Updated: May 7, 2019
What is an option?
An option provides the option-holder with the right, but not an obligation, to buy or sell a certain asset (generally, a number of shares in a company) for a certain price up until an expiry date.
The difference between options and shares
An option provides you the right to act with regard to an underlying asset, but does not mean tangible ownership. In contrast, shares provide you with a physical and beneficial interest in a company. Shares are exchanged between owners as the title to an asset, whereas an option sets up a contract between the buyer (option taker) and seller (option writer), such that both parties must honour their obligations should the other choose to buy or sell the underlying asset. These duties cease when the option is exercised, expires or the contract is closed (sold).
The benefits of options
Options appeal to active investors who regularly observe and understand markets, even if they cannot specifically predict which direction markets might head next. Benefits include:
Flexibility - you may delay your decision to buy or sell shares until a later date (if desired), however you fix the price in advance
Leverage - the lower price of options relative to shares means larger price movements magnify your potential profits (or losses)
Hedging - ‘put’ options mitigate risk by insuring against falling shares, affording freedom to sell an asset for a specific price until a certain date, regardless of what price it drops to
Income - when a stock is likely to trade flat, you can sell options to receive income
Components of an option
These are the fundamental components of an option:
Option type - put or call options, with the right to buy or sell an underlying asset respectively
Underlying asset - the asset subject to the options contract, which is usually shares in a company (in lots), but it can also cover other assets like ETFs, indices, commodities, etc
Expiry - the date up til which the option can be traded or exercised, otherwise it expires
Exercise price - this is the transactional value per share on the underlying asset if the right to buy or sell is taken up by the option-holder
Option premium - price of the option agreed between parties, as determined by the market
Exercise style - American (exercise before or at expiry); European (exercise only at expiry)
Options in action
Consider: ABC July $5.50 Call Option @ $0.25
Here, an option-holder may buy shares in ‘ABC’ for the exercise price of $5.50 per share, up until the expiry date in July by paying the option premium of $0.25 per option. If you wish to buy the attaching shares, you exercise (trigger) the option. You have fixed the future purchase price, even if the stock rises higher. The number of shares you can buy will depend on how many options you hold.
When buying the ‘call’, you are betting on the underlying asset (ABC shares) rising before the option expires. This will increase the value of the option. It also limits your maximum downside risk to the option purchase price, rather than the entire value of the stock. Upside potential is unlimited, albeit your breakeven point includes the option premium. If the option expires below this, you make a loss. You can sell the option before export on the same terms to lock in profits or salvage value.
An option provides its holder with the right, but not an obligation, to buy or sell an underlying asset at a designated exercise price, up until the option expires
Unlike shares, an option does not entail physical ownership of an asset, unless exercised
Options afford you trading flexibility, leverage, risk mitigation and income opportunities