What are Options?

An option is a right to buy or sell a fixed amount of a particular currency, equity or commodity at a particular price and date in the future. Before investing in options, it is important to understand what is a call option and what is a put option.

Call option:

Buying a call option contract gives the investor the right to buy (not an obligation!) a particular instrument at a particular date (expiration date of the option), price and amount. The seller of the call option (or the writer) has obligation to sell the amount. When the investor wants so sell the option, for example when the contracts price has risen, he can sell it. When at the expiration date of the option the price of the instrument is over the strike price of the option, the option is going to be exercised. When the price of the instrument does not reach the strike price of the option, the investor will not exercise the option, because the strike price of the option is higher than the instruments price. In this case the investor lost the paid capital for the option and the writer (seller) wins this premium.

Investing example for a call option:

The investor decides to buy XYZ corporation stock options. The share price is 147$ at the time when the investor buys the option. He buys 10 contracts (10×100 shares, one contract is usually 100 shares) april 150$ call option for 2$/contract. This means, that his total required capital for this investment is 2000$ (2$×1000). At the expiration the shares price is 153$, which means that the investors options are going to be exercised and he bought XYZ corporation shares for 150$. So he earned 3$/contract, which is 3000$ (3$×10×100). It is important to realise that the shares price moved 6$, from 147$ to 153$ and he gained “only” 3$/share. But, when the share price at the expiration date is for example 149$, the shares price gained 2$, but it did not reach 150$, so the investors options are not going to be exercised. In this case the investor lost 2000$.

Put option:

Buying a put option contract gives the investor the right to sell (not the obligation!) a particular instrument at a particular date (expiration date of the option), price and amount. The buyer of the put option (or the writer) has obligation to buy the amount. This case is just the opposite like at the call option, so the investor is waiting for a share drop.

Investing in options has got several reasons. Firstly for speculation, because this investing form has got a huge leverage, so it can make high profits regarding to the invested capital. Secondly for protecting an investment. For example, the investor has got 1000 XYZ shares. The XYZ share price is 147$ currently. So his total investment is 147000$. The investor buys 10 contracts april put option at 145$ for 2$/share, so he invested 2000$ (10×100×2$). If the price of the equity drops to 130$/share the investor has got the right to sell 1000 shares at 145$. In this case he did not lose 17000$ (147000$-130000$) because of the option. He lost “only” 4000$, 2000$ for the price dip of the shares from 147$ to 145$ and another 2000$, what he paid for the option.