12/27/2023

What are options: definition and classification

Scroll down

WANTS TO KNOW HOW TO MAKE EARNING FROM NEWS?

Register for free and get expert advice, access to a training course and webinars.

An option is a financial instrument that gives the buyer the right, but not the obligation, to buy or sell an underlying security, such as a stock, index, or exchange-traded fund (ETF), at a predetermined price on or before a specified date. Unlike futures contracts, which require the buyer to buy or sell the underlying security, options contracts allow the buyer to choose whether or not to exercise their right.

However, each option contract will have a specific expiration date by which the holder must exercise their option.

Understanding Options

Options are versatile financial instruments that grant buyers a right, but not an obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. These contracts are widely used by traders and investors for various purposes.

Call options give holders the right to purchase an asset at a predetermined price during a set timeframe. Put options, on the other hand, provide holders with the right to sell an asset at a predetermined price within the contract’s duration.

Traders often engage in options speculation to profit from anticipated price movements without having to invest in the underlying asset itself. This allows them to magnify their potential gains or losses, compared to buying the underlying asset directly.

Types of options

Call options. A call option grants the holder the privilege, not the responsibility, to purchase the underlying asset at a predetermined strike price before or on the expiration date. As the underlying security’s price increases, the call option’s value also rises (a phenomenon known as positive delta).

Put options. Contrary to call options, a put option grants the holder the right, not the obligation, to sell the underlying asset at a predetermined strike price no later than the expiration date. This unique feature of put options makes them a valuable tool for hedging against potential losses in an underlying asset. As the price of the underlying asset declines, the put option’s value increases, a concept known as negative delta.

 

American and European options

American options stand out from European options in their adaptability, allowing holders to exercise their rights at any point between the purchase date and the expiration date. European options, on the other hand, confine exercise to the expiration date only.

However, the distinction between American and European options lies not in their geographical origins but in their exercise guidelines. Many stock index options adhere to the European style, limiting flexibility.

Summary

Options trading offers a double-edged sword, presenting the possibility of both substantial gains and significant losses. Leverage empowers investors to safeguard their portfolios while providing traders with the potential to amplify profits from favorable price movements. This dynamism fuels the alluring opportunities that perpetually surface in the options market. However, aspiring traders must acquire a thorough comprehension of option pricing mechanisms, the associated risks, and the most effective trading strategies and platform selections to navigate this complex arena with prudence.

WANTS TO KNOW HOW TO MAKE EARNING FROM NEWS?

Register for free and get expert advice, access to a training course and webinars.

Fill out the form and get a free consultation!

Add review

Name *

Review *

Recommend to read

  • 4/19/2024
    How to read a company’s quarterly report

    The market is once again entering the period of quarterly reports: streaming service Netflix has just reported profits, and next week traders are waiting for reports from companies such as Visa and Tesla. So let's look at the importance of quarterly reports for financial analy...

    Read more
  • 4/18/2024
    How is the price of Bitcoin determined

    Very soon the Bitcoin halving is due to take place, which is carried out every 4 years. Analysts are divided on how significantly this event could affect the price of the asset. On the eve of the Bitcoin halving 2024, we consider the main factors determining price dynamics....

    Read more