What are options

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What are options and how do you trade them? A detailed explanation

Definition of an Option

An option is a contract that allows you to buy or sell a unit of the underlying asset in the future at a fixed price. Options come in call and put varieties.

Option is a contract

Example of an option

Let’s take a closer look. Suppose that the current value of a company’s stock is one hundred dollars per share. The buyer enters into a contract that grants the right to buy the asset at one hundred dollars per share for a limited period of time.

This type of contract is called a call option and the set price in the option contract is called the strike price. For the purpose of this example, we will say that the cost of this contract is two dollars. In other words, this is the price of the option.

Let’s look at three possible scenarios.

Call option – Scenario 1.

The share price increases to 120 dollars in the given time period. In this case, the buyer can exercise the option to buy shares at one hundred dollars. And immediately sell them for 120 dollars earning twenty dollars minus the two dollars that were paid for the option for a total profit of eighteen dollars. This is 900 percent of the 2 dollar investment.

Call option – successful scenario

Call option – Scenario. 2.

If the share price drops for instance to 80 dollars, it isn’t profitable to use the option and buy shares for 100 dollars. So the option runs out and the buyer loses the two dollars invested in the option.

Loss is limited

Call option – Scenario 3.

If the share price increases to 102 two dollars, the income will be two dollars which covers the amount paid for the option. This share price beyond which the trader will make a profit is called the break-even level for the purchased option.

A put option works the same way but in the opposite direction. With a put option the option holder has the right to sell shares at a predetermined price.

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In the example above where the share price drops with a put option the trader can buy the stock at eighty dollars and sell for 100 hundred dollars as set in the option contract. Thus making a profit.

Put option – successful scenario

Exercising option before expiration

A special feature of classic options is that you don’t have to wait for the expiration time in order to exercise the option. For example. A trader bought a put option for the same two dollars.

And an hour later the asset price fell to eighty dollars. The trader can sell the option whenever he wants in order to make a profit.

Exercising option before expiration

The strike price of an option

The fixed price for buying or selling shares under a contract is called the strike price. In our previous example. The strike price was 100 dollars for a call option. The higher the strike prices compared to the current share price the cheaper the option.

This is because the price is less likely to reach a higher strike price although the potential profit is greater.

Now consider a call option in which the strike price is below the current share price. Options with strikes like these are called in the money options. Since you are already making a profit. But the cost of such options is much higher and the profit percentage is lower.

In-the-money call option

For a put option everything works exactly the opposite. The higher the strike price is compared to the current share price the more expensive the option. The lower the strike price the cheaper the option.

Expiration time

The expiration time is the deadline for using the right to buy call or sell put the asset at a fixed price the strike price. The expiration usually falls at the end of the workweek.

This means for example that you can buy an option for the end of the current week or the following week or for the last week of the selected month.

The farther the expiration is from the current date the more likely the price of the asset will move in the direction the buyer wants so the more expensive the option. The cost of options is determined by the market. IQ Option uses 13 options exchanges.

Cost of an option

Market conditions depend on a combination of many factors: supply and demand among traders, price volatility in the past, time to expiration and more.

We wish you successful trading on the IQ Option platform.

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What are options and how do they work?

Discover the fundamentals of buying and selling options.

Interested in options trading with IG?

What is an option?

An option is a financial product that enables you to trade on the future value of a market. When you buy an option, you’re paying a premium for the right to trade a market at a set price, before a set date when the option expires. Options are similar in this regard to futures – but unlike futures, there’s no obligation to trade if you don’t want to.

Say, for example, that you have an option contract that allows you to buy gold at $1300 for the next week.

If gold hits $1325, you can exercise your option and buy it for $1300, $25 less than the current market price.

If gold stays below $1275, then there’s no obligation to buy it for $1300. Though by not trading, you’ll lose the premium you paid for the option.

Are options leveraged?

Options are a leveraged form of trading – like CFDs – which is one major reason they’re attractive to many traders.

Take the above as an example. By buying a gold option, you could have paid a lot less to open your position than if you’d chosen to buy gold itself. And if the precious metal moves up in price, you could sell your option on without ever exercising it – profiting from gold’s price movement without committing a lot of capital.

That makes options a powerful tool for traders, but also brings its own issues.

What are options used for?

There are three main reasons for trading options: to limit your risk by hedging, to buy yourself time to decide if a trade is right for you, or to speculate on the price movements of various markets. While they have other uses – such as in complicated spread strategies – the majority of traders will use options for one or more of these.

Hedging with options

Options trading was first devised as a hedging tool. Say you owned stock in a company, but were worried that its price might fall in the near future. You could buy an option to sell your stock at a price that’s close to its current level – then if your stock’s price falls, you can exercise your option and limit your losses. If your stock’s price increases, then you’ve only lost the cost of buying the option in the first place.

Buying time to decide

Another key use for options is to extend the time you have to decide about whether a trade is worthwhile. Here, instead of buying a market that you aren’t entirely sure about immediately, you buy the option to trade it before a set date in the future. If, further down the line, you decide that you want to buy the market then you can exercise your option. If not, then once again you’ve only lost the premium.

