Options are derivatives contracts, just like futures. They can be bought and sold on an exchange, but they can also be traded directly with brokers in the over the counter (OTC) market. Options are specifically contracts that provide traders and investors with the right to buy or sell an underlying asset at a specific price in the future. Unlike futures, however, there is no obligation to exercise an option when the contract reaches its maturity date.
Options are traded using a wide variety of underlying assets, including shares and exchange traded funds (ETFs).
Options contracts have a strike price and an expiration date – the expiration date is the date when the options contract must be exercised, or it becomes worthless. The strike price is the price of the asset at which the option contract lets you buy or sell it.
Options contracts break down into the following:
- Put options: Lets you sell something at the strike price. This is good if the actual market price is a lot lower – for example, you could buy the real physical share in the market, then sell it for a higher price, even though the market price was lower.
- Call options: Lets you buy something at the strike price. For example, if the market was much higher than the strike price, you could buy something more cheaply, then sell it more expensively.
When you buy an option, the purchase price is called a premium. This is the cost of the contract, not the underlying asset. You can also sell options if you already own something, like a share, and want to earn extra income from it. This is called ‘writing’ an option. You are offering to sell it to someone holding the contract at the strike price. However, if the owner of your option chooses not to exercise it, and it expires, you still get to keep the premium they paid you. The downside, of course, is that the option might indeed get exercised and you would need to sell them the share at the strike price. You would still get to keep the premium, of course.
How are options valued?
Whole academic papers have been written about this, yet it is easy to get a general feel for options pricing without going into the mathematics. The value of a particular options contract is really based on the likelihood that it will meet expectations. There are two important phrases you need to remember here:
- In the money: A call option is considered to be ‘in the money’ if the current market value of the underlying stock or other asset is above the strike price. Remember, a call option gives you the right to buy at the strike price. Being in the money means you could use it to buy something at below the market price (and sell it in the market for a profit if you wanted). An in the money put option gives you the right to sell at above the market price – you can sell something at a higher price than the market would give you for it. In the money options are the ones that will let you make money if you exercise them.
- Out of the money: An out of the money option is one where there is no profitable angle, at the moment. So, an out of the money call option has a strike price that is above the market price. Why would you want to exercise your right to buy above the market price? You wouldn’t. Hence, it is out of the money.
Now, there are two components of the value of an option: its intrinsic value and time value. These are useful ways to analyse an option.
- Intrinsic value: this is a measure of how much your option is in the money. What would your potential profit be if you exercised it?
- Time value: This is the difference between the intrinsic value above, and the premium. How much did you pay for it, and how much profit will still accrue to you? The longer the time to an option’s expiry date, the higher the premium will be. For example, an out of the money option, be it a call or a put, is going to be worth a lot less if it only has a few days left, especially if it is well wide of the current market price.
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