What’s it: An option is the right to buy or sell a certain number of commodities, currencies, or securities on a specific date for a specified price. Traded options can be bought or sold at any time on any exchange, in contrast to traditional options, which cannot be resold once bought.
Characteristics of an option contract
The standard features of an options contract are:
- Type of contract. The two types of options are the put options and call options. The two of them work in opposite ways.
- Option price. We call this the strike price, which is the price at which holders exercise their options.
- Option premium. It depends on the spread between the current market price and the future strike price plus the time value and volatility of the underlying securities price.
- Underlying assets. They can be stocks, ETFs, commodities, or even currencies.
- Number of underlying items. It depends on each type of underlying asset. For share options, for example, one contract usually consists of 100 shares.
- Contract expiration date. It varies widely and depends on each option and the underlying asset. It could be days or even years.
For a European option, you can exercise your rights only on the expiration date. Meanwhile, for the American option, you can exercise the right at any time until the expiration date, thus allowing you to buy more at a favorable price.
Types of the option contract
Two types of options are:
- Call options give the holders the right, but not the obligation, to buy securities at a specific price on a specific date. You buy when expecting the price will go up.
- Put options give the holder the right, not the obligation, to sell securities at a specific price before a specific expiration date. If you expect the security price to fall as it was during the bearish times, you buy a put option.
How options contracts work
Let’s discuss how the two types of options contracts work using a simple example. In this case, I’m using stock options as an example. One stock option contract typically covers 100 shares of the underlying asset.
How the call option works
To understand how call options work, let’s take a simple example. A call option with an underlying 100 shares entitles you to purchase the shares for $100 per share at any time for the next three months. Also, to purchase the option, you have to pay a $2 per share premium. So, you have to spend $10,000 to buy shares plus a total premium of $2 ($2 x 100). The total is $10,200.
Confident that the price will continue to rise, you buy the option. Say, the stock price rises to $120 per share in two months. You then exercise your options and buy 100 shares at $100.
You then sell your options (close your positions) and take profits. You sell each share for $120 and earn $12,000 in revenue. After you subtract the purchase price and total premium, your profit will be $1,800.
How the put option works
The opposite of a call option is a put option. It gives you the right to sell shares at a specific price within a certain date.
To understand how put options work, let’s take an example similar to the case above. Assume you are considering buying it because you see the possibility of the stock price falling. Call options allow you to sell 100 shares for $100 per share. You also have to pay a premium of $2 per share.
Say, the share price falls to $90 per share. You then buy the stock and issue $9,000 ($90 x 100). Coupled with the total premium of $200 ($2 x 100), the total money you are spending is $9,200.
You then exercise the put option and sell the stock at $100 and get $10,000 ($100 x 100). Your total profit is $800 ($10,000-$9,200).
Option advantages
First, options are a means of hedging. Investors hedge against the risk of price fluctuations. Large companies usually also take advantage of these contracts, especially those with considerable financial exposure to interest rates, exchange rates, and commodities. When financial market conditions deteriorate, they can compensate by taking options to mitigate risks.
Second, the profit potential is high. Speculators bet for significant returns with a limited initial payout. Whether prices fall or rise, they have the potential to make a profit. They can buy put options if they expect prices to fall in the future or buy call options if they expect prices to go up.
Third, the cost is relatively small. The cost of buying options (premium plus trading commission) is lower than the underlying security price.
Option disadvantages
First, the structure of the options is more complicated. High complexity is due to the various features of the options and needs of buyers. Some companies usually employ specialist personnel.
Second, the potential risk of loss is also high. You must understand the risks involved when investing or using it as a hedge. The time value of the option continues to decrease because it has a limited period. During this period, the price may not move according to your expectations, rendering your options futile.
