02.How options work
An option is a contract between two parties that gives the buyer the right, but not the obligation, to buy or sell a parcel of shares at a set price (the “exercise” price) on or before a future date.
There are two main types of options:
- a “call” gives the buyer a right to purchase the shares;
- a “put” gives the buyer a right to sell the shares.
The other party in the transaction, the one selling the option, is obliged to go through with the transaction on or before the option deadline if the buyer wishes it.
Options, a class of financial derivative, are commonly used by financial institutions and other investors for risk management. By paying what’s effectively an insurance premium to “lock in” a share price, a fund manager can limit the damage that a future fall in share prices would have on its investment portfolio. People with share portfolios can also sell call options, pocketing the premiums for extra income, while taking the risk that the shares appreciate and the buyer exercises their call option. But options aren’t just about playing safe – traders also use them to gain “leverage”, which increases the potential profits and risks without increasing the size of the initial outlay. Complex options strategies can also be employed as a speculative opportunity to make money.
More complex strategies
Buying a call or put option can be profitable or disastrous, depending on market conditions. Predicting share price trends, particularly in the short term, is notoriously difficult, even for professionals. Options trading education companies present complex strategies to address these difficulties. Techniques such as “straddles” and “strangles” involve buying a put and call option for the same share at the same time. Theoretically, by playing one option off against the other you can make money regardless of what happens to the share price. Investors use these strategies when they expect a big change in the underlying share price but are less confident about its direction. Another strategy is to both buy and sell options for the same share, with different strike prices.
Alternatively, an investor could sell a call and put option on the same share (known as a “short” straddle or strangle). In this case you’d hope the share price stays within a confined range, so that the buyers of your puts and calls won’t exercise their option to buy or sell them, and your profit will be the two premiums you’ve received. However, the risks with short straddles and strangles are great; if the share price moves outside the range specified by the options contracts, you may be forced to sell the shares at a very low price or buy them at a very high price – so your potential losses are unlimited.