What Is an Option?
09-22 15:00uSMART

 

I . What Is an Option?

The term option refers to a financial instrument that is based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they decide against it.

 

Each options contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.

 

KEY TAKEAWAYS

  • Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
  • Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.
  • Options trading can be used for both hedging and speculation, with strategies ranging from simple to complex.
  • Although there are many opportunities to profit with options, investors should carefully weigh the risks.

 

II . How Do Options Work?

Options are a type of derivative product that allow investors to speculate on or hedge against the volatility of an underlying stock. Options are divided into call options, which allow buyers to profit if the price of the stock increases, and put options, in which the buyer profits if the price of the stock declines. Investors can also go short an option by selling them to other investors. Shorting (or selling) a call option would therefore mean profiting if the underlying stock declines while selling a put option would mean profiting if the stock increases in value.

 

III. Understanding Options

Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract. Call options allow the holder to buy the asset at a stated price within a specific timeframe. Put options, on the other hand, allow the holder to sell the asset at a stated price within a specific timeframe. Each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller.

 

Traders and investors buy and sell options for several reasons. Options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors use options to hedge or reduce the risk exposure of their portfolios.

 

In some cases, the option holder can generate income when they buy call options or become an options writer. Options are also one of the most direct ways to invest in oil. For options traders, an option's daily trading volume and open interest are the two key numbers to watch in order to make the most well-informed investment decisions.

 

American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.

 

IV. Example of an Option

Suppose that Microsoft (MFST) shares trade at $108 per share and you believe they will increase in value. You decide to buy a call option to benefit from an increase in the stock's price. You purchase one call option with a strike price of $115 for one month in the future for 37 cents per contact. Your total cash outlay is $37 for the position plus fees and commissions (0.37 x 100 = $37).

 

If the stock rises to $116, your option will be worth $1, since you could exercise the option to acquire the stock for $115 per share and immediately resell it for $116 per share. The profit on the option position would be 170.3% since you paid 37 cents and earned $1—that's much higher than the 7.4% increase in the underlying stock price from $108 to $116 at the time of expiry.

 

V. Types of Options

(1)Calls

A call option gives the holder the right, but not the obligation, to buy the underlying security at the strike price on or before expiration. A call option will therefore become more valuable as the underlying security rises in price (calls have a positive delta).

 

A long call can be used to speculate on the price of the underlying rising, since it has unlimited upside potential but the maximum loss is the premium (price) paid for the option.

 

(2)Puts

Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell the underlying stock at the strike price on or before expiration. A long put, therefore, is a short position in the underlying security, since the put gains value as the underlying's price falls (they have a negative delta). Protective puts can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.

 

VI. Advantages & Disadvantages

Advantages

  1. A call option buyer has the right to buy assets at a lower price than the market when the stock's price rises
  2. The put option buyer profits by selling stock at the strike price when the market price is below the strike price
  3. Option sellers receive a premium fee from the buyer for writing an option

 

Disadvantages 

  1. The put option seller may have to buy the asset at the higher strike price than they would normally pay if the market falls
  2. The call option writer faces infinite risk if the stock's price rises and are forced to buy shares at a high price
  3. Option buyers must pay an upfront premium to the writers of the option