The term option refers to a financial instrument that is based on the value of underlying securities such as stocks, indexes, and exchange-traded funds (ETFs). An options contract offers the buyer the opportunity to buy or sell—the specific action depends on the type of contract held—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they decide against it. Each options contract comes with a set expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are generally traded 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 tailored for hedging, income, or speculation.
- Options trading can be used for both hedging and speculation, with strategies ranging from simple to sophisticated.
- Although there are many opportunities to profit with options, investors should carefully assess the associated risks.
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 time frame. Put options, on the other hand, allow the holder to sell the asset at a stipulated price within a predetermined period. Each call option typically has a bullish buyer and a bearish seller, whereas each put option has a bearish buyer and a bullish seller.
Traders and investors trade options for diverse reasons. Options speculation lets a trader hold a leveraged position in an asset at a lower cost than buying shares of the asset outright. Investors leverage options to hedge or lessen the risk exposure of their portfolios. Additionally, options can occasionally generate income for the investor.
Both American and European options have distinct characteristics concerning the exercise date. American options can be exercised at any time before their expiration date while European options can only be exercised on the exercise date itself.
Types of Options
Calls
A call option gives the holder the right, but not the obligation, to buy the underlying security at the predetermined strike price on or before the expiration date. As the underlying security rises in price, the value of a call option increases. This makes a long call option a preferred strategy to speculate on an anticipated price increase.
Puts
Contrary to call options, a put option gives the holder the right, but not the obligation, to sell the underlying stock at the strike price on or before the expiration date. A long put position benefits from a price decline, as the put option increases in value.
American vs. European Options
American options can be exercised at any moment between the purchase date and the expiration date, while European options can only be exercised on the expiration date itself. Given this flexibility, American options typically command a higher premium compared to otherwise identical European options.
Special Considerations
Options contracts typically represent 100 shares of the underlying security, and the buyer pays a premium fee per contract. Factors influencing the premium include the strike price and the expiration date, which may vary from daily to quarterly.
Options Spreads
Options spreads utilize various combinations of buying and selling different options to achieve the desired risk-return profile. Example strategies include bull call spreads and iron condors among others.
Options Risk Metrics: The Greeks
The term “Greeks” represents different aspects of risk in options trading. Key Greeks include Delta, Theta, Gamma, Vega, and Rho:
Delta
Delta (Δ) indicates the price sensitivity of the option relative to the underlying.
Theta
Theta (Θ) signifies the rate of change between the option price and time, indicating time decay.
Gamma
Gamma (Γ) shows the rate of change between an option’s delta and the underlying asset’s price.
Vega
Vega (V) represents sensitivity to volatility, signifying the change in an option’s value with a 1% change in implied volatility.
Rho
Rho (p) indicates the rate at which an option’s value changes for every 1% change in the interest rate.
Advantages and Disadvantages of Options
Buying Call Options
A call option’s advantage is allowing the holder to purchase an asset below the market price if market conditions are favorable, with a loss limited to the premium paid.
Selling Call Options
Selling call options allows the writer to earn premium income but involves higher risk since unlimited losses are possible if the asset’s price skyrockets.
Buying Put Options
Buying put options provides a way to profit from declining asset prices with the potential loss capped at the premium paid.
Selling Put Options
Selling put options offers premium income with the risk that the seller might need to buy the asset at a price above the market if it declines.
Pros
- Option buyers can leverage potential gains.
- Sellers earn premium income.
Cons
- Option writers face high exposure to risk.
- Buyers must pay premiums upfront.
Example of an Option
Let’s consider an example involving Microsoft (MSFT):
Suppose Microsoft shares are trading at $108 each, and you believe they will appreciate. You buy a call option with a $115 strike price, one month from now, for $0.37 per contract. Your total cost is $37. If MSFT rises to $116, the option is now worth $1, translating to significant profit compared to the premium paid. Conversely, should MSFT drop to $100, the maximum loss is limited to your $37 premium outlay.
Options Terminology to Know
Familiarize yourself with the key terminologies of options trading:
- At-the-money (ATM): Option strike price equals underlying trading price.
- In-the-money (ITM): Option holds intrinsic value.
- Out-of-the-money (OTM): Option’s value contains no intrinsic worth.
- Premium: Market price of an option.
- Strike price: Agreed price to trade the underlying asset.
- Underlying: Security tied to the option.
- Implied volatility (IV): Market-predicted volatility of the underlying.
- Exercise: Execution of trading rights assigned by the option contract.
- Expiration: Date on which the contract becomes void.
How Do Options Work?
Options enable speculation or hedging against an underlying’s price changes and bifurcate primarily into calls, which benefit from rising prices, and puts, which benefit from falling prices.
What Are the Main Advantages of Options?
Options provide leverage, enabling investors to control larger positions with smaller capital while hedging risks effectively.
The Disadvantages of Options
The complexity and challenging pricing of options make them best suited for experienced traders. The risk of significant losses necessitates thorough understanding before partaking in options trading.
How Do Options Differ From Futures?
Options provide the right but not the obligation to buy or sell an asset, unlike futures contracts, which obligate the transaction at expiration.
Is an Options Contract an Asset?
Yes, options represent derivative securities, classifying them as an asset type.
The Bottom Line
Options offer a way to leverage trading propositions or hedge against price volatility, where investors may also opt to short options for strategic benefits, provided they meticulously manage the risk implications.
Related Terms: strike price, expiration date, underlying security, American options, European options, premium.
References
- U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options”.
- CME Group Education. “Understanding the Difference: European vs. American Style Options”.
- The Options Industry Council. “Delta”.
- Financial Industry Regulatory Authority. “Options: Types”.
- CME Group Education. “What is Expiration Date (Expiry)?”
- The Options Industry Council. “Volatility & the Greeks”.
- CME Group Education. “Options Delta - The Greeks”.
- The Options Industry Council. “Theta”.
- Emery, Douglas R. and et al. “A Closer Look at Black–Scholes Option Thetas”. Journal of Economics and Finance, vol. 32, October 2007, pp. 59-74.
- The Options Industry Council. “Gamma”.
- McCormick School of Engineering, Northwestern University. “Math Lab: Constructing Greek-Neutral Portfolios of European Stock Options”.
- The Options Industry Council. “Vega”.
- CME Group Education. “Options Vega - The Greeks”.
- The Options Industry Council. “Rho”.
- Financial Industry Regulatory Authority. “Options: Buying and Selling”.
