One financial instrument that attracts investor interest is the options contract, often shortened to “option.” The term may sound difficult to a new investor, but an option is a derivative with a defined mechanism and several possible uses, including speculation and hedging. This guide explains basic concepts and mechanics so readers can understand the terms involved before making an investment decision.
Key takeaways
- An options contract gives the holder a right, but not an obligation, to buy or sell an underlying asset at a set strike price by an expiry date.
- The two main types are calls (the right to buy) and puts (the right to sell).
- The option premium is affected by factors including the strike price, time to expiry and volatility.
- Time decay, or theta, describes the decline in an option’s time value as time passes.
- Risk differs by position and strategy. Buyers’ risk may be limited, while sellers’ risk may be unlimited in some cases.
- Leverage can magnify percentage gains and losses; understand the contract and risks before trading.
Options: a right, not an obligation
Imagine that you may buy a house six months from now but are unsure where market prices will move. You might pay a small deposit to reserve the right to buy the house at today’s agreed price during the next six months.
If the market price rises above that agreed price, you could use the right to buy at the lower price. If the market price falls, you could let the right expire and lose the deposit. This illustrates the basic idea of an option.
Financial options can reference assets such as stocks, indexes, commodities or currencies. They give the holder a right to buy or sell the underlying asset at a predetermined strike price within a defined period ending on the expiry date. The buyer pays a premium for this right.
How an option differs from a futures contract
The key difference described here is the right. An option buyer may choose whether or not to exercise. An option seller must meet the contract obligation if the buyer exercises. This distinction is central to understanding option risk.
Call and put options
Options are commonly divided into calls and puts. Each has a different purpose and payoff.
Call option: the right to buy
A call gives its holder the right to buy the underlying asset at the strike price by expiry.
Example: reserving a concert ticket
Suppose a favorite artist may perform in three months, but ticket prices have not been announced. You pay a 200-baht premium to reserve the right to buy a ticket for 2,000 baht. If the announced market price is 3,500 baht, the example says you could exercise the right and sell at the market price or attend the concert, for a potential gain of 1,300 baht (3,500 − 2,000 − 200). If the ticket price is 1,500 baht, you could let the right expire and lose the 200-baht premium.
In this example, the call buyer expects the price to rise and pays a premium to limit the stated loss. Call buyers are often described as bullish on the underlying asset. A call seller is described as bearish or neutral, expecting the price to remain flat or fall.
Put option: the right to sell
A put gives its holder the right to sell the underlying asset at the strike price by expiry.
Example: insurance for a valuable item
Suppose you own a luxury watch worth 100,000 baht and worry that its value could fall over the next three months. You pay a 2,000-baht premium for the right to sell it to an insurer for 95,000 baht during that period. If its market value falls to 80,000 baht, the example calculates a 13,000-baht benefit (95,000 − 80,000 − 2,000). If its value rises to 110,000 baht, you could let the contract expire, lose the 2,000-baht premium and sell the watch in the market at the higher price.
In the example, the put buyer expects a price decline or wants to hedge a portfolio. Put buyers are often described as bearish. Put sellers are described as bullish or neutral, expecting the price to stay flat or rise.
Important contract terms
Strike price
The strike price is the predetermined price at which the holder may buy the underlying asset with a call or sell it with a put. A lower strike relative to the current market price increases a call’s value, while a higher strike relative to the current market price increases a put’s value.
Expiry date
The expiry date is when the option contract ends. After expiry, it no longer has effect and may expire without value if it has not been exercised. Time remaining until expiry affects the premium, particularly through time decay.
Option premium
The premium is the market price the buyer pays the seller for the right to buy or sell the underlying asset. A premium has two parts:
- Intrinsic value: the value an option would have if exercised now. For a call, intrinsic value is market price minus strike price when the result is positive. For a put, it is strike price minus market price when the result is positive. A zero or negative result means there is no intrinsic value.
- Extrinsic value (time value): value associated with the possibility that the underlying price will move favorably before expiry. It is affected by time remaining, volatility and interest rates.
Premium = intrinsic value + extrinsic value.
How premiums and time decay work
Why the premium changes
An option’s premium is not fixed. Common influences include:
- Underlying price: a move favorable to the option buyer—for example, a rise for a call or a fall for a put—may increase the premium.
- Volatility: greater volatility may increase the chance of a significant price move and raise the premium’s extrinsic value.
- Interest rates: rates may have a smaller effect, particularly for longer-dated options.
Time decay (theta)
Time decay is the decline in an option premium’s extrinsic value as time passes. This decline can accelerate as expiry approaches.
As an analogy, a ticket for a special event may have value months in advance because it gives the right to attend. As the event date approaches, its resale value may fall for someone who can no longer attend; if the holder does not go by the event date, the ticket expires without value. Options also have an expiry date; less time until expiry can mean less time value.
