexity.
Option Premium
The premium of an option is its price on the market. The premium consists of an intrinsic and extrinsic value for in-the-money options and extrinsic or time value for out-of-the-money contracts. The premium is more significant for more time to expiration or greater implied volatility.
Strike Price
The strike price is a set price at which a contract can be sold or bought when the option is exercised. For call options, the strike price, is the price where the option holder can buy the asset. For put options, the strike price is the price where the option holder can sell the security.
Expiration date
The expiration date is the last date on which the contract holder can exercise the option according to its terms.
Call options
Calls give the buyer the right to buy the underlying asset at the strike price, not the obligation. Investors buy calls if they predict the asset price will increase and sell calls if they think it will decrease. Calls become more valuable if the underlying security goes up in price. This means calls have a positive delta.
Put options
Calls give the buyer the right to sell the underlying asset at the strike price, not the obligation. Investors buy puts if they predict the asset price will decrease and sell puts if they think it will increase. The seller (writer) of the option is obligated to buy the asset if the buyer decides to exercise their option.
In the money
For the buyer of contracts, calls are in the money or profitable when the price of the underlying security is above the strike price. Put options are in the money when the price of the underlying security is below the strike price.
Out of the money
Call options are out of the money when the strike price is above the market price of the underlying security. Put options are out of the money when the strike price is below the market price of the underlying security.
At the Money
When the price of the underlying asset and the strike price is the same, options contracts are at the money. This is when an investor can sell them for a profit.
Difference between American and European Options
The main difference between American and European options is the exercise date. American options can be exercised at any time up to the expiration date. European options can only be exercised on their expiration date. Because American options give you more opportunities to sell, they typically have a higher premium than the European option.
Difference Between Options and Futures
Both options and futures are based on the underlying assets. The main difference is that with futures you have the obligation to buy or sell the asset in the future
Trading Options Contracts
Generally, options contracts are traded on major market exchanges. They are strictly regulated by the Securities and Exchange Commission (SEC).
If you are keen on trading options, we advise you to stick to the regulated market exchanges and avoid over-the-counter (OTC) markets. Options trading is risky enough without the added risk of trading on an unregulated exchange.
If you want to trade options, we advise going with a regulated brokerage firm. This can be either a discount broker or a traditional full-service broker, depending on both your preference and cash on hand.
A downside is that, because of the high risks associated, you will be required to apply first. This application will ask you very personal questions about your income, level of investing and trade experience, and your knowledge about options.
In Summary
Options contracts are financial derivatives that trade underlying assets, most often stocks.
This type of financial instrument is high risk, and traders who opt for options have the opportunity to earn huge profits or make significant losses.
We would recommend options trading to more advanced traders who have extensive experience in trade and investments.
