Options

Defintion

Options are financial instruments that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price (known as the strike price) on or before a certain date (known as the expiration date). The buyer of the option pays a premium to the seller for this right.

What are options?

There are two main types of options:

1. Call options:
– A call option gives the holder the right to buy the underlying asset at the specified strike price before or on the expiration date.
– Call options are typically used when the investor expects the price of the underlying asset to rise.

2. Put options:
– A put option gives the holder the right to sell the underlying asset at the specified strike price before or on the expiration date.
– Put options are usually used when the investor anticipates the price of the underlying asset to fall.

Here are some key points about options:

1. Expiration date: Options have a specific expiration date. After this date, the option becomes worthless, and the holder loses the right to exercise it.

2. Strike price: This is the price at which the underlying asset can be bought (for a call option) or sold (for a put option) if the option is exercised.

3. Premium: The buyer of the option pays a premium to the seller (also known as the writer) for the rights provided by the option. This premium is the cost of the option.

4. Option writer: The seller or writer of the option is the one who grants the rights to the buyer. In return, the writer receives the premium.

5. Leverage: Options provide leverage, allowing an investor to control a larger position in the underlying asset for a smaller initial investment. This can amplify both potential gains and losses.

6. Risk management: Options can be used for various purposes, including hedging against potential losses or to limit risk in a portfolio.

7. Versatility: Options can be used in a wide range of strategies, including bullish, bearish, and neutral strategies, depending on the investor’s outlook on the market.

8. American vs. European options:
– American options can be exercised at any time before the expiration date.
– European options can only be exercised on the expiration date.

It’s important to note that options trading carries a level of complexity and risk, and it may not be suitable for all investors. It’s crucial to thoroughly understand the mechanics and risks associated with options before engaging in trading activities. Investors often seek advice from financial professionals or conduct thorough research before trading options.

Example of options

Let’s say an investor is interested in purchasing shares of Company XYZ, which are currently trading at £100 per share. However, the investor is uncertain about the future movement of the stock price. To reduce this risk, the investor purchases a call option contract for Company XYZ stock with a strike price of £110 and an expiration date of one month from now.

If, within the next month, the price of Company XYZ stock rises above £110, the investor can exercise the call option and buy the shares at the predetermined strike price of £110, regardless of the current market price. On the other hand, if the stock price remains below £110 or decreases, the investor can choose not to exercise the option and incur only the initial cost of purchasing the option contract.