Options Basics

An option is a contract that gives the holder (buyer) the right, but not the obligation, to buy or sell an asset at a certain price by a fixed date. Meanwhile the writer (seller) of the options contract must sell or purchase the asset concerned if the buyer decides to exercise the option.

Clear as mud?

Let’s say you want to buy a Ferrari convertible advertised at $100,000. Unfortunately you don’t have enough capital right now, so you call the current owner and you write a contract that will allow you to buy the car in three months for $100,000. For exclusive rights to this contract, you deposit $1,000.

The value of the convertible will usually remain static for the next three months. However, there is still the possibility that its value will go up or go down.

In the first scenario, the value of the convertible goes up. If there is a freak accident that causes all the cars in the world to vanish, this convertible’s value will skyrocket. You could sell it at any price. And, fortunately for you, because you have an option which permits you to buy the car at $100,000, you can still buy it at that price, regardless of its new market value. As a result, you could sell either the contract or the convertible for a hefty profit.

In the next scenario, the value of the convertible goes down. The seller’s 21-year-old son takes the car for a joy ride and has an unfortunate incident with a street lamp. For a luxury car, the repair costs are exorbitant, and it would be less expensive to get another car. However, as the option buyer you have the right to purchase the car at $100,000, but you are not obligated to complete the transaction. So you choose not to exercise the buy the car, and your only loss is the premium you paid for the initial contract.

In the final scenario, the value of the car remains the same. When the expiration date of your contract arrives, you can choose whether or not to purchase it based on your circumstances. Whether you purchase or not, your maximum loss is the deposit you paid for the contract.

Options can be traded across a wide range of markets, including the stock, commodity, bond, interest rate and fx markets.

Traders and investors use options both to speculate and to hedge.

Speculating involves predicting the future price of an asset, then profiting when that asset goes up or down. If you have an options contract to buy a commodity at a certain price and its price goes up, you could sell it at a better price than you originally paid.

Likewise, if you have an option to sell a stock or a bond at a set value and the market price falls, you can either sell it for a higher price than the one in the market, or sell the options contract for a profit.

Hedging is when investors use options contracts for insurance – as the most you can lose when buying options is the original sum you pay for the contract, options buyers know their maximum risk from the outset.

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