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Last Updated on May 11, 2021 by Work In My Pajamas
An option gives the holder a right, but not an obligation, to carry out a pre-specified transaction.
Example: You bought a stock option that gives the holder the right to purchase 100 shares in Company XYZ on the 31st of March 2022 for $10 per share. On March 31st, the share price had rose to $20/share, so this turned out to be a profitable deal for you.
In the example above, what you bought was a call option, since it gave you the right to buy. The opposite is a put option; it gives the holder a right to sell.
Example: You bought a stock option that gives the holder the right to sell 100 shares in Company MNO on the 31st of March 2022 for $10 per share. On March 31st, the share price had dropped to $5/share, so this turned out to be a profitable deal for you.
One of the advantages of using options is that you can gain exposure to an asset without actually buying the asset. If your bankroll is too small to afford to buy a hundred shares for $50 per share, it may still be big enough to permit buying an options contract for a hundred shares. That way, you have exposure to the price movement, without actually owning any shares in the company.
Another good thing about options is that they make it easy to make money even in falling markets. If you believe that the price of shares in Company MNO is about to fall, you don´t want to buy shares. Instead, you could short-sell shares in Company MNO, but that is risky and usually also come with a significant short-selling cost. Using a put option is easier and has a limited downside.
Important: If you are the holder of an option, you are never forced to use it (exercise it). Also, today, most normal options are cash-settled. So, if you have the right to buy a 100 shares, you don´t actually buy those shares when you exercise the option. Instead, the entity that created (wrote/issued) the option will pay you the difference between the share´s market price and the price you have a right to buy shares for.
Example: You have the right to buy 100 shares for $50 each. The share market price is $65 on the expiry date when you elect to exercise (use) the option. The issuer of the option does not sell you any shares. Instead, they simply pay you $15 x 100 = $1500.
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Most Options Are Cash-Settled
Important: If you want to buy an option that actually gives you the right to become the owner of shares in Company MNO, have 100 kilograms of silver delivered, or anything else like that, you have to be very careful when you buy the option and make sure it is not an option that can and will be cash-settled instead. Exchange-traded options are always cash-settled, and many of the over-the-counter options are cash settled too.
Using Options
Options are used for various reasons. When it comes to options that are cash-settled, they are typically used for speculation or hedging.
Speculation is when you buy an option hoping that it will yield you a profit. If you buy an option that gives you the right to buy 100 shares at $50 a share, you will of course hope for the share price to go up far above $50. If you buy an option that gives you the right to sell 100 shares for $50 per share, you will be hoping for the share price to drop well below $50.
Hedging is a method for reducing risk, and buying an option can be a cost-effective way to reduce the risk of another investment. Using options to hedge is about limiting the possible downside by balancing the main investment with an option going in the other direction.
Sometimes short sellers use call options to manage the risk of the underlying price moving against them, e.g. because of a short squeeze.
