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A Quick Introduction to Options

Updated on May 3, 2016

Options are among the most popular derivatives instruments, often due to the quick rewards and breadth of opportunities they provide. However, option trading is not the same as stock trading and prudence says that amateurs should steer clear of this territory unless they have expert guidance.

So, what are options?

Similar to other derivative instruments, options derive their value from an underlying security that ranges from stocks to currencies. There are two parties on either side of an option contract - the option seller and the option buyer. As the name suggests, this offers the option buyer a choice to buy (call option) or sell (put option) the underlying asset on a specified date for a contracted price, also known as the strike price. Understand that it is only an option and as a buyer you will not be under an obligation to perform the contract. The option seller, though, will be so obliged if the buyer wants to complete the transaction on the stated date.

Therefore, the holder (buyer) assesses the worth of the option on the performance date and completes the transaction only if it is profitable. When you buy an option, you will need to pay an upfront fee, which works as a commitment fee. If you choose to drop the option on the performance date, your loss will be limited to the fee amount.

Options may be non-standardized contracts between any two parties, known as over-the-counter options (OTC) or may be standardized exchange-traded instruments (ETO). The OTC options offer enormous flexibility to meet a wide variety of business and investment needs, while ETOs carry the benefit of investment offloading before the expiry of the contract. This means you can sell an option you hold before its expiry on a designated exchange just like a stock.

Why to invest in options?

The option contracts arise out of the contrary opinions of two parties on the future prices of the same asset. For instance, in case of a call option, the buyer expects the price to go up, while the seller thinks the opposite will be true. These differing viewpoints serve the base for meeting a number of requirements, primarily:

  • Hedging. Options represent an effective strategy for guarding against various types of risks. An example would be currency hedges by international traders. An importer in the U.S. will need an insurance against the appreciation of a foreign currency (say, GBP) in which he or she needs to make a payment at a future date. This is because if GBP appreciates, they will need more units of USD for same amount of GBP payment. On the other hand, an exporter will hedge against the devaluation of foreign currency.
  • Deferment. Options may also be used to ensure a future investment at agreed upon price, especially in case of an immediate liquidity crunch.
  • Portfolio Management. Options can prove highly effective in overhauling an investment portfolio over a period of time. This strategy is particularly beneficial as the timing and quantum of the investments remains fixed. Therefore, last minute upsets are reduced to a great extent.
  • Speculation. One of the most common applications of options is for speculation. It can mean high returns in relatively shorter periods of time, but they also mean high risk and possibly, high losses.

What are the places to do options trading?

Standardized options are traded in a similar way as stocks. Apart from offline brokerage firms, you have online options, such as OptionsHouse, E*Trade, eToro, EZTrader and so on. You can open a cash or margin account with a minimum deposit at any of these websites.

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