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What Are Options In Finance?

Updated on April 19, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Options In Finance?

Options are financial contracts that allow the buyer a right, but not an obligation – like in the case of futures or stocks, to buy or sell an asset on a specific date at a particular price called the strike price, which is predetermined at the date when the option is being purchased or sold.

What Are Options In Finance

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The contract allows the buyer to purchase or sell the asset without actually possessing it. It can be done online or with the help of brokers and are widely used for either speculation or hedging. The process is risky but with proper analysis and detailed understanding, investors can use it to take advantage of market fluctuations to earn profit.

Key Takeaways

  • Options are financial contracts that grant the buyer the right, but not the responsibility, to purchase or sell an asset at a predetermined price, known as the strike price, specified when the option is bought or sold.
  • The call option gives the holder the right to buy the underlying asset at a specified price and on a selected date. The right to sell them at a preset price and date is granted to the put option holder.
  • Options have a limited shelf life because of their expiration dates. Therefore, they are a valuable resource if they are utilized.
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What Are Options In Finance Explained

Options in finance are a type financial instruments or contracts that has two parties, a buyer and a seller. The buyer has the right and the seller has an obligation to meet the right of the buyer in the contract.

The contracts or real options in finance are based on an underlying asset, which can be an index, a stock, commodity or any other type of asset that can be bought and sold. However, in this process, there is no need to actually buy or sell the asset in physical form. The selection of the type of contact will depend on the viewpoint of the buyer and seller as per market conditions.

These financial products allow the investors to hedge their risk exposure of portfolio or to speculate and earn profits during trending markets. It helps or provides a platform for investment to those who cannot otherwise afford to invest in certain assets, especially commodities that are very highly priced, like oil.

The popularity of Options has surged over the last few years.

You will agree with this statement once you read the statistics provided by the Options Industry Council.

  • The year 1973: Volume of options traded = 1 Million
  • The year 2015: Volume of options traded = 5 Billion

That’s a huge leap. Is anybody interested in Trading Options? This is an awesome route to diversify your portfolio.

However, your first step should be to understand what Options in Finance are? So in this article, we will focus on the nuts and bolts of Options.

Infographics

Reading time: 90 seconds 

Options Infographics

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What Are Options In Finance Book Vs Analogy

We will try to break down “What are Options in Finance” in two ways: 1) What the Books say! 2) How I like to Decode them!

#1 What the Books say about what are Options in Finance!

#2 How I like to Decode What are Options in Finance?

Understanding Options in Finance can be intimidating at first. Even I had a tough time when I first started. But don’t worry. You can find the underlying idea behind an option in many simple things. Let’s discuss one analogy for the same.

The Party Planners Analogy:

Now consider two scenarios:

Scenario 1: Having The Right! 
  • Later you learn that Party Planners have arranged birthdays of Celebrities and have now raised their prices to $5000.
  •  In this case, you still pay them the earlier promised amount of $3000 as you have the right to the same.
Scenario 2: No Obligation! 
  • You learn that the Party Planners are poor in planning and Organizing through word of mouth.
  • In this case, you don’t have to go forward with them, as you don’t have an obligation.
  •  But you lose your earlier paid amount of $500. You don’t mind the same as you can save your Parent’s party.

This is similar to how Options work. You have the right but not the obligation to exercise them. Let’s now discover some important terms and concepts of Options trading.

Parties To The Option Contract

An Option Contract consists of the following two parties:

  1. Holder: Buyer of the Contract
  2. Writer: Seller of the Contract

When the option contract holder chooses to initiate the transaction, he is said to be exercising the option.

When the holder does not initiate or exercise the contract, then the contract eventually expires.

Underlying Assets In Options

Being a form of derivative, Options derive their value from an underlying asset. So what are these underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more?

  • Stocks
  • Bonds
  • Indices
  • Foreign currencies
  • Commodities
  • Basket options (collection of different assets)

Call And Put Options

The key to understanding what options in Finance are is to know what are Calls and Puts!!!

  • The call option gives the holder the right but not the obligation to buy an underlying asset at a specified price and a predetermined date.
  • The put option gives the holder the right to sell an underlying asset at a specified price and a predetermined date.

Types

Here we will understand what in-money options and out of the money optionsOut Of The Money Options”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more are. The image above will help you to remember what option types are.

types of options
  1. In the Money Call Option:

The call optionCall OptionA call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration).read more is in the moneyIn The MoneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price.read more when the current market price exceeds the strike price.

