The Ultimate Guide to Options : The basics

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05/29/2018 | 08:48 am
Trading options requires a certain level of basic knowledge. It’s not usually something you do if you’ve never invested in an exchange-traded product before.

But although options are (relatively) complex investment instruments they’re definitely worth taking a closer look at.

They can be a great way to invest in an underlying share or index using only a small amount of money. Or you can use them to protect your current portfolio against market movements.

So, let’s dive into the wonderful world of options!

1. Definition and characteristics

1.1. Definition

First things first: What is an option?

“An option is a contract that gives you the option - not the obligation - to buy or sell the underlying asset at a predefined price and before or at a predefined date.”

Let’s clarify this definition with an example.

A much-used example when it comes to explaining how an option works is that of selling a house.

Let’s say we’ve got Anna, who owns a house that’s worth $300 000 and that she wants to sell. On the other hand, we’ve got Bill who wants to buy Anna’s house but won’t have the $300 000 for another 3 months.

Anna is willing to take her house off the market for 3 months if Bill pays her $5000. This means that Bill now has the right - not the obligation! - to buy Anna’s house for $300 000 in 3 months time. 

There are several scenarios possible here:

Scenario 1 - the house price goes up.

Three months after Bill and Anna made their deal, it turns out that Anna’s house is worth $350 000. Bill will now exercise his right to buy Anna’s house for $300 000. Well done to Bill!

Scenario 2 - the house price goes down.

Three months after their deal, Anna’s house is worth only $250 000. Obviously, Bill won’t exercise his right to buy Anna’s house for $300 000 and he doesn’t have to because there is no contractual obligation.

Scenario 3 - the house price stays the same.

In this scenario, Bill can either exercise his option and buy the house for $300 000 or not. In any case, he has controlled a house worth $300 000 for three months for $5000.

This animated video shows you also how a call option contract works:

1.2. Characteristics

Options - just like all other topics - come with their own jargon. Terms you need to know in order to understand what we’re talking about. Options have specific product characteristics, we’ll take a look at some of the most important terms here.

Call options & Put options

There are two types of options: calls and puts.

A call option gives you the right (and indeed, not the obligation) to buy the underlying asset at a predefined price, within or at a predefined date.

In the example of Anna's house, Bill’s right to buy the house in three months time for $300 000 is like a call option.

A put option, on the other hand, gives you the right - not the obligation - to sell the underlying asset at a predefined price, within or at a predefined date.

If we stick with Bill and Anna, we’d get something like this: Anna pays $5000 for the right to sell her house to Bill for $300 000 in three months time. If three months from now her house is only worth $250 000, Anna will exercise her option and Bill will have to buy Anna’s house for $300 000.

The underlying asset

This is the investment product from which the option price derives (which is why options are a so-called derivative product). The underlying asset of an option can be a share, an index, a commodity such as gold or a currency pair, for example.

The exercise price (aka Strike)

The exercise price of an option is the predefined price at which the holder of the option contract can buy or sell the underlying value. In our example above, the exercise price is the $300 000 that Bill can by Anna's house for.

The expiration date

Options don’t last forever, they have an expiration date. Depending on the option, this can be three months - like in our Anna and Bill example - six months, a week or even a day.

Once the option is expired, the contract becomes worthless (and the value of the option zero).

Wrapping it up

Alright, that’s the first chapter of our Ultimate Guide to Options all done. In the next chapter, we’ll dive deeper into the functioning of call and put options. Of course, there will be plenty of examples to illustrate things further. Until then, happy learning.

Image credit:

Neelie Verlinden
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