When it comes to finance there is a whole host of terminology that not only sends your head into a spin; it also makes you want to hand over all your financial responsibility to someone else to manage.
As tempting as this sounds, there is no reason to abdicate your personal finance responsibilities to someone else just because you are overwhelmed by the terminology used.
After all, doesn't the financial industry purposely use off putting and confusing language as a barrier to entry into the world of finance?
One such area of finance that can be off-putting is the world of options.
Let us take options as an example. To a layman, an option is a choice we make. In any given situation we have a choice to make, this choice is also an option. We can opt to do A, B or C.
In Finance an option has an entirely different meaning that has nothing to do with choice and more to do with betting on an outcome.
What Is An Option In Finance?
An option gives the investor an obligation free means to either buy or sell an asset at an agreed price by a particular date or on a specified date.
And there we have it.
An option is simply one person saying to another I’ll buy/sell you what I have at a set price within a specified period or on a set date.
Once both sides are in agreement, the terms then become the basis of a contract, which is called an options contract.
What Is An Options Contract?
An options contract is an agreement between two parties, the buyer, and the seller, where the option buyer has the right to buy or sell an option at an agreed price no later than the set date.
The price that has been set is known as the strike price and the time element of the agreement is known as the expiration date.
As we demystify options and options contract, the next logical question to ask is where are they used.
Options are used in all areas of finance, and they are found in securities, commodities and in real estate transactions.
The term security refers to an asset that can be traded.
There are three main types of securities:
Equity securities such as stocks. These represent ownership in a publicly traded corporation
Debt securities such as bonds, banknotes, and debentures - this is when money has been lent to a company or government body. The person giving the money (creditor) can be an individual or organisation
Derivatives such as options, futures, forwards are the third type of security that is available to investors.
Commodities are the raw materials used as an input or raw material in the production of other goods or services. Examples of commodities are things like copper, wool, wheat, gold, diamonds and other precious metals.
The premise of a commodity is that there is little to no difference between a commodity coming from one producer and another.
This type of option is an agreement on a piece of real estate that gives exclusivity of purchase to the buyer and this means the seller is unable to sell the property to anyone else until the agreement has expired.
Prices To Be Aware Of With Options
To explain this, we’ll focus on stock options.
As a derivative instrument, the price of an option is based on the price of the underlying securities.
For stock options, this would be the price of the stocks that makes up the option.
There are also two prices to keep in mind when looking at options.
The first being the strike price, which is the price at which an option can be bought or sold. The strike price is determined when the contract is initially written. When the price is reached, the investor knows their option is profitable, also known as being in the money.
The second price to take into account when looking at options is the premium price. This is the amount paid for the option and in effect is your initial investment. It is also the amount you would lose if the option is not exercised or does not meet the strike price.
Options are usually sold in multiples of 100, so a premium price of $3.50 means you’ll be paying $350 for the option.
How Options Work
Now we know what an option is, how does one make money from options. How do they work?
The easiest way to explain this is through the use of a simple example. Before delving into the specifics of a contract, here are the two things each contract must have.
1) Each contract must have a strike price
2) Each contract must have an expiration date
Other things to note about options is they are usually sold in blocks of 100, and the price paid for options is called the premium.
Here is the example:
The current stock price of company XYZ is $65 and the premium to purchase that option is $3.15. The expiration date of the contract is the third Friday in July at a strike price of $70.
Note the key features in the contract.
- Current stock price
- Strike price
- Premium price
- Expiration date
As options are purchased in multiples of 100, the price of the contract is $315 ($3.15 x 100).
The option can only be exercised once the price of the stock gets to a minimum of $70.
If the stock price is $69, and the option is still in date, the option cannot be exercised. It is in effect worthless.
If the stock price is of company XYZ has increased to $75, the option can now be exercised, so long as the option is still in date, that is it has not expired. With these figures the option can be exercised for a profit.
An important note to make here is the investor bought the option for $315 ($3.15 x 100) so when the stock price was $69 the investor lost the $315 option purchase price as the strike price was $70. When the stock price was $75, the investor not only made the $315 purchase price back, the investor also made a profit.
One can choose to exercise an option once the strike price is met this, however, doesn’t seem to be how options work.
The CBOE (Chicago Board Options Exchange) believe that only 10% of options are exercised once the strike price is met. They also believe most options are traded out before the expiratory date and about 30% of options expire.
Now we know what an option is, what an options contract is, where they are used and how they work, the next question to answer is why are options used.
Type Of Options
There are two types of stock options:
These options can be exercised at any time between the date of purchase and the expiration date of the option. They also make up the majority of the public exchange traded stock options.
Also known as “share options” in the UK.
These options are not as common as American options and can only be settled on the expiration date.
An example of stock options is employee stock options. The main difference between this type of option and options, in general, is that employee stock options usually vest rather than maturing by a certain time.
To be able to buy the stock an employee must remain employed by an organisation for a specified period of time before the right to purchase the options can be exercised.
Also, rather than an
A grant price is the price the stock options has been set at, which is what the market value is at the time the stock options are granted.
So, if the share price goes up when the stock option is exercised, then the employee make a profit. If the share price goes down, the employee makes a loss.
Why Use Options?
There are two main reasons why options are used, and these are to speculate and to hedge.
This is like betting on the outcome of a situation. Just like we are always told the price of shares can go down as well as up, when it comes to speculating, you can speculate (bet) on whether the price is going to go up, down or remain unchanged.
Using options to speculate allows you to make money no matter what is happening in the marketplace.
In speculating, you need to predict if the price would go up or down, by how much and within what time frame. If the stars align and you are correct in all these areas, you stand to make a profit. If not, you’ll be making a loss as there is no leeway to be almost right.
Hedging is a form of insurance policy that allows you to take advantage of gains made in an investment while minimising the impact of the downside.
It is all about minimising your losses.
So options are used depending on if you want to bet on the outcome of a situation or if you want to minimise your losses.
What Are Stock Options?
This type of option is used by employers as an incentive to keep hold of employees.
Employee stock options are not available to members of the public, nor are they available to all employees within an organisation.
It is usually a benefit offered to middle managers and above.
How Do Stock Options Work?
Similar to options, stock options are privileged, meaning when new stock is issued, current stockholders are allowed to buy shares that are equal to the percentage they currently own in the company, at a price that is below the value of the new issue.
For instance, if you own 1.5% of a company, you can buy another 1.5% max, of the new issue at a special price only available to current shareholders.
It is worth pointing out like options; stock options give shareholders the right to buy and not the obligation to buy or sell a stock at an agreed price within or on a set date.
Where To Buy Options
Buying options is not for the faint hearted as there are a lot of moving parts to it.
Like all investments, it is always best to speak to your financial adviser before investing.
This article only gives a basic explanation of options and is aimed at people who have little to no knowledge of options.
Even if you are not buying options, it is a good idea to understand the basic premise of options as it may be something you consider adding to your riskier investment options in the future.
Also, by having a broad understanding of this type of investment, you would be able to ask the right type of questions and understand the answers you are given.
Having said this, where can one go to buy options? Here is a list of a few option brokers.
To conclude this article about options, we have defined what an option is, looked at what is included in an option contract. Explored the different type of options that can be purchased. We also outlined the costs involved in purchasing options.
Now you are armed with a basic understanding of options.