Forex trading involves risk. Losses can exceed deposits

Option definition

Forex trading involves risk. Losses can exceed deposits

An option is a financial instrument that offers the holder the right – but not the obligation – to buy or sell an asset at a set price within a set time period.

How do options work?

There are two types of options:

  • Calls, which give the holder the option to buy an asset at the strike price before the expiry date
  • Puts, which give the holder the option to sell an asset at the strike price before the expiry date

What is the holder?

Options are a contract between two market participants: the writer and the holder. The writer is the option provider, and the holder is the person who has the right to buy or sell the asset. In return for that right, the holder pays the writer a premium.

What is the strike price?

The strike price is the price at which the holder can buy or sell the asset, set out in the contract from the outset.

What is the expiry date?

All options have an expiry date – the point at which the option contract is no longer valid, and the holder no longer has the opportunity to buy or sell the underlying asset.

Call example

Put example

Gold is trading at $1400

Gold is trading at $1400

The holder pays a premium to the writer for the right to buy one troy ounce gold for $1500, within the next two weeks

The holder pays a premium to the writer for the right to sell one troy ounce of gold for $1300, within the next two weeks

Gold rises to $1700 one week later. The holder can now exercise his option and buy gold for $1500 thus $200 less than its current market price

Gold drops to $1100 one week later. The holder can now exercise his option and sell gold for $1300 thus $200 more than its current market price

Options tend to trade in lots, with the size of the lot varying depending on the type of option. In equity options, for instance, each contract represents 100 shares of the stock underlying the option.

Who profits from options?

In options trading, either the writer or the holder can make a profit:

  • if the asset’s price does not move beyond the strike price before the option expires, then the writer profits from the premium paid by the holder
  • the holder makes a profit if the asset’s price moves beyond the strike price by more than the premium they initially paid, before it expires

Using options for hedging

While options are used to speculate on market movements, they are also used as a tool for hedging. If you hold a large amount of a certain stock, for instance, you can mitigate the risk of your stock falling in value by buying a put option with it as the underlying asset. If the price of your stock drops beneath the strike price of your option, you can still sell at the strike price and cut your losses.

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