Too embarrassed to ask: what is an option?
Rather than buy shares in a company, traders who want to profit from short-term moves in the market often prefer to use financial tools such as options. But 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.
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