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.
-
How much could your cash ISA save you in tax?Official data reveals ISAs will collectively save us an estimated £6.7 billion in tax this year. We’ve crunched the numbers to find out how much a cash ISA could save you
-
The 8% pension rule: what is it and is it enough to retire on?
You are probably saving this amount into a pension each month without even realising with the 8% pensions rule. But is what is this and is it enough to give you a comfortable retirement?
-
What is an investment trust?
Videos “Active” investment funds come in two main varieties, one of which is investment trusts. But what exactly is an investment trust?
-
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.
-
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.
-
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?
-
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?
-
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.
-
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.
-
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
