Exploring The World Of OPTIONS
The stock market is made up of several different types of financial instruments. To succeed as an investor or trader, one needs to have proper knowledge about every asset class. From equity to derivative instruments, there are a plethora of options that a trader or investor can choose from. While investing and trading in equity is pretty straightforward to understand, financial derivatives can be a bit tricky. Being an active market participant, you might have heard about options.
Options are one such financial instrument that traders and investors can use to their benefit. When you purchase a stock, you own a very small portion of that company and can hold on to your investment forever. However, options on the other hand are financial contracts made between two parties that have an expiration date. Financial derivatives might seem like a complicated topic initially, but once you have a proper understanding of the framework, you can use derivatives to your advantage and create a well-diversified and balanced portfolio.
While some people may not be interested in trading options, we at Financial Education believe that having proper knowledge about every financial instrument is crucial to succeeding in the financial markets. Options give investors the ability to hedge their investments, speculate on their analysis, and much more. So, in this article, we shall go over what options are, how they work, and dive deep into the world of this financial derivative. So, let’s get started!
What Are Options?
So, before we begin, let’s understand what options are from the very basics. In the world of finance, an option is a contract that gives its owner or holder the right, but not the obligation, to buy or sell an underlying instrument or asset at a pre-specified strike price before the contract expires on the expiry day. Options can be bought or sold just like any other asset class using brokerage accounts. Options are generally purchased to speculate on the price movement of an underlying asset or financial instrument, hedge positions and investments, or diversify and balance one’s portfolio. Options are part of the larger group of securities known as derivatives. The price of a derivative is derived from the price of the underlying asset it is based upon.
Therefore, options are also a type of financial asset that have a valuation and can also be traded to generate profits. Their valuation has a complex relationship between the underlying asset value, market volatility, time until expiration, and several other factors. Options can be traded in over-the-contract (OTC) transactions between private parties or they can also be exchange-traded in live markets in the form of standardized contacts. So basically, an option is a contract that allows a buyer the right to buy or sell an underlying asset or financial instrument at a specified strike price on or before a specified date, depending on the form of the option.
The strike price may be set by reference to the spot price (market price) of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction (to sell or buy) if the buyer (owner) “exercises” the option. Options are of several types, that include; stock options, commodity options, index options and more.
We at Financial Education believe that options are a very powerful and efficient asset class as they can help enhance an individual’s portfolio. They can add additional income, protection, and the benefit of leverage to a portfolio and also help in diversification and hedging. It all depends on the need of the investor and the scenario they are going to use options in. While some may use options to hedge their positions and investments against sudden volatility and black swan market events, others may use them to generate a consistent stream of income or even speculate and wager on the direction of a stock.
The founder of Financial Education, Jeremy Lefebvre believes that options are a dynamic asset class that can be used in a variety of situations depending on the investor’s goal and requirements. Option contracts have existed for decades and their use can be seen since ancient times. Established in 1973, The Chicago Board Options Exchange set up a regime using standardized forms and terms and trade through a guaranteed clearinghouse. Since then, trading activity and investor interest in options have been increasing steadily.
In a nutshell:
- An option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset or financial instrument at a specified price on or before the contract expires on a certain date.
- Options are a versatile instrument and can be used to speculate, hedge risk, and generate income.
- Options are a form of derivate as they derive their value from an underlying asset or financial instrument.
- Options can be of several types that include: stock options, commodity options, index options, and more.
Components and Features of an Option Contract
An option contract has several features and components that make it a complex yet efficient financial instrument. Let’s understand the components of an option contract in detail before we proceed further:
The strike price of an option contract is the specified price at which the owner of the option contract can buy or sell the underlying asset or security if they decide to exercise the contract. The strike price of an option contract is fixed and does not change, unlike the market price of the option contract, which keeps fluctuating in relation to the price of the underlying asset.
An option premium is the amount required to purchase the option contract. The premium gives the owner the right to exercise an options trade, however, if the owner decides not to exercise the contract before its expiry, then they lose the premium amount.
Expiration Date or Expiry:
Every options contract has a specified expiry date at which the contract will expire. If the option is not exercised within the specified time period or before the expiry, it will expire worthless and the owner loses the premium.
Every options contract is deliverable in a fixed quantity that makes the option contract a standard size. For example, if the options contract is for 100 shares, then the owner has the right to buy or sell 100 shares within the specified time period at a fixed strike price.
