What are Options?

Trading Options contracts

Although the origins of options can be traced back to the early ages- the establishment of the first modern, regulated exchange was not until 1973 with the Chicago Board Options Exchange (CBOE). Options contracts are now traded, primarily on shares, on most major exchanges around the world.

While somewhat more complicated than other derivatives- their advantages can be significant when they are used properly (as with any financial instrument). Generally speaking, they are a preferred instrument of more sophisticated short to medium-term traders, as well as of those who wish to use them to protect (hedge) other assets such as physical share portfolios.

Key considerations:

  • High versatility with many possible trading strategies and combinations thereof
  • Can be used to trade multiple asset classes
  • Options do expire
  • Both long term (years) and short-dated contracts are available (referring to expiry dates)
  • Relatively illiquid- particularly long-dated contracts
  • Relatively high trading costs
  • Can be used to gain high leverage- increases risk and reward potential

Buying or selling an option is buying or selling the right, yet not the obligation, to buy or sell a quantity of assets (most commonly shares) at certain price, before a certain time (expiry date) in the future. In these, an up-front premium is involved.

Generally, there are two types of options-Calls and Puts; a Call is the right to buy a quantity of assets, a Put is the the right to sell them. So, you could buy the right to buy, or sell the right to buy (Calls). Or, buy the right to sell, or sell the right to sell.

Whenever you buy a contract, you pay a premium. Conversely whenever you sell a contract (as the initial step), collect a premium.

Once understood, options can either be traded with relative simplicity or using highly sophisticated strategies- both of which can be very powerful.