What Are Options?
The most common form of financial instruments that the average investor can trade, are usually fairly conservative like stocks, mutual funds and bonds. However for the more adventurous investor, there is another type of financial instrument called options which can be more suited to their appetite for risks. Of course with the increased level of risks faced, the potential for baigger rewards is also there. So what are options? Options are essentially contractual agreements between two parties, a buyer and a seller, to agree to buy or sell a certain underlying asset at a certain price within or on a certain predetermined timeframe.
What are Options used for?
As mentioned earlier, options are contracts but also are financial instruments which can be bought and sold like stocks or bonds. The main difference between options and other types of financial instruments is the purpose for which they were designed for. Options initially came about because of the need for the market to quantify uncertainties. They were used for hedging against adverse price fluctuations. A buyer of an options contract is given the right by the seller of the option but not the obligation to buy an underlying asset at a fixed price usually within a 3 months period.
For example, let’s say you are an avid collector of classic cars. One day you managed to find a rare car which you want to buy but lack the funds to buy it with. You decide to call on your bank to arrange for a loan to which your bank agrees but can only release the money to you in 10 weeks after all the loan processing is done. Rather than losing the opportunity to purchase the car, you can enter into a contract with the seller to agree to sell the car to you for $100,000 within 90 days so you have time to raise the necessary funds.
Let’s suppose for this option, you paid 5% of the agreed purchase price ($100,000) which is $5000. Now for $5000, you have secured the rights to buy the car at $100,000 within 90 months. Because you know the bank is going to release the money to youin 10 weeks, you will be able to close the transaction within the timeframe of the option contract and not worry about the car being sold off during the interim period.
In the above example, we have seen how an option contract can be used to hedge against the possible risk of the car being sold off while your car loan is being processed. However, this is only one possible scenario that could play out. In a world of uncertainties, there can always be other possibilities.
Let’s say while waiting for the loan to be dispersed, you do some research and discover that the car that you wanted to buy was a special edition production and is the only one of its kind in the world. Because of this, the value of the car is tripled ($300,000). As you hold the option to buy the car at $100,000, the seller of the car is obligated to sell it to you for $100,000 despite its value being tripled. So if in the end you decided to resell the car after purchasing it, you will stand to make a profit of $195,000 [$300,000 – ($100,000 + $5,000)].
Of course, it is entirely possible that after doing further research that you discovered much to your dismay that the car you wanted to buy is only a replica and not the real deal. And because of this discovery, the car is actually worth much less than $100,000. Since the option contract gives you the right to buy the car at $100,000 but not the obligation, you do not have to go through the deal. However you will end up losing the $5,000 that you paid for the option contract. On the brighter side of things, this is the maximum amount that you could possibly lose. Had you gone through with the deal, your losses could had ended up much more.
So far in our examples, we have discussed the use of options contracts on the basis of risk mitigation. However, option contracts can be much more than that. They can also be used as instruments for profiting in the uncertainties of life. For example, after discovering that the car you want to buy is the only one of its kind in the world, the bank called to inform you that your loan processing will take more than 3 months. This means that you will have no ability to exercise the option contract within the time frame agreed with the seller of car.
However, instead of taking a loss of $5000 paid for the option, you could assign the option to 3rd party say for $100,000. We have to remember that the value of car had tripled to $300,000 from $100,000. This mean the implicit value of the option contract has also increased not necessarily by 300%. Hence, even after having paying $100,000 for the option contract and another $100,000 for the car, the 3rd party still gets to profit $100,000 from the increased value of the car. The world of financial investing works pretty much in this manner with regards to options.
Most investors of financial options are speculators and do not take actual possession of the underlying asset. They gamble on the assumption that the option’s price will rise before its expiry and sell it to profit from the price difference that they paid for it.
“Call” And “Put” Options
Options contracts can be in two forms; “Call” Options or “Put” Options.
- Call Options
With a Call option, the holder of the option has the right to BUY an underlying asset at a specified price within a specified timeframe. Normally, buyers of call options are hoping that the price underlying asset will rise within the interim period. This is actually akin to holding a long market position.
- Put Options
For a Put option, the holder of the option has the right to SELL an underlying asset at a specified price within a specified timeframe. With Put options, you want the price of the underlying to fall before the end of specified time frame. We call this having a short market position.
Types of Options
Options can be classified into two types: Traditional/Vanilla Options or Exotic Options.
- Traditional/Vanilla Options
This is an all encompassing term for describing options with the standard financial terms like a fixed strike price, expiration date and covers one underlying asset. They can either be American type options (these can be exercised from the time of purchase right to the expiration period) or European type options (these can only be exercised at maturity).
- Exotic Options
These refer to options with non-standard terms and are normally traded in the over-the-counter (OTC) market. Currently, the most popular types of exotic options in the retail financial market are binary options. Binary options differ from traditional/vanilla options because of the way they are structured. With binary options, the payout is predetermined and fixed whereas with vanilla options, the payout is dependent on the price of the underlying asset.
Binary options also differs from vanilla options in the sense that they can only have two possible outcomes, in-the-money or out-of the-money. With vanilla options it is also possible to have a third outcome, at-the-money where the strike price of the option is the same as the market price of the underlying asset.
The Allure of Investing In Options
Regardless of the type of options invested in, options represent a very cost effective way of investing in the financial markets. This is because the profit potential is so huge when compared to having to plough investment capital into the purchase of the actual underlying asset. In other words, options allow investors to profit from the same price fluctuations in the price of the underlying asset without actually having to risk a large amount of capital. If we refer back to our example in scenario 3 above, we can see that with just $5000 capital outlay, we stand to gain a profit of $95,000.
Options Are Not Without Risks (Then Again What is?)
Despite the potential to reap large amount of profits within a short period of time, you should always remember that options are very high risk financial instruments. Unless one has a very clear understanding about how options work and the level of risks involved, one should never attempt to trade in options. Then again, even if you are not interested in trading options in a speculative manner, it is still good to learn how they work in the event that you have to use them for hedging as part of your risk mitigation strategy.