What are options?

Options belong to a group of products called derivatives. A derivative’s price is dependent on or derived from the price of something else. You can buy options contracts in various asset classes, such as equities, indexes, bonds and commodities, among others.

A financial option is a contractual agreement between two parties. An option gives the buyer the right to buy (in the case of a call option) or sell (put option) the underlying asset at a specific price when or before the option expires. Options grant the owner rights, and create the seller obligations. Here are the key definitions to understand the different option types:

• Call option: This gives the owner the right to buy a specific amount of the underlying asset at a specific price by a predetermined date. A call option provides the opportunity to profit from price gains at a fraction of the cost of owning the asset. This also creates the seller the obligation to give you the asset at the pre-agreed price.
• Put option: This gives the owner the right to sell a specific amount of the underlying asset at a given price by a specific date. Here, the entity you bought the option from has the obligation to buy the underlying asset at the agreed price. For example, if you own put options on Apple shares that you own, and the price of the stock is going down, the put option is increasing in value. So, if the specific price agreed in the option is e.g. $450, but Apple shares are now worth $400, then you are in a winning position of $50 per share.

Options differ from real assets in that they don’t grant you ownership of a given asset. Options trading is speculative in nature and carries substantial risk of loss.

How options work

The price of options depends on 3 factors:

• The future price of the underlying asset
• Their expiration date
• The volatility of the underlying asset

The value of option contracts depends on the probabilities of future price events. Prices usually increase when an event from which an option would profit is likely to happen. For example, a call value goes up as the price of the underlying asset increases.

Options are also characterized as a wasting asset. As the expiration date of your options nears, their value decreases. This happens because of the lower probability for price movements in the underlying stock. Since time is a component in the price of an option, a one-month option is less valuable than a three-month option for the same product. This is because a longer time frame allows for a higher probability of a price move in your favor, and vice versa. This also means that options with a more distant expiry date will be more expensive.

Volatility in the price of the underlying asset also increases the price of an option because uncertainty pushes up the odds of a positive outcome for you. Bigger price swings will increase the chances of an event occurring. So the more volatility, the higher the price of the option.