Options trading is a way for traders to speculate on the future direction of an underlying asset. This can be done through a broker’s trading platform, such as Saxo Bank. In this article, we take a look at what are options, how they work, what types of options are there, and how people can use them. Keep reading for more information below.
What are options?
Options are derivative contracts that give the holder the right but 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 what is known as a premium by the seller for this right. If market prices are unfavourable for option holders, they can simply let the option expire worthlessly and not exercise the right. This makes sure that potential losses will not be higher than the premium. On the other hand, if the market moves in a favourable direction, holders can choose to make use of the options contract.
Options trading terminology to know
Options trading can seem overwhelming at first glance. As such, it is essential traders understand options trading jargon before trading in the markets. Here are a few popular trading terminologies to know:
- Derivative: Options are derivative instruments, meaning they derive their value from another asset. For example, the value of a stock option comes from the price of a given stock.
- Strikeprice and expiration date: The predetermined price of an options contract is what is known as the strike price. Traders have until an option contract’s expiration date to exercise the contract at the strike price.
- Intrinsicvalue and extrinsic value: Intrinsic value refers to the difference between an option contract’s strike price and the current price of its underlying asset. Conversely, extrinsic value refers to other factors outside those considered the intrinsic value that affect the premium, such as how long the option is good for.
- Premium: This is the price to buy an option, and it is calculated based on the underlying asset’s value and price.
- In the money and out of the money: Depending on the underlying asset’s price and the time remaining until the option expires, an option can either be in the money (profitable) or out of the money (unprofitable).
How options work
Options trading allows people to speculate on a few things, namely:
- By how much an asset’s price will fall or rise
- By what date these price changes will happen
- Whether an asset’s price will fall or rise from its current price
Basically, the more likely something is to happen, the more expensive that particular option will be. Additionally, the less time there is to expiry, the less value an option will have. This is because the chance for the underlying asset to make a move lessens as it moves closer to expiry. This is why options are also known as a wasting asset. Conversely, if there is more time available, an option is likely going to be more expensive because the probability that a price moves in a trader’s favour will increase.
Another thing that influences the price of an option is volatility. This is because having uncertainty pushes the odds of a particular outcome higher. If the volatility of an option rises, large price swings are likely to happen that could increase the chance of an event happening. As such, the greater the volatility, the higher the option’s price.
Types of options
Options are known as a derivative asset, as their price and value are intrinsically linked to the price of something else (namely the underlying asset). If a trader purchases an options contract, it grants them the right but not the obligation to sell or buy the underlying asset at the set price on or before the expiration date. There are two main types of options, namely calls and puts.
A call option is one that gives holders the right but not the obligation to purchase the underlying asset at the strike price on or before expiration. A call option therefore becomes more valuable as the underlying asset’s price rises. Traders can choose to sell the call option and earn the difference between the premium initially paid and the current premium. On the other hand, they can also exercise the option to purchase the underlying asset at the agreed-upon strike price.
Puts are the opposite of call options, as they give the holder the right but not the obligation to sell the underlying asset at the strike price before or on the expiration date. All put option therefore becomes more valuable as the underlying asset’s price falls. As such, traders can sell the options contract and collect on the difference between the premium they initially paid for and the current premium.
What is leverage in options trading
Options are considered leveraged financial products, and they allow traders to speculate on the movement of a market without necessarily owning the underlying asset. This means potential returns can be magnified, but so can losses, especially for those selling options. This makes leverage a double-edged sword when trading.
For traders looking for increased leverage, options trading is generally seen as an attractive choice. By choosing their trade and strike size, traders can gain greater control over their leverage when compared to trading in the spot market.
How can traders hedge with options?
Traders can hedge with options as the instrument provides them with a way to limit potential losses on other positions that have been opened. For instance, if a trader bought some stock from a company, but was worried that the price of the stock would drop in the future, they could purchase a put option on the stock that had the strike price close to the stock’s current price. If the stock’s price drops below the strike price when the option contract expires, then the trader’s losses are limited due to the option’s returns. Conversely, if the stock’s price rises, then the trader has only lost the cost of purchasing the option in the first place.
Overall, options, while they may be complicated at first glance, are not that difficult to grasp when you understand their basic concepts. When used correctly, options can provide traders with plenty of opportunities to take advantage of, especially when it comes to speculating and hedging on financial assets.