When used correctly, options can be a powerful way of enhancing your portfolio, and they can be used for both outright speculation and to manage risk for other investments.
Options are derivatives, since they rely on the movements of something underlying. This can for instance be a share price, a commodity price or an index. If you make a profit or not from the option you bought will depend on the price movements of the underlying. Because of this, options can be used to gain exposure to an asset without actually owning that asset.
What´s the difference between a call option and a put option?
A call option gives the holder a right, but not an obligation, to buy something at a pre-determined price on or before a certain date. .
A put option gives the holder a right, but not an obligation, to sell something at a pre-determined price on or before a certain date.
The pre-determined price mentioned above is called strike price.
Holder vs. writer
- If you buy an option, you are the holder of that option.
- If you create an option, you are the writer of that option and you are responsible for honouring it if the holder elects to exercise the option.
Today, most options are cash-settled. It means that even if you have a call option that gives you the right to buy 100 shares in Company JKLM, the issuer of the option will not sell you 100 shares when you elect to execute the option. Instead, the issuer will pay you the difference between the current market price and the option´s strike price.
Example: The strike price is $100 per share and the current market price, on the day you execute your option, is $120 per share. The issuer you will pay you 100 shares x ($120 – $100) = $2,000.
Similarly, if you have a put option that gives you the right to sell 100 shares, you do not have to actually provide the issuer with 100 shares to execute you option and get your profit.
Important: Do you need an option that gives you the right to not cash-settle? Do you actually want to become the owner of 100 shares, have 1,000 kilograms of aluminium delivered, etcetera? In that case, you have to be very careful when you buy the option and make sure it can not be cash-settled by the issuer. This type of option is much more rare and it will not be traded on an exchange.
Options and time decay
If we take a look at the options market, we will see that – in most cases – an option that expires in a year costs more to buy right now than an option that expires in three months, even if everything else is equal about them, including the strike price. Similarly, all other things being equal, an option with three months left of its life is very likely to cost more than the one that expires in one month, and so on.
Why is that?
The price decline as an option moves closer to its expiry date is known as time decay. The market acts on the assumption that the closer the option comes to its expiry date, the less are the chances of a beneficial price move in the underlying. Unless the price of the underlying actually moves, an option that is out of the money today will cost even less tomorrow than today.
Options and volatility
Volatility in the underlying has a tendency to push up the market price of the option. You might think that great swings up and down for the underlying would make traders reluctant to invest in the option, but that is normally not the case – the options market usually appreciates volatility in the underlying and react by paying more for the option.