What is an Option Trading
Christopher El Khoury
What are options?
An option is the contract for an underlying asset such as stocks or other forms of securities. Option trading refers to the use of options as a financial instrument to buy or sell a security on a contracted date at a predetermined price. The parties involved in the contract are a taker (buyer) and a writer (seller) where the taker is required to pay a premium to the writer prior to the formation of contract.
What happens if an option contract is not fulfilled?
The contract provides the holder the rights, but not the obligation to exercise the contract. If the contract is not acted upon, the contract simply expires. Different from Futures, the holder is not obliged to buy or sell the asset if they have decided not to.
Type of options
Call options - allow holders to buy assets at a stated price at a specific time period.
Put options - allow holders to sell the assets at a stated price at a specific time period
A long call can be used to speculate on the rising price of an underlying asset. The upside is that it has unlimited potential for the prices to skyrocket, but the downside of it is having to pay a premium price for the contract (maximum loss).
A long put is a short position of the underlying security. It gains value as the underlying asset’s price falls. With this option, protective puts can be offered as insurance for holders to hedge risks, but this also means shrinking the holder’s profit.
American options vs. European options
An American option contract can be exercised anytime before the expiry date of the option whereas an European option contract can only be exercised on the expiration date. They are both termed as vanilla options. Other styles are: asian options, bermudan options, exotic options, and so forth.
Why is it risky?
It may be difficult to predict stock price movements and the value of an option is dependent on the market which makes it subject to market volatility. Given the flexibility of time period until the expiry of contract, option poses a degree of risk for parties in a contract. Therefore, it is important that one should consider their risk tolerance and trading strategies before purchasing an option.
What are the advantages of options?
Options trading does provide flexibility when it comes to exercising contracts. Compared to purchasing individual stocks, holders are able to leverage to enter contracts at a lower capital required. It is usually used as a method to diversify or hedge an investor’s portfolio.