Introduction to Options

What are Options

Options belong to the expansive family of derivatives. In essence, derivatives get their value from the price of something else. To grasp the concept of options, let’s visualize a simple scenario:

Imagine you’ve got your eye on a piece of land but aren’t quite ready to buy. Instead, you pay the owner a small fee to hold it for you at a fixed price for the next three months. If property prices shoot up during this period, you still get to buy it at the agreed price, making a potential gain. If not, you can decide not to buy, forfeiting only the small fee. This arrangement protects you from skyrocketing prices while offering the flexibility to back out.

In the world of finance, this is precisely what options offer — an agreement that grants the option owner the right, but not the obligation, to buy or sell an asset at a predetermined price up to a specific date. This ‘right’ comes at a cost, known as the option’s premium. Investors use options for various purposes: to hedge against potential price drops, generate additional income, or speculate on market movements. Think of them as flexible financial tools, letting you capitalize on market opportunities while limiting potential losses to the premium paid. Simply put, options give you options!

How Do Options Work

Fundamentally, there are two primary options to consider: ‘Calls’ and ‘Puts’. A call option gives the investor the right to buy an asset at a predetermined price (the strike price) and date (the expiry date), beneficial when expecting the asset’s price to rise. A put option allows the investor to sell, which is advantageous when expecting the asset’s price to fall. Investors use options either to hedge, protecting themselves from potential adverse price movements, or to speculate, hoping to profit from future price changes.

When you hear about the price of an option, you’re hearing about its ‘premium’. The price of this premium is based on the probability of future price events happening. Quite simply, the more likely something is to occur, the more expensive an option premium will be. These premiums are based on an option’s intrinsic value & extrinsic value (or time value). Let’s break them down.

Intrinsic value is like immediate profit — it’s the difference between the current asset price and the option’s set price (or strike price). Extrinsic value, on the other hand, considers variables like how much time remains before the option expires, and how volatile the assets or market conditions are. For example, more time left on the option typically results in higher premiums because the option buyer gains value from being able to wait longer. Greater volatility in the underlying assets typically leads to higher premiums because the option buyer has a higher likelihood of seeing the option in the money.

What about Exotic Options? Read on.