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?

Options trading on Wall Street
(Image credit: Getty Images)

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. 

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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.

Jacob Wolinsky

Jacob is the founder and CEO of ValueWalk. What started as a hobby 10 years ago turned into a well-known financial media empire focusing in particular on simplifying the opaque world of the hedge fund world. Before doing ValueWalk full time, Jacob worked as an equity analyst specializing 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. Full Disclosure: Jacob only invests in broad-based ETFs and mutual funds to avoid any conflict of interest.