Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price, on or before a specific date. Options are commonly used for stocks, but they can also be used for other assets like commodities, indices, and currencies. They provide flexibility for both hedging risk and speculating on price movements.

How Options Work

There are two main types of options:

1. Call Options: These give the holder the right to buy the underlying asset at a specific price (the strike price) before or on the option’s expiration date. Traders buy call options when they believe the price of the underlying asset will rise.
2. Put Options: These give the holder the right to sell the underlying asset at a specific strike price before or on the expiration date. Traders buy put options when they believe the price of the underlying asset will fall.

For example, if you purchase a call option for a stock with a strike price of £100 and the stock’s price rises to £120, you can buy the stock at £100 and immediately sell it at the market price for a £20 profit per share. However, if the stock price falls below £100, you are not obligated to exercise the option, and you only lose the premium you paid for the option.

Key Features of Options

1. Premium: The price paid to purchase an option, known as the premium, is determined by various factors, including the underlying asset’s price, time until expiration, and market volatility.
2. Strike Price: The price at which the buyer of the option can buy (in the case of a call) or sell (in the case of a put) the underlying asset.
3. Expiration Date: Options contracts have an expiration date, after which the right to exercise the option expires. The time value of an option diminishes as the expiration date approaches.

Uses of Options

1. Hedging: Investors use options to hedge against potential losses. For example, a stockholder might buy put options to protect against a decline in the stock’s value.
2. Speculation: Traders use options to speculate on price movements. Call options are used when expecting a price rise, while put options are used when expecting a price drop.
3. Leverage: Options allow traders to control a large position in the underlying asset with a relatively small amount of capital (the premium). This can lead to high returns, but also increases the potential for losses.

Risks of Trading Options

1. Limited Time Horizon: Options expire, meaning that time works against the holder of the option. If the expected price movement doesn’t happen before the expiration, the option becomes worthless.
2. Premium Loss: If the underlying asset’s price doesn’t move in the predicted direction, the trader loses the premium paid for the option. Unlike futures, losses are limited to the premium, but gains can also be capped depending on the strategy.
3. Complexity: Options are more complex than other financial instruments, with pricing influenced by factors like time decay (the diminishing value of options as expiration approaches) and implied volatility.

Conclusion

Options provide a flexible way to hedge risk or speculate on market movements with a smaller initial outlay. While they offer significant profit potential through leverage, they come with the risk of losing the entire premium if the market doesn’t move as expected. Understanding the mechanics and risks of options trading is crucial for success in this area.