Speculating with options

The flexibility of options has also made them a popular tool for speculation. That’s because the prices that options trade at will vary depending on a number factors, including how much time you have left to exercise your right to trade, and the value of the underlying market. An option to buy gold for $1300, for instance, will typically trade at higher price when gold is at $1299 than when it’s at $1200.

Speculators might trade options with no intention of ever exercising them. Instead, they’ll buy an option then sell it on when its premium increases.

For more information on option price movements, see how to trade options.

The different types of option

Options come in two main varieties: calls and puts.

  • Calls give you the right, but not the obligation, to buy a market at a set price before a set date
  • Puts give you the right, but not the obligation, to sell a market at a set price before a set date

Buy a call option, and you’ll get a long position on its underlying market. The more the market’s price rises, the more profit you can make. Buy a put option, and you have a short position on the underlying market. The further the market drops, the more profit you can make. Once either option expires, it will become completely worthless.

Here’s how to calculate the profit or loss on an options trade:

Calls

Profit or loss = underlying market’s price – strike price – premium

Puts

Profit or loss = strike price – underlying market’s price – premium

The components of an options trade

Options can seem complicated at first because of the terminology used by traders. Here’s a rundown of some of the key terms involved in options, and what they mean:

  • Writers and holders: the buyer of an option is known as the holder, while the seller is known as the writer. In a call, the holder has the right to buy the underlying market from the writer. In a put, the holder has the right to sell the underlying market to the writer
  • Premium: the fee paid by the holder to the writer for the option
  • Strike price: the price at which the holder can buy (calls) or sell (puts) the underlying market
  • Expiration date: the date on which the options contract terminates. After the expiration date, the option is worthless – so if the underlying market doesn’t hit the strike price before the expiration date, the holder can’t earn a profit
  • In the money: when the underlying market’s price is above the strike (for a call) or below the strike (for a put), meaning the holder can exercise the option and trade at a better price than the current market price
  • Out of the money: when the underlying market’s price is below the strike (for a call) or above the strike (for a put), meaning that exercising the option will incur a loss on the trade
  • At the money: when the underlying market’s price is equal to the strike, or very close to being equal to the strike

What can you trade with options?

  • Forex. Including majors like AUD/USD, EUR/USD, GBP/USD, USD/CHF and EUR/GBP
  • Shares. Including ASX 200 shares and a selection of leading US shares
  • Stock indices. Including the Australia 200 and Wall Street
  • Commodities. Including metals and energies

Four things to consider before trading options

Deciding whether you want to trade options means weighing the benefits against the potential downsides:

What Are Options Contracts?

An options contract is an agreement that gives a trader the right to buy or sell an asset at a predetermined price, either before or at a certain date. Although it may sound similar to futures contracts, traders that buy options contracts are not obligated to settle their positions.

Options contracts are derivatives that can be based on a wide range of underlying assets, including stocks, and cryptocurrencies. These contracts may also be derived from financial indexes. Typically, options contracts are used for hedging risks on existing positions and for speculative trading.

How do options contracts work?

There are two basic types of options, known as puts and calls. Call options give contract owners the right to buy the underlying asset, while put options confer the right to sell. As such, traders usually enter into calls when they expect the price of the underlying asset to increase, and puts when they expect the price to decrease. They may also use calls and puts hoping for prices to remain stable – or even a combination of the two types – to bet in favor or against market volatility.

An options contract consists of at least four components: size, expiration date, strike price, and premium. First, the size of the order refers to the number of contracts to be traded. Second, the expiration date is the date after which a trader can no longer exercise the option. Third, the strike price is the price at which the asset will be bought or sold (in case the contract buyer decides to exercise the option). Finally, the premium is the trading price of the options contract. It indicates the amount an investor must pay to obtain the power of choice. So buyers acquire contracts from writers (sellers) according to the value of the premium, which is constantly changing, as the expiration date gets closer.

Basically speaking, if the strike price is lower than the market price, the trader can buy the underlying asset at a discount and, after including the premium into the equation, they may choose to exercise the contract to make a profit. But if the strike price is higher than the market price, the holder has no reason to exercise the option, and the contract is deemed useless. When the contract is not exercised, the buyer only loses the premium paid when entering the position.

It is important to note that although the buyers are able to choose between exercising or not their calls and puts, the writers (sellers) are dependent on the buyers’ decision. So if a call option buyer decides to exercise his contract, the seller is obligated to sell the underlying asset. Similarly, if a trader buys a put option and decides to exercise it, the seller is obligated to buy the underlying asset from the contract holder. This means that writers are exposed to higher risks than buyers. While buyers have their losses limited to the premium paid for the contract, writers can lose much more depending on the asset’s market price.

Some contracts give traders the right to exercise their option anytime before the expiration date. These are usually referred to as American option contracts. In contrast, the European options contracts can only be exercised at the expiration date. It is worth noting, however, that these denominations have nothing to do with their geographical location.

Options premium

The value of the premium is affected by multiple factors. To simplify, we may assume that the premium of an option is dependent on at least four elements: the underlying asset’s price, the strike price, the time left until the expiration date, and the volatility of the corresponding market (or index). These four components present different effects on the premium of calls and put options, as illustrated in the following table.

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