Options are a form of financial derivative. When you buy an option, you are buying a contract that gives you the right to buy or sell a particular asset (be it shares, indices or currencies) during a set period of time at a set price. You pay a premium for this contract.
How do options work?
Options come in two forms: calls and puts. If you buy a call, it gives you the opportunity to buy the underlying asset named in the contract at a set price. If you buy a put, you have the opportunity to sell the underlying asset.
The writer is the provider of the option. In a call, they are the party you are buying assets from. In a put, they are the party you are selling assets to. In return for taking on the risk of trading an asset with you at a guaranteed price, you pay them a premium.
What are the benefits?
- Risk management. Imagine that you own a large amount of a particular asset. If that asset begins to fall in value, then a put option on that asset would rise in value and offset the drop in your portfolio.
- Diversification. The ease of trading, and lower fees associated with options trading, can help you diversify your portfolio into new asset classes without taking on prohibitive admin or costs.
- Time to decide. Instead of trading an asset outright, you can buy an option and have the time until the option expires to decide whether you think the trade is worth it.
- Ease of trading. You can use options to speculate on markets without ever intending to trade the underlying asset. Just buy a call or a put option, and then sell it on for a profit if the market moves favourably.
- Leverage. Buying an option means getting exposure to a position many times larger than the premium you have paid. So you can use them to make your capital go further, with the increased risk that is inherent to leveraged trading.
What are the risks?
- Time constraints. Options might buy you time, but you should always bear in mind that an option can become worthless the moment it expires.
- Early exercising. Selling some types of an option can mean taking on risk if the buyer chooses to exercise his right to buy early, as you may be forced to sell your asset at a discount to the current market price.
- Time erosion. A significant part of an option’s value will often come from the remaining time it has before it expires. This value will diminish as expiry draws closer.
- Margin calls. Some options will require you to provide extra security to prove that you can meet the obligations of the options contract if it is exercised. This might mean adding extra funds to prevent your position from being closed, leaving you liable for any resulting losses.