What is an Option?
An option is a financial derivative, meaning that its value is derived from another financial instrument such as a stock or commodity. Options contracts grant the owner the right to buy or sell a financial instrument at a predetermined price for a given period of time. Options can be traded between private parties in over the counter (OTC) transactions, or they may be exchanged in a established market in the form of standardized contracts.
Options are commonly used by investors as "insurance" for their portfolio, however, there are various use cases that options can have in and investors portfolio such as speculation, income generation, and arbitrage trading.
Types of Option Contracts
As stated, options derive their value from an underlying instrument, this can be a stock, a commodity, a futures contract and even cryptocurrencies. In essence, there can exist option contracts for any object of value as long as there exist a market for it, however, the most common underlying types of instruments for options are stocks and commodities.
There exist two types of option contracts: Call Options and Put Options.
Call Options give the contract owner the right to buy the underlying instrument.
Put Options give the contract owner the right to sell the underlying instrument.
Standardized option contracts usually control 100 units of the underlying instrument. In other words, a stock call option contract on ticker XYZ would give the owner the right to buy 100 stock of XYZ.
Each option contract must specify the price (also known as the strike price), as well as an expiration date.
Example Use Case (Hedging)
Say you own 100 shares of Amazon stock which is currently trading at $1,000, you are afraid that the price of Amazon stock might severely drop within the next 3 months. As a result, you decide to hedge against this by buying 1 put contract that expires in 3 months.
In this case, the investor could buy a 3-month put contract at a strike price of $1,000. In other words, the investor buys the right to sell 100 shares of Amazon stock at a price of $1,000 for the next three months. So if the price of Amazon were to decrease to say $800 within the next three months, the investor's porfolio value will remain at $100,000 = $1,000 * 100, because he has the right to sell his Amazon shares at the strike price of $1,000.
It is important to note that standardized Option contracts are priced and traded in an exchange and are susceptible to market forces. Therefore, hedging a position with options comes at a cost depending on the factors that affect the price of an option.
Factors that affect the price of an option
As one may imagine, there are many moving parts when pricing option contracts. Some of these factors include:
- Price of the underlying
- Time to expiration
- Risk free interest rate
- Volatility of the underlying (More on this in another post)
We will further explore these variables and their relationship with option contracts in a future post.
Summary
In this article you learned what option contracts are and how they are useful for investors. Options can be traded over the counter or as standardized contracts in an exchange. There are various factors that affect the price of option contracts such as price of underlying, time to expiration, risk free interest rate, and the volatility of the underlying.