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Options have now become a mainstream product. Once used mainly for hedging, the introduction of options contracts on retail trading platforms has led to the rise of trading options as if they were regular assets.
As options expiry frequencies were increased, now to daily expiries for a great many underlying instruments, options trading has become a powerful force.
These financial instruments can be powerful tools in an investor’s toolkit, but they also come with complexities that require understanding before diving in.
In this post, we’ll break down the basics of options—what they are, how they work, key terms to know, how they can be used, and some relevant risks to note.
What Are Options?
Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an asset at a specific price within a certain period of time. The underlying asset could be stocks, bonds, commodities, or even currencies.
A buyer of options is called a holder and a seller of options is called the writer. The writer always has an obligation towards the holder, but the holder doesn’t have an obligation.
The two main types of options are call options and put options.
Call Options
A call option gives the buyer the right to purchase an asset at a predetermined price (called the strike price) before the option expires. Investors typically buy call options when they expect the price of the underlying asset to go up. If the price rises above the strike price, the option becomes more valuable, allowing the buyer to purchase the asset at the lower strike price.
For example, imagine you buy a call option for stock ABC with a strike price of $50. If ABC’s stock price rises to $60, you have the right to buy the stock for $50, potentially profiting from the $10 difference. However, you would be paying a cost or a premium to buy this option and therefore, your profit would be $10 less the premium.
However, if the price moves lower to say $40, then you can just buy the stock in market for lower price, and you would let your options contract expire worthless. Note that you would however, be losing your premium, or the cost you paid to purchase the option.
Let’s look at a payoff diagram that may make this clearer.
Let’s say you bought an option on ABC stock for $2 as a premium, with a strike price of $50. This is what the payoff would look like:
As you can see, if we allow this option to expire worthless, our loss will be the $2 in premium. This is why people often say the downside is capped. Also note, that although our strike price is $50, our breakeven would be at $52, because we only start to make money on this option if the market price of the stock moves above the strike price and our cost, which is ($50+$2) = $52.
Technically, the payoff diagram also makes it very clear, that the potential upside is unlimited. However, note that this is only in theory because the option will have an expiry and the upside will end at the market price on the day the option expires.
Remember: Always factor in the premium! While it may seem that buying call options is risk-free, because your downside is capped, over time the premiums add up.
Put Options
A put option is kind of the opposite of a call. It gives the buyer the right to sell an asset at the strike price before the option expires. Investors buy put options when they anticipate that the price of the underlying asset will fall. If the asset’s price drops below the strike price, the option becomes more valuable, as the holder can sell the asset at the higher strike price.
For instance, if you own a put option with a strike price of $50, and the stock falls to $40, you can still sell the stock for $50, potentially making a profit, minus the premium paid.
The payoff diagram for a put option is slightly different.
As you can see, while the downside is capped, the upside is also limited on a put option. The maximum profit you can generate is the payoff if the underlying asset price goes to zero. As before, if the premium paid is $2, then the buyer starts making money only once the breakeven price of ($50-$2) = $48 is reached. At any level below $48, the buyer would exercise the option to make a profit.
Key Terms to Know
Here is a summary of a few key terms related to options that we should know:
Strike Price / Exercise Price: The predetermined price at which the buyer of the option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
Premium: The cost of the option, which is paid to the seller (also known as the option writer). It’s the price you pay to gain the right to exercise the option.
Expiration Date: The date on which the option expires. After this date, the option becomes worthless if not exercised.
In the Money: When an option is profitable. For a call option, this means the market price is above the strike price. For a put option, the market price is below the strike price.
Out of the Money: When an option is not profitable. For a call option, this means the market price is below the strike price. For a put option, the market price is above the strike price.
How Options Work
When you buy an option, you’re essentially paying for the right to potentially profit from a move in the price of the underlying asset without actually owning the asset itself. The option’s premium (the price you pay) is determined by several factors, including:
The current price of the underlying asset: The closer the asset’s price is to the strike price, the more valuable the option.
Time to expiration: The longer the time before the option expires, the more expensive the option, as there’s more time for the asset’s price to move.
Volatility: If the underlying asset is volatile, meaning its price tends to fluctuate widely, the option’s premium will likely be higher. This is because there’s a greater chance the asset will reach a profitable price.
Options can be either exercised (where the buyer buys or sells the underlying asset) or traded (where the buyer can sell the option itself for a profit or loss before it expires).
Why Use Options
Options can serve a variety of purposes, from hedging risk to amplifying returns. Here are some common uses:
1. Hedging
One of the most common uses of options is as a hedge—a way to protect against potential losses. For example, if you own shares of a stock and fear its price might fall, you could buy a put option to protect yourself. If the stock does decline, the put option would increase in value, offsetting some of your losses.
2. Speculation
Options also offer a way to speculate on the direction of an asset’s price. If you believe a stock is going to rise significantly, buying a call option allows you to profit from that rise with a much smaller investment than buying the stock outright. Similarly, if you expect a stock to fall, buying a put option lets you profit from the decline.
3. Income Generation
Some investors use options to generate income. By selling (or “writing”) options, particularly call options, they collect premiums, which can provide a steady stream of income. However, this strategy comes with the risk that the option buyer may exercise the option, forcing the seller to buy or sell the underlying asset at a less favorable price.
Options Strategies
What kind of option you buy will depend on your view of the underlying asset. We’ve set out some strategies below based on your market view of where you think the underlying asset's price may go. But always remember that selling options comes with an obligation to buy or sell the underlying, and therefore is much riskier.
The Risks of Options
While options can be profitable, they also come with risks. One of the main risks is that options can expire worthless if the underlying asset’s price doesn’t move as expected. In that case, you lose the premium paid for the option. Options can also be complex, with pricing influenced by volatility, time decay, and market sentiment, to name a few factors.
For sellers, the risk can be even higher. Selling a call option without owning the underlying asset (a strategy known as writing a "naked" call) can result in unlimited losses if the asset’s price rises significantly.
Conclusion
Options are versatile financial instruments that can be used for a variety of investment strategies, from hedging risk to speculative trading. However, they require a solid understanding of how they work and the risks involved. In this day and age, with options becoming more and more relevant, it’s important to constantly remind ourselves about the basics.
If you’re new to options, consider starting with a small position and gradually increasing your exposure as you become more comfortable. And remember, while the potential for profit is there, so is the potential for loss—so it’s crucial to stay informed and make decisions based on your financial goals and risk tolerance.
The above article is presented for information and educational purposes only. The article is not investment or trading advice.
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