What Is Options Trading?

Options trading is a financial practice that involves buying and selling options contracts, which are derivatives that derive their value from an underlying asset. These contracts grant the holder specific rights regarding the underlying asset without obligating them to act. Understanding options trading requires a clear grasp of what options are, how they function, and the types of assets that can be traded through options.

Understanding Options

At its core, an option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, known as the strike price, before or on a specified date, called the expiration date. Options come in two main forms: call options and put options. A call option provides the holder with the right to purchase the underlying asset at the strike price. O the flip side, a put option gives the holder the right to sell the asset at the strike price.

The price paid for an option is known as the premium. This premium compensates the seller of the option for the potential risk of having to buy or sell the underlying asset at the strike price. The premium itself is influenced by several factors, including the current price of the underlying asset, the strike price, the time remaining until the option expires, and the volatility of the underlying asset.

How Options Work

Consider you are purchasing a call option on a stock currently trading at £50. You decide to buy a call option with a strike price of £55, and the premium for this option is £2 per share. Options contracts are typically cover 100 shares, so the total cost of the option is £200 (£2 premium per share multiplied by 100 shares).

Now, let’s say the stock price rises to £70 before the option expires. Since you have a call option with a strike price of £55, you can exercise this option to buy the stock at £55, even though it is worth £70 in the market. This gives you a profit per share based on the difference between the market price and the strike price. In this case, the profit per share would be £15 (£70 market price minus £55 strike price).

However, you must subtract the premium you paid to acquire the option. The premium was £2 per share, so your net profit per share is £13 (£15 profit per share minus £2 premium). Since each contract covers 100 shares, your total net profit is £1,300 (£13 profit per share multiplied by 100 shares).

If, instead, the stock price does not rise above the strike price of £55 and stays below it, the option would be worthless if you choose not to exercise it. In this scenario, you would not exercise the option because buying the stock at £55 would not be advantageous when it is available for less on the market. Your total loss in this case is limited to the premium paid for the option, which is £200.

Therefore, the option premium affects your profit or loss by being the initial cost that must be accounted for in any calculations. The potential profit from the option is determined by how much the market price exceeds the strike price, minus the premium paid. If the market price does not exceed the strike price, the premium paid represents your total loss.

Assets Traded Through Options

Options can be traded on a wide range of underlying assets. While they are most commonly associated with stocks, options can also be based on other assets such as:

Stock Indices: Options can be traded on stock indices like the FTSE 100 or the S&P 500. These options give traders the right to buy or sell a basket of stocks that make up the index, allowing for speculation or hedging on broader market movements.

Commodities: Options are available on commodities such as gold, oil, and agricultural products. For example, an option on crude oil might give the holder the right to buy or sell oil futures at a specific price before a certain date.

Currencies: Currency options allow traders to speculate on or hedge against changes in exchange rates between currencies. For instance, an option might provide the right to exchange euros for US dollars at a predetermined rate.

Interest Rates: Options can also be based on interest rates, such as options on Treasury bonds or interest rate futures. These options allow traders to speculate on or hedge against changes in interest rates.

Exchange-Traded Funds (ETFs): ETFs, which are investment funds traded on stock exchanges, can also have options. These options allow traders to gain exposure to a diversified portfolio of assets.

More Examples of Options Trading

To provide a clearer picture, let’s look at a couple of examples of options trading:

Call Option Example: Suppose you believe that the price of a particular stock, currently trading at £40, will rise significantly over the next three months. You might buy a call option with a strike price of £45 and an expiration date three months away. If the stock price rises to £55, you can exercise your option to buy the stock at £45, potentially making a profit (minus the premium paid) by selling it at the higher market price.

Put Option Example: Imagine you hold a stock currently trading at £60, but you are concerned that its price might fall. To protect yourself, you might buy a put option with a strike price of £55. If the stock price drops to £45, you can exercise your put option to sell the stock at £55, thereby limiting your losses compared to selling it at the lower market price.

The Pros and Cons of Options Trading

Options trading offers several benefits. It provides the flexibility to profit from various market conditions, whether prices are rising, falling, or remaining stable. Options can also be used to hedge against potential losses in other investments, offering a form of insurance for your portfolio.

However, options trading also comes with significant risks. The potential for loss is substantial, especially if the market does not move as anticipated. Buyers of options risk losing the entire premium paid if the options expire worthless. Sellers of options, particularly those who do not hold the underlying asset, face potentially unlimited losses.