Options are a type of financial derivative that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date. Options are traded on exchanges and can be bought and sold through most online brokerages.
Options are typically used by investors as a way to hedge against other investments in their portfolio, or to speculate on the direction of an underlying asset. For example, an investor might buy a call option to bet on a stock price going up, or a put option to bet on a stock price going down.
Trading options is generally considered a higher-risk endeavor than other types of investing, such as buying stocks or mutual funds. That's because with options, you're betting on the future direction of an underlying security, and there's no guarantee that your prediction will be correct. That being said, options can be used to generate income and help diversify a portfolio.
What are Options?
An option is a contract that entitles you to buy or sell an underlying security, such as a stock, at a set price within a specific time period. There are two types of options: call options and put options.
Call options give you the right to buy a security at a set price (the strike price), while put options give you the right to sell a security at the strike price.
An options contract specifies the following:
- The underlying asset
- The strike price
- The expiration date
- The type of option (call or put)
Options are one type of derivative, which means their value is derived from another asset. In this case, the asset is the security you have the option to buy or sell.
The main difference between options and other securities is that with options you're not obligated to buy or sell the underlying security—you can choose whether or not to exercise your option.
There are two main types of options: American-style and European-style. American-style options can be exercised at any time before expiration, while European-style options can only be exercised at expiration. Most options traded on exchanges are American-style. Expiration dates can range from days to years, depending on the type of option.
Both call and put options have an expiration date, which is the last day you can exercise your option. If you don't exercise your option by the expiration date, it expires worthless.
When buying or selling an option, you're charged a fee by your broker called a premium. The premium is essentially the cost of buying or selling the option.
If you exercise a call option by buying the underlying security at the strike price, you'll also have to pay any commissions and fees associated with buying that security. The same goes for exercising a put option—if you sell the underlying security, you'll have to pay commissions and fees as well.
It's important to remember that with any investment there's always some level of risk involved—you could lose money on your investment no matter what type of security it is. But there are different types of risks associated with different securities. For example, stocks are subject to market risk—the chance that the overall stock market will go up or down—as well as company-specific risks like poor management decisions or unforeseen events that could impact the company's bottom line.
With options, there's an additional layer of risk called time decay. Time decay is the rate at which an option's premium diminishes as its expiration date approaches—think of it like water evaporating over time. When an option has more time until expiration, it has more time to become profitable, so it will have a higher premium than an option with less time remaining until expiration. Therefore, as time passes and an option gets closer to its expiration date without becoming profitable (i.e., without being in-the-money), its value decreases as more and more of its time premium evaporates away.]
Should You Trade Options?
Now that we've answered the question "what are options?" and gone over some of their key features, it's time to ask ourselves whether or not we should trade them. When making this decision, there are several factors we need to consider:
Our investment goals: What are we hoping to achieve by investing in options? Are we looking for short-term gains or aiming to build long-term wealth?
Our investment horizon: How long do we plan on holding onto our investment? Remember that options contracts have expiration dates—are we comfortable holding onto our position until then?
Our level of risk tolerance: How much risk are we comfortable taking on? Trading options doesn't necessarily mean taking on more risk—there are strategies we can use that limit our downside while still providing us with upside potential. However, all investments come with some amount of risk inherent in them.
Deciding whether or not to trade options comes down to understanding what they are and what role they can play in our overall investment strategy. Whether you're looking to hedge your bets or speculate on the direction of an underlying asset, trading options might be for you—but only if you're comfortable with taking on some extra risk. Make sure you do your research before entering into any options contracts so you know exactly what you're getting yourself into!