What is an option?
Traders who want to profit from short-term moves often use options, but what is an option and how do they work?
Many people reading this might be asking "What is an option?" In this article, we'll take a look at these financial products.
An option is simply the right to buy (a 'call' option) or sell (a 'put' option) a quantity of any asset by an agreed expiry date for a fixed ('strike') price.
What is an option?
Options can be used in a portfolio as a way to manage risk and potentially increase returns. By buying a put option, an investor can protect their portfolio from potential losses if the value of the underlying asset decreases.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
On the other hand, buying a call option can provide the opportunity to profit from a potential increase in the underlying asset's value. Overall, options can offer flexibility and customization for an investor's portfolio strategy.
As with insurance policies, the buyer of an option pays a non-refundable premium to the seller for the right to either exercise the option before it expires or abandon it. So, someone who holds gold and is worried about the price falling but doesn't want to sell in case they are wrong could buy a three-month 'put' option instead.
Should gold fall over the three months, it can be delivered to the option seller at the higher fixed strike price rather than the market price. Should gold rise, the buyer can abandon the option, hold onto their gold and just suffers the option premium cost.
The risks of option trading
It's crucial to understand that options trading carries inherent risks. If the underlying asset's value moves in an unexpected direction, options can expire worthless, resulting in a loss of the premium paid.
Additionally, options are complex and require a thorough understanding of the underlying asset and market conditions. Before incorporating options into a portfolio strategy, you should carefully consider the potential risks and rewards, as well as the risk of potential margin calls.
Margin calls are triggered when a trader's account value falls below a certain level, requiring the trader to deposit additional funds to maintain the required margin level. In options trading, margin calls may occur when an option holder's account cannot cover the potential losses of an option position.
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
Jacob is an entrepreneur, hedge-fund expert and the founder and CEO of ValueWalk.
What started as a hobby in 2011 morphed into a well-known financial media empire focusing in particular on simplifying the opaque world of the hedge fund.
Before devoting all his time to ValueWalk, Jacob worked as an equity analyst specialising in mid- and small-cap stocks. Jacob also worked in business development for hedge funds.
He lives with his wife and five children in New Jersey.
Jacob only invests in broad-based ETFs and mutual funds to avoid any conflict of interest that could arise from buying individual stocks.
-
The best houses for sale with wildflower meadows
The best houses for sale with wildflower meadows – from a 1770s mill house in Petersfield, Hampshire, to a cottage in Fittleworth, West Sussex
By Natasha Langan Published
-
Will a Santa Rally bring festive cheer to investor portfolios this year?
Investors will be hoping for a seasonal stock market boost in December
By Marc Shoffman Published
-
What is a dividend yield?
Videos Learn what a dividend yield is and what it can tell investors about a company's plans to return profits to its investors.
By Rupert Hargreaves Published
-
High earners to pay nearly £2000 more in tax due to fiscal drag
Videos The government froze tax thresholds, which will drag employees into higher tax bands as wages rise with inflation. We explain what fiscal drag is, and how to avoid it.
By Nicole García Mérida Last updated
-
What is a deficit?
Videos When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter?
By MoneyWeek Published
-
Too embarrassed to ask: what is moral hazard?
Videos The term “moral hazard” comes from the insurance industry in the 18th century. But what does it mean today?
By MoneyWeek Published
-
Too embarrassed to ask: what is contagion?
Videos Most of us probably know what “contagion” is in a biological sense. But it also crops up in financial markets. Here's what it means.
By MoneyWeek Published
-
Too embarrassed to ask: what is a marginal tax rate?
Videos Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
By MoneyWeek Published
-
Too embarrassed to ask: what is stagflation?
Videos Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is
By MoneyWeek Published
-
Too embarrassed to ask: what is the metaverse?
Videos The term “metaverse” sounds like something out of a science fiction novel (and it is). But what does it actually mean?
By MoneyWeek Published