Options

Overview

There are two types of options, which include a buy (called a call option) and a sell (called a put option). A call option gives the holder the right to buy an underlying asset at a predetermined price (called the strike price) on or before a specified expiry date, and a put option gives the holder the right to sell the asset at the strike price at the specified time. 

Key terms

Premium: The premium is the price paid upfront to buy the option. 

“In the money”: An option is “in the money” when exercising it would be profitable given the price of the current price of the asset which is being tracked. 

“Out of the money”: An option is “out of the money” when it’s not profitable given the current price. 

Uses

Protective put: A protective put includes buying a put option on a share that you already own, acting as insurance against a potential price fall. 

Covered call: A covered call means selling a call option against shares that you already hold, which is a common way to generate additional income from an existing portfolio. 

Furthermore, options can also be used for pure speculation, offering leveraged exposure to a price move for a relatively small upfront premium, allowing people to make money off of significant predictions. 

Pricing intuition 

The maths of the Black-Scholes model fully explains the pricing intuition of options, but without getting into the complications of that, simply an option's premium reflects both its intrinsic value (how far into the money it already is) and also its time value, which is heavily influenced by how much the underlying asset’s price is expected to move before expiry. 

Risks

An option buyer’s maximum loss is capped at the premium, which can make buying options a defined-risk strategy. Selling an option is a very different risk profile since a call seller who doesn’t own the underlying asset can lose unlimited amounts in theory if the price rises sharply, as they have to buy the asset at the market price to deliver it at the lower strike price.