What are Options and how do they work?

When someone starts reading about investing, they will very quickly come across options. These sections will often talk about hedging, and use words like exercise price, strike price, maturity date, call and put. So what are options?

Like any financial security, an option is simply a contract between two parties. It gives the buyer the right, but not the obligation, to buy or sell a certain asset at a certain price, and on a certain date. There are three parts to this definition, so lets break down what they mean.

The first part is the right to either buy or sell an asset. This is where we get call and put options. Call options give us the right to buy an asset, while put options give us the right to sell an asset. It doesn’t get more complicated than that.

The second part of our definition is that there is a define asset that we get to buy or sell the asset for. This price is either called the exercise price or the strike price.

The final part of the definition is the date at which we can buy or sell the asset. This is the maturity date. At this date, we now have the option to buy or sell the asset if we wish to. European options can only be exercised on the maturity date, while American options can be exercised at any time up until the exercise date.

To get this option, we need to buy it. The price we pay for an option is called the premium. There are several factors that go into determining how much the option should cost. These include the interest rate environment, the volatility of the price of the underlying asset, the strike price of the option, and the time to maturity on the option. A popular method for pricing options is the Black-Scholes model. This was developed by economists in the 1970s, and is essentially a formula that you plug some information into, and out pops the price of the option.

The basic assumption is that the riskier the underlying asset, the higher the price of the option. This brings us to the idea of hedging.

Hedging is a process in which derivative instruments (such as options) can be used to protect an investor against adverse price movements. If we buy a certain stock, we want the price to move up. If we move down, however, we are going to lose money. So, what we can do is sell a call option, which profits when the price goes down, and if the trade moves against us, we have some of out losses earned back on the option.

So lets break down what the effects we can get from different options.

A call option gives us the ability to buy the underlying asset. We, of course, want to buy at the lowest price possible. So, if we buy a call option, we profit when the price goes up, and we make a loss when the price of the underlying asset goes down.

A put option is the opposite. We always want to sell an asset at the highest price possible, so if we buy a put option, we profit when the price of the asset goes down, and we make a loss when the price of the asset goes up.

In both of these cases, however, we are not obligated to buy or sell the underlying asset. So, if the price moves against the option, the most we will lose is our premium. This is why options are great hedging instruments.

When we are buying options, we have defined risk. The premium is also usually quite small compared to the price of the stock it is related to. If the most we lose is our premium, then our risk is limited to only that. The trade off, however, is that the smaller the premium, the more likely it is that we lose that premium.

In a future blog post, I will write about different strategies that can be implemented with Options in order to reflect different opinions about the markets.

If you would like to get a basic understanding of trading options, the following book is cheap and a good introduction to the markets.

Options Trading for Beginners: How to Get Started and Make Money with Stock Options (Options Trading, Stock Options, Options Trading Strategies)

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