For option buyers, time decay can reduce the premium each day. If the underlying price does not move quickly or far enough to offset the decline in time value, the buyer may lose money even if the price moves in the expected direction. Sellers may benefit from a decline in the option’s time value.
Risk, return and leverage
Options may offer the potential for high returns, but also involve substantial risk. Understanding both sides is important.
Leverage
Leverage means using a relatively small amount of capital to control exposure to an underlying asset with a higher value. For example, a buyer might place a 10% deposit to control the right to buy a parcel of land. A 20% rise in the land price could produce a large gain relative to the deposit, while a fall could mean losing the deposit. Leverage can magnify percentage returns when an expectation is correct, but it can also magnify losses.
Risk depends on the position
- Option buyers (long calls or long puts): the maximum risk is the premium paid if the contract expires out of the money.
- Option sellers (short calls or short puts): risk can be unlimited, particularly for an uncovered (naked) call if the underlying rises sharply. A seller can face a large loss when the underlying moves against the position.
Risk management is therefore central to options trading.
Basic options strategies
Four basic strategies are:
Buying a call (long call)
- Objective: expect a significant rise in the underlying price.
- Maximum loss: limited to the premium paid.
- Potential return: unlimited if the price rises above strike price plus premium.
Buying a put (long put)
- Objective: expect a significant fall in the underlying price or hedge a portfolio.
- Maximum loss: limited to the premium paid.
- Potential return: unlimited if the price falls below strike price minus premium.
Selling a call (short call)
- Objective: expect the underlying price to stay flat or fall, or seek premium income.
- Risk: risk can be unlimited if the underlying rises sharply.
- Return: limited to the premium received.
Call selling requires particular caution. A covered call means the seller already owns the underlying shares, which can limit some risks.
Selling a put (short put)
- Objective: expect the underlying price to stay flat or rise, seek premium income, or potentially buy shares below the current market price.
- Risk: maximum loss is the strike price minus the premium if the price falls to zero.
- Return: limited to the premium received.
A cash-secured put means the seller keeps enough cash to buy the underlying shares if assigned.
Additional considerations
Implied volatility
Implied volatility (IV) is described as a market estimate of future volatility, rather than historical volatility. A rise in IV can make both calls and puts more expensive, while a fall in IV can make them cheaper. Option buyers may prefer to buy when IV is low and sell when it is high, while sellers may take the opposite view. Understand how IV cycles may affect a strategy.
Risk management and the Greeks
Risk management includes more than knowing the maximum possible loss. Risk management can include:
- Position sizing: match the number of option contracts to the portfolio size and the trader’s risk tolerance.
- Stop-losses: even buyers with a stated maximum loss may use a stop to avoid losing the entire premium; sellers may use one to limit losses.
- Other Greeks: Delta describes premium changes relative to changes in the underlying price; Gamma describes changes in Delta; Vega describes premium changes relative to changes in implied volatility. These measures can help assess and manage options risk.
Using options to hedge
Options can also be used to hedge:
- Portfolio protection: an investor holding many shares and concerned about a market decline might buy a put on a market index or on shares in the portfolio, like insurance against a decline.
- Covered call: an investor who already owns shares might sell a call to seek premium income. If the share price stays below the strike, the seller keeps the premium; if it rises above the strike, the shares may have to be sold at the strike price.
Hedging requires understanding how the option relates to the underlying asset and calculating an appropriate position size.
Points for beginners to consider
- Do not focus only on possible returns: leverage also brings risk. Pursuing high returns without understanding risk can be damaging.
- Respect strategy complexity: learn basic strategies such as long calls and long puts before considering more complex ones.
- Remember time decay: option buyers should account for time decay and the time remaining to expiry.
- Study the contract: learn the basic terms, contract types, strategies and risk controls; books, seminars or advice from a qualified professional may also help.
- Start cautiously: practice with a small amount that you can afford to lose.
Conclusion
Options are flexible derivatives used for different purposes, including speculation, seeking premium income and hedging. Leverage, premiums, time decay and differences between buyer and seller positions can create complex risks. Understanding the contract and its possible outcomes is essential before trading. Options trading requires knowledge, careful risk management, continued study and a cautious start.
Frequently asked questions
Are options suitable for beginners?
Options are complex and may be riskier than investing directly in shares. Beginners should study the strategies and risks before trading.
How much capital is needed to trade options?
The initial amount may be lower than buying shares directly, but the appropriate amount depends on the strategy and contract size.
How are options different from regular stock trading?
An option gives a right, but not an obligation, to buy or sell an underlying asset at a specified price within a set period. Buying shares means owning part of a company.
Can losses exceed the amount invested?
Some strategies, such as naked calls or puts, may expose an investor to losses greater than the initial investment. Understand the risks and strategy before trading.
Where should I start learning about options?
Start with the basic concepts, terminology, contract types and simpler strategies. A simulated account (paper trading) can provide practice before risking real money.
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