Options are contracts that provide specific privileges to the trader but are not legally binding. In other words, options give buyers the right to buy or sell underlying assets or securities within a period (i.e. before the expiration date) for a predetermined price (i.e. a strike price). The contract holder is not obligated to buy or sell. They may opt-out of a contract simply by letting the contract expire. The freedom traders have to choose whether or not to execute an option is why they are called options.
Options are derivatives. This means that they are financial instruments that get their value from underlying assets or securities.
There are 2 ways of executing an options contract. These are usually based on two main trading styles i.e. the American-style and European-style options.
- American-style options – These are options that can be exercised at any time before the date of expiration.
- European-style options – These are options that can only be exercised on the expiration date.
Types Of Options
Traders can buy options by paying an option premium. There are two main types of options i.e. calls and puts. Both are based on traders having the right to buy or sell while not being obligated to do the same.
- Call Options – These give the option holder the right to purchase an asset at a specific price before a specific time. The holder can choose to opt-out of the contract, by letting it expire. A premium is used to buy the contract upfront. This type of option is used by traders who speculate on upward price movements of the underlying assets.
- Put Options – These give option holders the right to sell a particular asset at a predetermined price (strike price) and a specific timeframe (i.e. before the contract expiration date). The trader must pay a premium upfront to open an options trading position. This type of option is used by traders who speculate on downward price movements of underlying assets.
For both call and put options, holders are protected from significant losses. When they choose not to exercise an option, only the premium is lost. An option has no use once it has expired.
Calls and puts are often abbreviated as ‘C’ and ‘P’ respectively in online quotes.
To determine whether an option is making a profit or loss, here is a formula.
- Call Options
Asset price – strike price – premium = Profit or loss
- Put Options
Strike price – Asset price – premium = Profit or loss
Uses Of Trading Options
Options trading has several useful benefits including its significant number of uses.
- Hedging
Options trading were first created as a hedging tool. Hedging protects underlying assets from price fluctuations. This means that through trading options, the value of the underlying asset can be protected from future price movements.
For example, if a holder is afraid that prices may drop, a trading option could ensure that the asset is sold at its current market price or a price that’s close. This will curb potential losses. Similarly, if price movements rise, the trader may choose not to exercise the opt. This would limit losses such that only the premium is lost.
- Speculating
Options allow traders to predict price movements without any major risks. A holder may observe several factors in the market while the position is open. Because holders are not obligated to buy or sell at the end of the contract, options are quite popular tools for speculation.
Many traders use options without the intention of exercising them. Instead, they may simply opt to sell their positions when premium prices are higher.
- Buying Time
Options are a useful tool for traders who are unsure about what move to take. An option can allow a holder the time needed to observe price movements while limiting the risks of making losses. If their speculations were correct then they will be able to make some profits and if they were wrong they can let the option expire.
Wrapping Up
Options trading is popular because of its many useful benefits. Trading contracts don’t obligate holders to exercise their options which is one of its biggest advantages. A holder can use options as a hedging tool and hence protect the value of their underlying assets.
