If you’re into the stock market, you’ve probably heard about options before. In Wikipedia, the following sentence can be found on the topic of options:
In finance, an option is a contract which conveys its owner, the holder, the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset value, time until expiration, market volatility, and other factors. Options may be traded between private parties in over-the-counter (OTC) transactions, or they may be exchange-traded in live, orderly markets in the form of standardized contracts.
This may sound a bit complicated to some. In this article, I will explain how options work as simply as possible with an example.
Options, like futures and CFDs, are derivatives.
What are options?
Let’s assume that you want to buy a new television. So you go to your dealer and find a model that costs $1,000. You don’t have enough money right now and want to buy the TV in a month. It could be that the TV will be more expensive in a month. The seller wants to assure you that you will get the TV in a month for $1,000. He issues you an option with a base value of $1,000. For this option he charges $10. So now you pay $10 to get the TV for $1,000 guaranteed. This fee is called an option premium and must always be paid for options. As the expiration date of the option gets closer, the option premium decreases.
What happens when the option expires and the price has increased?: You now go back to your TV dealer on the due date and find that the TV now costs $1,100.
You put the television with base value 1,000 option on the table and get the TV for $1,000. Since you have already paid $10 for the option, the TV has cost you $1,010, instead of $1,100, so you have saved $90. Since the option is “In the Money”, you could also sell it for $100 and collect $90 profit without buying the TV.
What happens when the option expires and the price has fallen?: If you go to your TV dealer on the due date and find that the TV only costs $900, you would of course not exercise the option, because you could buy it now for $900. You let the option expire worthless and have lost $10. Whether you buy the TV now or not is up to you.
You can buy options with the aim to sell them at a better price. Options are therefore traded by traders without interest in the underlying product to have.
What are put and call options?
In the above example, you have made sure that you will get the TV for $1,000 and no more. You bet on rising prices, so you bought a call option. If you want to profit from falling prices, you buy put options.
Why is trading options not for beginners?
It is hard to get accurate and correct numbers, but most options expire worthless. So if you buy puts or calls, you run a great risk of losing your money with them. This is on the one hand because beginners prefer to buy the cheap out of the money options and on the other hand because the expiration date is chosen too short term. Anyone who buys options must not only forecast the market correctly, but also in the right time window. For example, if I buy the S&P 500 ETF SPY today, the price may crash. If I’m unlucky, I’ll have to wait months, or years, for the price to recover. But I have the chance to sell my SPY at the end with a profit if I wait long enough. But if an option expires worthless, then the money is gone.
Short selling options: Options can also be sold short. In the long term, this is the better variant to make money with options. However, I advise any stock market novice not to short options, because this can entail infinite losses. Option traders who have experience, however, can certainly make money shorting options.
What is the difference of European and American options? There are American options and European options. The difference is that American options can be exercised at any time and European options can only be exercised at expiration. So if I short sell options, they can be exercised at any time.
Do you have any questions about options, or have something to say about this article? Then please leave a comment.