Introduction to Options
As always, we shall start with a definition. Options are a form of derivative. Options take the form of a contract where one party sells the right in the contract (often called the writer of an option) to the buyer of an option. The buyer pays a premium for the option to the seller and in return the buyer has the right but not the obligation to exercise the option. The option contract has references to the underlying asset, the duration of the option and expiry date and a reference price as well.
These contracts are traded both over the counter (OTC) and on exchanges. There are two types of options, call options and put options. Call options entitles the buyer to buy the asset by a fixed date and price. Put options entitle the buyer to sell the asset by a fixed date and price. The price of the contract is known as the strike price, which is agreed by both parties, and the contract should be executed by a particular date known as exercise date.
As well as call and put options there are American and European options too. Don’t be fooled by their names as they have no relation to where they are traded. There is a difference between American and European options. American options can exercised at any time during a pre-agreed period whereas European options have to be exercised on the exercise date (one date). This means that American options are more valuable than European options as the former gives the buyer more opportunities to exercise over some duration of time rather than as at expiry date as with European options.
There are four different positions a trader can place in the options market. These positions are as follows; long calls, short calls, long puts, short puts. A long call is when a trader believes that the option exercise price will be greater than the share price and that the share price will increase. The trader then has the option to buy the stock at a designated price. If the share price is higher than the exercise price then the trader profits.
A short call is when the trader thinks the share price of a stock will decrease when the other party has an option of buying the shares from the trader. If the share price decreases then the trader will make a profit. If the stock price increases then the trader will make a loss.
A long put is when the trader thinks the share price is in a bearish market. In other words, the share price will decrease. The trader can sell the stock before the exercise date. If the share price is below the strike price then he/she will make profit. If the share price is above the strike price than the contract will be not be valuable and the contract will run its course until the exercise date.
A short put is when the trader thinks that the share price is in a bullish market. In other words, the share price will increase. If the share price of the stock is above the strike price then he/she shall make profit. If the share price of the stock is above the strike price then he/she shall make profit.
There are two uses of options for financial intermediaries, one is for speculative purposes and the other use is for hedging. It is also important to note that there are transaction costs which involve the execution of the trade. It is might be wise to diversify your portfolio as this may help diversify the risk across all asset classes.
Options contracts do bear risks. The seller/writer of an option can have infinite losses if markets go against the seller. The buyer of an option only stands to lose the premium he/she has paid.
