What are options
Understanding the basics
Options are a type of derivative that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date.
Like other derivatives, the value of an option is linked to an underlying asset, such as a stock, index, bond, commodity, currency or interest rate.
Options are used by investors for a variety of purposes, including expressing a market view, managing risk and gaining exposure to financial markets.
How do options work?
An option contract gives the holder certain rights relating to an underlying asset.
Unlike some other derivatives, the holder of an option is not required to exercise those rights. Instead, the holder can decide whether or not exercising the option is beneficial based on market conditions.
Every option contract has:
- An underlying asset
- A strike price
- An expiry date
- A premium, which is the cost of purchasing the option
The value of an option can change over time as market conditions and the price of the underlying asset change.
Types of options
Call options
A call option gives the buyer the right, but not the obligation, to buy an underlying asset at a predetermined price before or on the expiry date.
Investors may consider call options when they believe the price of the underlying asset may increase.
Put options
A put option gives the buyer the right, but not the obligation, to sell an underlying asset at a predetermined price before or on the expiry date.
Investors may consider put options when they believe the price of the underlying asset may decrease or when looking to manage risk associated with an existing investment.
Options vs futures
Options and futures are both derivatives, but they work differently.
Feature |
Options |
Futures |
Obligation to transact |
No obligation for the buyer |
Contract obligation exists |
Upfront premium |
Required |
No |
Expiry date |
Yes |
Yes |
Based on an underlying asset |
Yes |
Yes |
Used for market exposure and risk management |
Yes |
Yes |
Understanding the differences between options and futures is important when exploring derivatives markets.
Why do investors use options?
Investors may use options for several reasons:
- Options can be used to take a position on whether an asset's price may rise or fall.
Manage risk
- Options can form part of a broader risk management strategy and may be used alongside other investments.
Gain market exposure
- Options provide another way to gain exposure to a market without directly buying the underlying asset.
Portfolio flexibility
- Because options have different characteristics from other financial products, they can offer investors additional flexibility when considering investment approaches.
Important considerations
Before using options, investors should understand:
- How option contracts work
- The underlying asset and market
- Strike prices and expiry dates
- The risks involved
- Potential gains and losses
- Whether the product is suitable for their objectives and level of experience
Like all investments, options involve risk and are not suitable for all investors.