  1. Out of the Money Call Option:

The call option is out of the money when the market price is below the exercise strike priceExercise Strike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more.

  1. In the Money Put Option:

The Put option is in the money when the current market price is above the strike price.

  1. In the Money Call Option:

The Put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more is out of the money when the current market price is below the strike price.

Options contracts?

#1 Contract Size

  • Contract size means the amount or the number of underlying assets covered by the option contract.
  • Let’s say that the underlying asset is Stock/Shares, and one contract includes 100 shares.
  • So when the holder exercises one option contract, 100 shares change hands.

#2 Strike Price

  • Strike Price is the predetermined Buying or Selling price for the underlying asset if the option is exercised.
  • For the Call Option, the strike price is the one at which the security can be bought.
  • For the Put Option, the strike price is the one at which the security can be sold.

So what is the relation between the strike price and the market price of the security?

The answer is profit.

If the option is exercised, then the difference between the current market price and the strike price is the amount of profit made.

#3 Premium

Once everything is selected, clicking on the “Get Data” button will give you the Premium amount.

Options Premium

Options Premium has two main components:

Intrinsic Value:

Don’t get daunted by intrinsic value; it’s easy to understand.

Intrinsic value is the difference between the underlying price and the strike price.

Let’s present it with the help of a formula to understand it better.

  • Intrinsic Value: Call Option

For Call Options, this is how you will calculate the Intrinsic Value:

Intrinsic value = Current Stock Price – Strike Price

  • Intrinsic Value: Put Option

For Put Options, this is how you will calculate the Intrinsic Value:

Intrinsic Value= Strike Price – Current Stock Price

Time Value

So let’s now understand what time value is.

  • Suppose you buy an option with a strike price of $100. But unfortunately, its price goes down to $90.
  • Now, in this case, you will not exercise your option, because you will be at a loss.
  • But in 1 or 2 months, the prices are expected to rise to $105. So, in this case, you will make a profit of $10 if you hold it for another month.
  •  You might have to pay an extra $5 to hold your contract. This extra $5 is your Time value.

So long story short:

Time value is the amount you are ready to pay, hoping the market might move in your favor.

Source: Optionseduction

Option Premium Formula:

Now understand this formula for Option premium:

Premium= Intrinsic Value + Time Value

So in our case, the option premium comes to:

Premium = $10 + $5 = $15

Factors affecting Option Premium

Various factors may affect the options premium. Some of them are:

  • Price may either increase or decrease. Changes in the price lead to an increase or decrease in the premium.
  • Strike Price plays a major role in determining the option’s intrinsic value. The more the option becomes in the money, the more the premium increases. Similarly, it decreases when the option becomes out of money.
  • Volatility is the measure of the risk or the variability in the price. Hence you can say that the higher the volatility, the greater the expected fluctuations in the price and vice-versa.

Why Trade Options?

Given a choice, most of us will prefer buying stocks to buying options. Opting for trading is considered a bit more complicated, but it can give you the benefits that stocks cannot give.

You can learn more about Options Trading StrategiesOptions Trading StrategiesOptions trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index.read more here.

The following are some reasons as to why Options are beneficial:

Cost Advantage

To understand this, let’s take an example of Buying a Stock and Buying Call Options on the same stock. You will be able to see how the returns generated vary.

We have taken examples of two different investors, one investing in Stocks and the other in Options. These are simple examples just to understand the difference in returns. Actual trading may involve additional calculations as well.

Investing-in-Stocks
Investing-in-Options

Out of box Returns

From the above example, we have understood the vast difference in the return percentage. Buying a Stock gave us an overall return of 10%, whereas with buying an Option, the returns shooted to 60%.

Leveraged Gains

Options enable you to put in less money and obtain additional gain.

Steps for Options Trading

Steps for Options Trading

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Now that you have understood what options in Finance are, let us look at Options Trading.

There are three major milestones of Options Trading.

  • Preparation
  • Getting Started
  • Advanced Leap

Step 1: Preparation

Starting with the first step, you will do all the necessary preparations as follows:

  • Open your brokerage account:

To enter your trading transactions, you need your brokerage accountBrokerage AccountA brokerage account is a taxable investment account in a brokerage company where a person deposits its assets and instructs the company to trade in shares or bonds on their behalf. In addition, the company deducts some brokerage or commission.read more. Open the same and do some initial research to find the best account for yourself.

  • Approve Yourself:

Get yourself approved by the Securities and Exchange Commission as per their options trading requirements.

