Options

What are Options?

In finance, options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific period.

If you are holding a call option, you have the right to buy the underlying asset. If you have a put option, you have the right to sell the underlying option.

Options are commonly used in financial markets for hedging, speculation, and income generation.

Today, a vast majority of the options are cash settled and will not give you any right to actually buy or sell the underlying asset. If you want to obtain an option that actually gives you a right to take delivery of the underlying asset or sell the underlying asset, the selection of available options will be much smaller and it will be more complicated to obtain this type of option.

Types of Options

Call Options

A call option gives the holder the right to buy an asset at a specified price (strike price) before or on the expiration date. Investors buy call options if they expect the asset’s price to rise.

Put Options

A put option gives the holder the right to sell an asset at a specified price before or on the expiration date. Investors buy put options if they expect the asset’s price to fall.

How Options Work

Options Trading

When you buy an option, you pay a premium to the seller for the right to buy or sell the asset at the strike price. This premium is the cost of the option.

If the option is in-the-money (favorable price movement), the holder can exercise the option to buy or sell the asset at the strike price. If it’s out-of-the-money (unfavorable price movement), the holder can let the option expire, losing only the premium paid.

Option Writers

Option sellers (writers) receive the premium in exchange for taking on the obligation to buy or sell the asset if the holder exercises the option.

Benefits and Risks

Benefits

• Efficient: You can gain exposure to a price, e.g. a stock price, without actually owning the asset. This can help keep transaction costs down.
• Leverage: Brokers that offer options typically also offers leverage. You can therefore control large positions with a smaller investment.
• Flexibility: Options can be utilized for various strategies to profit from different market conditions. You can profit from falling prices without short-selling.
• Risk Management: You can use options to hedge against potential losses in other investments.

Risks

• Limited Time: Options have an expiration date, and if the anticipated price movement doesn’t occur within this period, the option can expire worthless. This makes the option different from many other instruments. If you for instance were to purchase actual company shares instead, and the price drops, you could always decide to hold on to them for a long time, hoping that the price will go up again.
• Complexity: Long-term successful option traders typically have a deep understanding of market movements and option pricing.

Common Strategies

Covered Call

This strategy involves holding a long position in an asset and selling a call option on the same asset.

Protective Put

This strategy involves holding a long position in an asset and buying a put option on the same asset. This strategy protects against downside risk.

Straddle

This strategy involves buying both a call option and a put option with the same strike price and expiration date. This strategy profits from significant price movements in either direction.

Final thoughts

Options are versatile financial instruments used for hedging, speculation, and income generation. They provide opportunities for profit in various market conditions but also come with risks. Understanding the basics of options, how they work, and common strategies can help investors use them effectively in their portfolios.