What Are Options?

Options are a type of financial derivative, which means their value is derived from the value of another asset, called the “underlying asset.” An option gives the holder the right, but not the obligation, to buy or sell this underlying asset at a specific price on or before a certain date. Common underlying assets include stocks, indices (like the S&P 500), commodities (such as gold or oil), and currencies. Options are commonly used in the stock market, where the underlying asset is typically a company’s stock.

Think of options as a form of insurance. For example, if you own a stock and want to protect yourself against a decline in its price, you might buy an option that allows you to sell the stock at a predetermined price, even if the market price drops. Like insurance, there are both buyers and sellers - investors can choose to sell protection to others (and be paid for doing so) or to buy protection from someone (and pay for doing so). When buying options, like with an insurance policy, on ‘average’ you tend to lose, but the payout can be very large when it pays out. By contrast, when selling options, on average you collect the premium and nothing happens, but in times of significant turmoil you may have to pay up.

Two Types of Options

Call Options

A call option gives the buyer the right, but not the obligation, to purchase the underlying asset at a specified price (known as the “strike price”) before the option expires (expiry). Investors pay a fee to purchase a call option, called the premium. A Call buyer profits when the underlying asset increases in prices. The call seller profits from the premium if the price drops below the strike price at expiration because the buyer will typically not execute the options.

Put Options

A put option gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price before the option expires. Investors buy put options when they believe the price of the underlying asset will fall. For instance, if you own a stock and are concerned about its price dropping, you could buy a put option to sell the stock at a predetermined price, thus limiting your losses. A put option becomes more valuable as the price of the underlying stock or security decreases. Conversely, a put option loses its value as the price of the underlying stock increases. As a result, they are typically used for hedging purposes or to speculate on downside price action.

Key terms you need to know

Strike Price: The price at which the option holder can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. It’s a critical factor because it determines the profitability of exercising the option.

Premium: The cost of purchasing the option. This is paid upfront by the buyer to the seller. The premium is influenced by factors such as the price of the underlying asset, the strike price, the time until expiration, and the volatility of the underlying asset.

Expiration Date: The date on which the option expires and can no longer be exercised. Options have a finite life, so it’s important for investors to monitor this date.

In-the-Money (ITM): Describes an option that has intrinsic value. For example, a call option is in-the-money if the underlying asset’s price is above the strike price.

Out-of-the-Money (OTM): Describes an option that has no intrinsic value. For instance, a call option is out-of-the-money if the underlying asset’s price is below the strike price.

Volatility: Refers to how much the price of the underlying asset is expected to fluctuate. Higher volatility generally increases the premium of an option because the potential for large price movements makes the option more valuable.

Examples of widely-traded derivatives

Covered Calls

This strategy involves owning a stock and selling a call option against it. The income from selling the call (the premium) provides some downside protection, while you still hold the stock and can benefit from potential appreciation up to the strike price. It’s a conservative strategy that generates income from stocks you already own, while capping potential gains if the stock price rises above the strike price.

Protective Puts

This strategy involves buying a put option to protect a stock you own from a potential decline in price. It’s like buying insurance for your portfolio. It helps limit losses without having to sell the stock, which can be important if you want to hold onto the stock for the long term.

Potential Risks to Consider

Risk of Loss: Options can lead to significant losses, especially for sellers of ‘naked’ options (who have obligations, but don’t have the stock/cash ready to fund those obligations). For buyers, the maximum loss is the premium paid, but sellers can face much larger losses if the market moves against their position.

Time Decay: Known as “theta,” this refers to the erosion of the option’s value as it approaches expiration. For option buyers, this means the option loses value over time if the underlying asset doesn’t move in the desired direction.

Complexity: Options can be complex financial instruments, and without a clear understanding, investors may end up making decisions that lead to unexpected or unfavorable outcomes.

Liquidity Risk: Some options may have low trading volume, making it difficult to enter or exit positions at desired prices. This can increase the cost of trading and reduce potential profits.

Leverage: Leverage in options trading lets you control a large amount of stock with a relatively small investment, but it also magnifies potential losses. For instance, if you purchase an option with a small premium expecting the stock to rise, but it declines instead, you could lose the entire premium. This loss can represent a much larger percentage of your initial investment compared to the actual change in the stock’s price.

Expiration: Every option contract comes with an expiration date, after which it becomes worthless if not exercised. If the market doesn’t move in the anticipated direction before this date, the option holder risks losing their entire investment. For example, if you buy a call option expecting a stock to rise but the stock price remains flat, the option will expire worthless, and you’ll lose the premium paid.

To learn more about the risks associated with options, please read the Characteristics and Risks of Standardized Options before you begin trading options.

Additional Considerations

Taxes

Tax consequences when investing in options can be complex, and we recommend consulting your tax advisor prior to making any investment decisions – true for options and any other type of investment!