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Options

TL;DR

  • Type of contract that gives the holder the right, but not obligation, to transact an asset in the future at a specified price and time.

  • Types of options: calls and puts

What is an option?


An option is a contract between two parties.


This contract gives the holder the right to buy and sell an asset at a specific price by a specific date. Each contract consists of 100 shares of the underlying asset. However, the holder of the contract is not obligated to exercise their contract but has the right to whenever after they purchase the contract. The date chosen for the contract is the expiration date before the option gets exercised and the chosen price is the price you plan to exercise your contract at. Since options grant holders the right to transact but not obligation to trade their contracts, they must pay a premium for these rights. Based on the risk connected with your specific expiration date and strike price, the premium will fluctuate. As the price of a contract goes up or down, so does the premium associated with the contract. There are 2 types of options: calls and puts. However, there are different types of option orders which can be made. Let’s break down the basics first.


Calls


If you think the price of an asset is going to rise, you would bet on the price going up and buy a call option. This allows the holder to buy that asset at the stated price by a specific date. For example: Lei is confident that NIO shares will skyrocket as the company increases its global presence. If the stock is currently trading at $38.70, Lei believes that the asset could go higher by the end of the year. He therefore buys 1 $40 call expiring by the end of 2021. With this contract, Lei has bought the right to buy 100 shares of NIO at $40 each before the end of 2021. If the price of NIO skyrockets past $40 before the end of the year, Lei’s option contract will be “in the money:” he can either choose to sell his option and make the difference in the premium amount or he can exercise the option, buy 100 shares of NIO at $40 and make the difference between the trading and strike price.


Puts


If you think the price of an asset is going to fall, you would bet on the price going down and buy a put option. Similar to a call option, a put option is bought with a strike price and expiration date in mind. However, unlike a call option, a put option gives the holder the right to sell shares of an asset. Just like Lei chose a strike price higher than the current trading price because he was bullish about the asset, he would do the opposite with a put option. For example: if NIO was currently trading at $38.70 and Lei was bearish about NIO, he would buy a put option for $35 for the end of the year. The only way he makes money is if NIO’s price starts to decrease towards $35 and he either sells the contract to make the difference in the premium or he exercises it and makes the difference between the trading and strike price. Options “in the money” have strike prices lower than the current trading price.


Benefits and Drawbacks


Since options can be thought of as contracts rather than securities, an option holder does not actually own the asset. The advantage of this is that the cost of owning an option contract (100 shares) is much cheaper than actually buying 100 shares. This is because the only cost for buying an option contract is the premium amount. As a result, risk is much lower since you are paying less and therefore your potential losses are also lower. Lastly, combining options can create a strategic position for an investor who is able to hedge their positions. For example, an investor can buy both a call option and put option, to hedge their risk, in case the asset price moves in an unexpected direction.


Compared to trading common shares, options are traded less frequently and tougher for investors to enter/exit positions quickly. In addition to this, not all stocks listed on public markets have option contracts. Some brokerages also require higher commission fees to trade options. Lastly, due to time decay, the value of your option premium will decrease everyday no matter the movement of the underlying asset. Therefore, trading options can be extremely profitable but requires experience to avoid large losses.