Options are financial agreements between a buyer and a seller. An option is a

Overview

Options are financial agreements between a buyer and a seller. An option is a contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset on or before a specific future date. The owner can exercise the option or simply let it expire. Options are generally tied to stocks, futures markets, or commodities. Options provide an important tool in investment strategy, allowing an investor to speculate on price movements, as well as hedge, or protect, an investment. Given that the contract's value is determined by an underlying asset and other variables, it is classified as a derivative, that is, its value is derived from something else.

When an investor buys an option, they establish a contract with a seller. The contract establishes a specific price, called the strike price, at which the contract may be exercised or acted on. A contract also comes with an expiration date. When an option expires, it is defunct and no longer has any value. The investor has the option to use the contract or to let it expire.

Types of Options

There are two basic types of options: put options and call options. Either can be bought or sold. When you purchase a put option, you buy the right to sell the asset on or before the expiration date of the contract. Call options give the holder the right to purchase the asset at the strike price on or before the expiration date. In general, investors buy put options when they believe the value of underlying investment will fall in value; they buy call options if they think the value of the underlying investment will rise in value. In either case, the option holder can also sell the option to another buyer during the contract.

The option gives the buyer a right and creates an obligation for the seller; consequently, the buyer pays an option premium to the writer. This is the price of the option. The buyer begins the contract with a net debit, because they paid an initial fee for the right to the option. The buyer must subtract the cost of the premium from any profit to realize their net income. If the option is not exercised, the buyer forfeits the price of the option. The seller starts the contract with a net credit after collecting the premium. If the option is never exercised, the seller keeps the money. If the option is exercised, the seller keeps the premium, but must buy or sell the underlying asset, depending on the contract.

Value of Options

The value of an option depends on whether or not it is in-the-money. A put option is in-the-money if the current value of the asset is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is worth nothing. A call option is in-the-money if the current value of the asset is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price.

Option Price

An option's price has two parts: an intrinsic value and a time value. Intrinsic value is the amount that the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the price is. The longer the amount of time for market conditions to improve, the greater the time value.

Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. The general climates of the overall market and economy also have a strong impact on prices. The volatility of the underlying asset is also important, as investors attempt to gauge how likely the option will move in-the-money.

Option Trading

In option trading, buyers and sellers do not usually interact directly, but through a clearinghouse such as the Options Clearing Corporation. The clearinghouse guarantees that an assigned seller, also called the writer, will fulfill his obligation if the option is exercised.

In the investment world, there are many different types of options. Most asset types have an option available. Called listed options, these options are traded on established exchanges, just like stocks. Some popular types of options: stock options, bond options, index options, interest rate options, commodity options, and currency options.

The most basic types of options, like those listed above, are called "vanilla options." They're easily understood, traded often, and are basic in their structure. More complex, less easily understood options are called exotic options.

Why Use Options?

Why use options? Two primary reasons: speculation and hedging.

Speculation is betting on the price of a stock (or other security) to either rise or fall. When you simply buy a stock, you can only make money when the stock price goes up. Your principal rises with the stock's value. Using options, you can make money when the asset goes up, down, or remains stagnant. Options allow for increased leverage in speculating. Options allow the holder to acquire the right to stocks without paying the full price of the shares up front. The difference between the price of the stock and the option can be invested elsewhere until the option is exercised.

The other important use of options is in hedging. Hedging is a form of insurance that makes an investment in one asset to reduce the risk of price movements in another asset. Hedging reduces the overall profit potential, but it protects from large losses when the asset's value goes down. You make a bet in both directions, limiting losses. Or, if you own one important asset, believe it will perform well, but want to help limit losses if it does in fact does poorly, you can buy options to help protect the initial investment. Doing this is possible utilizing options.

Advanced investors usually use options. It's not recommended that beginning investors utilize options as part of their investment program.