DEFINITION: The term “option” refers to a financial tool whose value is contingent upon the value of underlying assets, such as stocks, indexes, and exchange-traded funds (ETFs).
An options contract provides the purchaser with the choice of either buying or selling, the choice hinging on the underlying asset, depending upon the specific kind of contract.
Options differ from futures in that the holder is not obliged to buy or sell his asset but may do as he chooses.
Options contracts always designate an expiration date by which the option must be exercised.
The indicated price on an option is referred to as the “strike price.”
Options are commonly bought and sold via retail, including online, brokers.
ETYMOLOGY: The concept of purchasing the right to buy a commodity at some point in the future is already attested in Antiquity.
Options, under earlier appellations, were in common use during the late Renaissance origin of modern banking and the Early Modern beginnings of modern industry and commerce. The English word “option” itself is attested from the early seventeenth century.
The English noun “option” derives, via French, from Latin optio, optiōnis, meaning “choice” or “option.” Optio, in turn, derives from the verb opto, optare, “to elect,” “to select,” or “to elect.”
USAGE: Options involve a buyer and a seller, with the buyer offering a premium in exchange for the privileges authorized by the contract.
As financial instruments, options exhibit a good deal of versatility.
“Call options” authorize the holder to purchase the asset at a predetermined price within a specified period, while “put options” authorize the holder to sell the asset at a predetermined price within a specified period.
In the case of call options, one might say that a bullish buyer is matched with a bearish seller, while in the case of put options, a bearish buyer is matched with a bullish seller.
Traders and investors engage in the purchase and sale of options for various reasons.
First, engaging in options speculation enables a trader to maintain a leveraged stance in an asset with lower expenditures compared to acquiring shares of the asset.
Second, investors employ options to hedge against (mitigate) the risk exposure of their portfolios.
Third, the holder of an option may sometimes have the potential to generate earnings by purchasing call options or assuming the role of an options writer.
Fourth, options also present a straightforward avenue for investing in certain circumstances, such as, for example, oil.
In all cases, options traders should closely monitor their options’ daily trading volume and open interest level (the number of options or futures contracts held by traders in active positions at a given time), which are significant data for making astute investment choices.
Calls versus Puts
A call option entitles its holder, but without creating any obligation, to purchase the underlying security at a pre-determined price called the “strike price”—regardless of market conditions when the option is exercised—whether on or before the expiration date.
The value of a call option increases as the price of the underlying asset goes up (calls exhibit a “positive delta”). In other words, a call is tantamount to a bet that the underlying security will increase in price.
Note that a long call has a limitless potential for gain (if the value of the underlying security continues to rise), while the maximum potential for loss remains capped (at the strike price).
Unlike the case with call options, a “put” entitles its holder, but without creating any obligation, to sell the underlying security at the strike price before or on the expiration date.
The value of a put increases as the price of the underlying asset goes down (puts exhibit a “negative delta”). In other words, a put is tantamount to a bet that the underlying security will decrease in price. Thus, a put essentially constitutes a short position in the underlying security.
Note that a long put has an inherently limited potential for gain (established by the strike price) and a potential for loss that is limited to the whole value of the strike price (if the value of the underlying asset drops to zero).
However, like short positions, puts may be desirable because they function as insurance, establishing a lower limit on price and enabling investors to mitigate risks in their positions.