Investors have a large array of financial products in the market to choose from. One of these products is options. In this article we discuss what an option is, the uses of options and the pros and cons from using them.
What is the definition of an option?
The basic definition of an option is a contract between two parties where the buyer has the right but not the obligation to buy or sell an underlying asset at an agreed strike price before or on the agreed date.
Types of options
There are two types of options, a call and a put. A call option is a right to buy a stock and a put option is a right to sell the stock. In an options contract, there are two parties where there is an agreement to buy or sell at a pre-determined future price of an underlying asset before an agreed date. The buyer has the option but not the obligation to buy or sell the underlying asset on or before the agreed expiry date. However, the seller of the option (writer) has an obligation to buy or sell the agreed underlying assets.
An example of a call option is if a buyer takes out a call option for stock ABC with a strike price of $35. Stock ABC is currently trading at $40 so the buyer can exercise their call option and purchase the shares for less than the market price. However, if stock ABC starts to fall to a market price of $30, then the buyer can choose not to take up the option as the strike price is higher than the market price of the stock.
What is the purpose of options?
Investors may use derivatives to hedge positions. For instance, if an investor has an equity holding and wants to protect that position, they may purchase a put option. This means they have a right to sell at a later date at a pre- determined price. Hence if their equity share value decreases, they have an option of using their put option and sell it at a higher price of what the underlying asset is trading at in the market.
Options can also be used for speculation. So these investors are trading these positions in an attempt to achieve high returns. There is high volatility in options so speculators can make money from the large price movements.
What are the risks?
Writers of options have unlimited loss potential. As a seller of an option you have the obligation to honour the options contract so if the market moves against you have no choice but to sell the underlying assets at the pre-determined price.
There is also a time decay risk where the value of options can decrease as they reach closer to expiry.
Investors may also face liquidity risk as certain option types may only trade very low volume.
Lauren Hua is a private client adviser at Fairmont Equities.
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