Options

An option is a standardized right to buy or sell a certain underlying security, tradable on a stock exchange. With the purchase of an option, one receives the right to buy or sell a certain number of shares on a defined date (expiration date) at a predetermined price, but does not have to exercise this right (i.e. option and not obligation). One can use it to speculate on rising and falling prices.

Key points

  1. Options belong to the futures transactions. 
  2. Stocks often serve as the underlying, but there are also options on indices or exchange rates of currencies. 
  3. Options are used by companies for hedging or by investors for speculation. 
  4. Options offer the chance of very high profits at high risk. 

Options explained simply

How it works


For the right to buy (call option) or sell (put option) the underlying asset later, the buyer of the option pays a premium to the issuer (equivalent to the price of the option at the time of purchase). If the price of the underlying asset is higher than the pre-agreed strike price on the reporting date, the buyer of a call option makes a profit.

An investor purchases a call option at a price of €5 on share X. The share is currently quoted at €80, and the agreed strike price is €90. In scenario 1, share X is quoted at €100 on the expiration date. The investor uses his option and buys the share for 90 €. After deducting the premium of €5, a profit of €5 was achieved. In scenario 2, share X is quoted at 85 € below the strike price, this means an expiration and thus total loss of the option.

In summary, an option is a bet on the price of an underlying asset in the future. 



Why are options used?

Options are used by companies to hedge their exposure. Private investors use options because very high profits are possible, but trading options should only be used by very experienced investors. Strongly founded previous knowledge is necessary, besides the profit depends on many different factors which must be considered at the same time. Most private investors lose money when trading options.

4 basic options

In the field of options there are 4 different basic types. All advanced options strategies are composed of these four basic types:

  • Long Call 
  • Long Put 
  • Short Call 
  • Short Put 


For now, we will leave it at these terms. Each of these basic options will be discussed and explained later in a separate lesson. However, the general explanation of terms already takes place here. 

What do these options mean in general?

Here it is worth paying attention. The following lines can be a bit confusing. But if you have understood this text, you will have undreamt-of possibilities.

"Long"... means the buyer side of the option. The option is bought by the investor.

"Short"... refers to the seller side of the option. The option is sold by the investor.

So far, so good. Now it gets a bit more complicated. Call and put are always explained from the buyer's side (i.e. the "long" side).

"Call" ... refers to the call option. The buyer of the option (long) gets the right to buy a security.

"Put"... denotes the put option. The buyer of the option (long) receives the right to sell a security. 


conclusion

An option regulates the rights and obligations between the buyer and seller of an underlying security (for example, a stock or a commodity). The buyer of the option buys a right. The seller of the option sells an obligation. He undertakes to buy the buyer's shares or to sell him shares in a company if the buyer honors his right.


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