The tulip mania of 17th century Europe, subject of the 2017 film Tulip Fever, is an early example of options trading – fortunately today’s markets are more regulated.
An option is a contract between two parties in which one party has the right, but not the obligation, to buy or sell an asset at a set price within an agreed time frame; the contract is binding, with strictly defined terms and properties.
Options have a specific language – the most common terms are:
|Holder||People who buy options|
|Writer||People who sell options|
|Strike price||The price at which the underlying security can be bought or sold if the option is exercised|
|Premium||The price at which an option can be bought or sold|
|Expiration date||The date by which an option must be exercised|
|Exchange traded||An option traded on a regulated exchange, has standardised contract and is settled through a clearing house|
|Over the counter (OTC)||Options are traded between two private parties, not listed on an exchange, the terms of an OTC option are unrestricted and may be individually tailored|
|In the money||A call option is in the money if the security's price is above the strike price. A put option is in the money if the security's price is below the strike price|
|Intrinsic value||The amount by which an option is in the money|
|Represents the possibility of an option increasing in value|
|An option on its own without any underlying security|
The main options used by investors are calls and puts.
A call option gives the holder the right to buy an asset at a certain price within a specific time period.
An investor who expects the price of an asset to increase can buy a call option.
-This allows them to purchase the asset at a fixed price at a future date, rather than purchase the asset immediately.
-The cash outlay is the premium, which is lower than the outlay required to purchase the asset. The investor has the right but not the obligation to buy the asset at the future date.
-The risk of loss is limited to the premium paid, unlike the potential loss had the stock been bought outright.
An investor who expects the price of an asset to decrease can sell or write a call option.
-The investor selling a call option is obliged to sell the asset to the call buyer at a fixed price (the strike price).
-If a seller does not own the asset when the option is exercised, they are obligated to purchase the asset at the market price.
-If the stock price decreases, the seller of the call will make a profit in the amount of the premium.
-If the stock price increases over the strike price by more than the amount of the premium, the seller will lose money, with the potential loss being unlimited.
A put gives the holder the right to sell an asset at a certain price within a specific period of time.
An investor who expects an asset’s price to decrease can buy a put option to sell the asset at a fixed price (the strike price) at a future date.
> The investor is not obligated to sell the asset.
> At expiry, if the asset’s price is:
• below the exercise price by more than the premium paid, the investor makes a profit
• above the exercise price, the investor can let the put contract expire worthless and only lose the premium paid.
An investor who expects an asset’s price to increase can sell a put option.
> The investor selling a put is obliged to buy the asset from the put buyer at the strike price.
> At expiry, if the asset’s price is:
• above the strike price, the seller of the put will make a profit in the amount of the premium.
• below the strike price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the strike price minus the premium.
A margin is an amount, calculated by ASX Clear, that’s required to cover the risk of loss on an options contract due to an adverse market movement. Simple options strategies, such as a covered call, don’t require margining because stock is lodged as collateral.
For more information about options, including some commonly used option strategies, read our blog ‘A limited option?’