  • Learn the Lingo:

Get yourself acquainted with all the Options trading terminologies. This will help you understand the process easily.

  • Understand Charts & Patterns:

Once you start trading, you will pay great attention to the Price Movements. So to know how this works, it is necessary to get hands-on technical analysis knowledge.

Step 2: Getting Started

  • Keep Calm and Paper Trade First

To strike the iron when it’s hot, you need to know the temperature at which it gets hot. Similarly, for trading options, first, understand its nuances. Start Paper tradingPaper TradingA paper trade is a virtual trade that allows investors to practice stock trading for educational purposes without investing real money. It helps investors learn different trading strategies by keeping track of their positions and portfolio on a virtual trading platform.read more, know how much your returns are, and then proceed further.

  • Stick to Limit Orders

Limit ordersLimit OrdersLimit order purchases or sells the security at the mentioned price or better. In the case of sell orders, it will be triggered at a limit price or higher, whereas for the buy orders, it will be triggered only at a limit price or lower.read more set the maximum and minimum limit at which you are willing to buy or sell. This also helps you to maximize your returns.

  • Balanced Portfolio is the key to better returns.

This is like the old saying, “Don’t hold all the eggs in one basket.” Similarly, ensure that all the options are not Call or Put—balance both types to maximize your returns.

Step 3: Advanced Leap

  • Try the untouched

Once you are confident and considering making some good returns, move forward with advanced-level strategies. Make sure you know your statisticsStatisticsStatistics is the science behind identifying, collecting, organizing and summarizing, analyzing, interpreting, and finally, presenting such data, either qualitative or quantitative, which helps make better and effective decisions with relevance.read more well before taking this step.

Source: Wikihow

Disadvantages

  • Time Sensitive Investments

Since the contract is for a short period, you may lose your entire investment even with a correct market direction prediction.

  • Higher Commissions

When you compare the commissions for a normal Stock and an option, you will find a large difference. Yes, commissions for Options are higher.

  • Complexity of Operations

Options and Strategies are not easy. They may become complicated for novice investors.

  • Time Decay Factor

Many times options expire worthless. Again this is the effect of the time-sensitive nature of the options.

Source: www.zeromillion.com

Beware of the Option Risks!

Now that you have a basic understanding of What options are in Finance and Options Trading let us look at Options Risks. Remember that there are two sides to the same coin. Just as there are many advantages to trading options, various risks are also involved.

  • Wasted assets if not exercised!

Options come with a Limited life as they have an expiry date. Thus if they are not exercised, they are a wasted assetWasted AssetWasting assets refer to fixed assets or financial instruments that have a short life or lose their value over time. Fixed assets like equipment, furniture or vehicle and the financial market instruments such as options belong to this category.read more.

  • Leverage may Backfire

Although the initial capital required may be low, even small market movements can greatly impact the Option ContractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more. Also, have a look at Financial LeverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more

  • Losses may Mountain for the option “Writers.”

It is seen that option writers are at greater risk than option holders. They receive a limited fixed premium, but the loss can be unlimited.

  • Options Liquidity at stake

There are different options, which may pose a problem of low liquidity for each type. This may cause a problem in making the required trades at the right prices.

What are Options in Finance – Know what you want

I would say that you clearly know what you want to accomplish before you start trading options. You may want to earn more income or increase the value of your portfolio.

Once you know your goal, you can easily narrow down appropriate strategies.

So Start your Options Trading with these three words:

Learn, Apply, Master!!!

Frequently Asked Questions (FAQs)

What are real options in finance?

Real options are ventures that use physical assets rather than financial instruments. The choice to enlarge, postpone, delay, or altogether terminate a project are all valid alternatives. Financial analysts and business managers use real choices’ economic worth to guide their judgments.

What is the difference between an option and a future?

An option allows the buyer to purchase (or sell) an asset at a predetermined price at any point during the contract term but does not obligate them to do so. A futures contract binds the buyer to buy and the seller to sell and deliver a particular asset at a predetermined future date.

Which is more risky, futures or options?

Although a lot might depend on your risk tolerance, futures are often riskier than options. A futures contract is a legally binding arrangement between a buyer and a seller in which they agree to exchange an asset at a specified price in a preset future month. As a result, both parties are committed to the transaction.

This is a guide to what are Options In Finance. We explain it with infographics, book vs analogy, parties & underlying assets. Here we also discuss why Trade Options along with steps for options trading. You can also learn more about Derivatives from the following articles.

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