Options trading provides a way for investors and traders to speculate on the future direction of a particular asset, such as a stock or bond. This is because options contracts give people the choice but not the obligation to sell or buy an underlying asset. In this article, we take a look at what are options, key terms traders should know, how options trading works, and more.
What are options?
Options are derivative contracts that give holders the right, though not the obligation, to either sell or buy an underlying asset at a predetermined price at or before the contract expires. Option buyers are charged a premium by sellers for this right. Like most other financial instruments, options can be bought using a brokerage account. As they are derivative assets, a holder does not actually have to physically purchase the underlying asset in question. If market prices are unfavourable to option holders, holders can simply let the option expire worthlessly, so that their potential losses are not higher than the premium paid.
Options are often divided into two categories. These are call and put contracts. With a call option, buyers have the right to buy the underlying asset sometime in the future at a predetermined price, otherwise known as the strike price. On the other hand, with a put option, buyers have the right to sell the underlying asset sometime in the future at a predetermined price.
Key terms to know
While trading options may seem confusing at first glance, they are not as complicated as they appear. To better understand options, traders should familiarise themselves with a few key terms.
Derivative: Options are what is known as a derivative instrument. This means they mainly derive their value from the underlying asset. For example, a stock option would derive its value from the price of said stock.
Premium: This is the price needed to first buy an option. It is calculated based on the underlying asset’s value and price.
Strike price: The predetermined price of an option is what is known as the strike price. Traders generally have until the option’s expiry date to exercise the contract at its strike price.
Intrinsic and extrinsic value: Intrinsic value refers to the difference between an option contract’s strike price and the current price of its underlying asset. On the other hand, extrinsic value refers to other factors that affect the premium, such as how long the option is good until it expires.
In the money and out of the money: Depending on the price of the underlying asset and the time remaining until the option contract expires, an option can either be in-the-money (profitable) or out-of-the-money (unprofitable).
How option pricing works
When trading options, buyers are supposed to pay a premium upfront. This then gives them the option to either buy or sell the underlying asset at the designated strike price by the contract’s expiration date.
A lower strike price typically has more intrinsic value for call options. This is because the option lets buyers purchase the underlying asset at a lower price than what it is currently trading for. If the underlying asset remains at the current price, a call option is considered in the money, and traders can buy the underlying asset for a discount.
On the flip side, a higher strike price has more intrinsic value for put options. This is because the contract allows holders to sell the underlying asset at a higher price than what it is trading currently. Options are considered in the money if the underlying asset stays at the current price, but holders have the right to sell it at a higher strike price if they wish.
How option trading works
When it comes to doing well in options trading, the main point is to determine the probability of future price events happening. The more likely something will occur, the more expensive the option contract will probably be, in the likely event it potentially generates a profit.
This means the less time there is to the expiry date, the less value an option will have. This is because the chance of a price movement occurring diminishes the closer the option contract draws to expiry. As such, an option is also known as a wasting asset. Since time is a component of what makes up the price of an option, a one-month option is likely going to be less valuable than a three-month option. The reason behind this is that with more time, the probability of the underlying asset’s price moving in an option holder’s favour increases, and vice versa.
On the whole, options trading allows people to speculate on:
- By how much an asset’s price will fall or rise
- By what date the price changes will happen
- Whether an asset’s price will fall or rise from its current price
How a trader potentially makes a profit will depend on the type of option they have. More specifically:
Call options: Once the underlying asset’s price has overtaken the break-even price, traders can sell the call option. This is called closing their position. This way, a trader can earn the difference between the premium they have paid and the current premium. Or a trader can exercise the option to purchase the underlying asset at the agreed-upon strike price.
Put options: Once the asset’s price has dropped below the break-even level, traders can sell their options contract, which is called closing their position. This way, they can collect the difference between the premium they paid for and the current premium. Or a trader can exercise the option to sell the underlying asset at the agreed-upon strike price.
Benefits of option trading
When it comes to trading options, there are a few benefits. For starters, options trading combines both flexibility with specificity. Meaning, that while trades need to pick a specific strike price and expiration date, they also have the flexibility to see how things will work out during that period of time. If a trader ends up being wrong in their predictions, they are also not obligated to execute the trade.
As options contracts have an expiration date, most strategies may appeal to traders who are looking to limit their exposure to a given underlying asset for a shorter period of time. Options trading is also a great tool to hedge against volatile price movements. For instance, traders may look to buy options contracts to mitigate certain potential losses in the future.
Overall, options trading provides individuals with a way to speculate and hedge against future price movements of a particular asset. Traders also do not need to buy the asset and can instead let the contract expire worthlessly. This makes options trading a highly attractive instrument for traders to take advantage of in their trading journey.