Types of Options – Call & Put Options
Now that you have a good understanding of what options are, let’s understand the type of option contracts. Options are a type of derivative security, and their price and valuation are directly linked to the underlying asset. There are two types of option contracts that you can buy or sell; Call Option and Put Option. Let us understand these in detail:
A call option is a form of option contract that gives the contract holder the right, but not the obligation to buy a security or financial instrument at a specified price, known as the strike price, within a specified time frame or before the contract expires. The buyer of a call option stands to benefit if the price of the underlying asset increases.
Therefore, if the price of the underlying asset will increase, the option premium will also go up, resulting in a profit for the call option buyer. On the other hand, if the price of the underlying asset declines or even remains sideways, the call option buyer will lose money as the premium will erode and diminish. Additionally, the time-decay of options has a very important effect on the premium of an option contract.
Call options are further of 2 types:
In the money call option: In this case, the strike price is less than the current market price of the security.
Out of the money call option: When the strike price is more than the current market price of the security, a call option is considered as an out of the money call option.
A put option is a form of option contract that gives the contract holder the right, but not the obligation to sell a security or financial instrument at a specified price, known as the strike price, within a specified time frame or before the contract expires. The buyer of a put option stands to benefit if the price of the underlying asset declines, as that will increase the put option premium.
Put options are a great way for investors to hedge their investments and prepare their portfolios against black-swan events and high volatility. Put options can be bought or sold, according to the requirement and analysis of the investor or trader. Like call options, put options can further be divided into in the money put options and out of the money put options.
In the money put options: A put option is considered in the money when the strike price is more than the current price of the security.
Out of the money put options: A put option is out of the money if the strike price is less than the current market price.
Advantages & Disadvantages of Options
We at Financial Education believe that options are a versatile financial instrument and have several advantages and disadvantages. Investors and traders can use options to hedge risk, speculate on the price of securities, balance their portfolios and benefit financially. Let’s go over some of the advantages and disadvantages of options:
- Leverage & Cost Efficient
Options provide high leverage that can help a trader or investor take up large positions at a much lower margin when compared to stocks. This allows an investor or trader to benefit from the large quantity and generate wealth provided their analysis and prediction are correct.
- High Return Potential
The returns on options trading would be much higher than buying shares on cash. As such, the option contract pays equal profit as the simple stock buying if one had chosen the right strike. As we are getting options on a lower margin and getting the same profitability the percentage return would be much higher comparatively.
- Multiple Strategies & Risk Reward Ratio
Some strategies, which include buying options, allows a trader to have unlimited upside with limited downside. Additionally, options allow you to create unique strategies to take advantage of different characteristics of the market – like volatility and time decay. The trades can be combined to create a strategic position with the help of a call and put options of different expiries and strike prices.
- Hedging & Low Risk
Options are high-risk instruments when compared to owning equities, however; there are also scenarios where options are utilized to avoid and minimize risk. Options are used widely to hedge the positions. The risk in options is predefined as the maximum loss can be the premium paid to buy the option.
- Low Liquidity
Several individual stock options do not have high volume and therefore are not tradable in large quantities. This is because each optionable stock will have options trading at different strike prices and expirations, which means that the particular option you are trading will be very low volume unless it is one of the most popular stocks or stock indexes.
- High Commissions
Option trading is more expensive as compared to future or stock trading. However, there are some discount brokers that give the opportunity to traders to trade on lower commissions. But most of the full-service brokers charge higher fees for trading in options.
- Time Decay
When a person buys options, time decay is a factor that causes the erosion of premium and causes losses even if your view was correct. Every option has an expiry, and time decay causes the value of the option premium to decrease constantly.
- Complex Layout
Options often seem very complicated to beginners as there are several complicated aspects in options that can confuse a beginner. Most beginners, and even some advanced investors, think they understand options when they actually don’t.
- Low Liquidity
We hope that this article provided you with valuable information and helped you understand what options are. According to the founder of Financial Education, Jeremy Lefebvre; options can seem like complicated financial instruments, however once you have a good understanding of this asset class, you can use options to your advantage and benefit financially. But before making any investment decision, always check the current market conditions and other factors that might affect the value of an asset class, as investments in the financial market are subject to market risk. If you liked this article, make sure to visit Jeremy Lefebvre’s YouTube channel “Financial Education” for the more informative content! Happy investing!