Too embarrassed to ask: what is an option?

When long-term investors put money into the stockmarket, they will usually buy shares or invest in a fund which owns a range of shares on their behalf.

They typically plan to hold these shares for a prolonged period of time – perhaps years or even decades.

However, traders who want to profit from short-term moves in the market often prefer to use financial tools known as derivatives.

A derivative is a type of financial product which derives its value from an underlying asset, such as a share, bond or commodity.

An option is one such derivative.

An option is a contract that gives the buyer the right (but not the obligation) to buy an asset, such as a share, for an agreed price (the “strike” price), on or before a certain “expiration” date.

If the option gives the holder the right to buy at a given strike price, it’s known as a “call” option. If it confers the right to sell, it is known as a “put” option.

So if you buy a call option, you will profit if the share price rises above a certain level by a certain date. If you buy a put option, you will profit if it falls below a certain level.

If an option is in profit, it is said to be “in the money”.

The person who buys the option pays an upfront fee – the premium – to the seller of the option (who is referred to as the option “writer”).

If the buyer “exercises” the option, the writer has to sell them the underlying asset if it’s a call option, or buy the asset from them, if it’s a put option.

If you write an option, you are betting that the option will expire worthless – “out of the money” – and you will thus make money from the premium.

Many factors dictate the price of an option, including how close the asset price is to the strike price; how much the price of the underlying asset tends to swing about – ie its “volatility”; and how far away the expiration date is.

Options are sophisticated financial instruments that can be very profitable, but are also much riskier than buying shares or bonds alone.

To learn more about what options might be used for, subscribe to MoneyWeek magazine.