Updated July 14, 2023
Definition of Options in Finance
Options are derivative instruments since they are financial instruments whose value is derived based on the underlying asset. An option is a contract between two parties to transact an underlying asset, i.e. buy or sell such an asset at the pre-agreed price and date.
One point to note is that owners of the options have the right to exercise the option on an agreed future date at the exercise price, but they are not obligated to do so. The following article provides an outline of options in finance.
Explanation
Though the options owners are not obligated to buy or sell the asset before a future date, they can only exercise their right in the stipulated time period; if the owner does not exercise the option in the agreed time period, it will lapse and become ineffective. Options facilitate their owners with the speculation over positive and negative market bend or movement. This helps investors in managing the risk and avoiding potential losses.
Options may have underlying assets like bonds, stocks, foreign currencies, commodities, etc. One option contract usually consists of 100 shares or units of underlying assets. The options buyer needs to pay the premium of an option to the seller on the purchase of each contract. Options are sold on national stock exchanges and over-the-counter, i.e., OTC market. The trader chooses the strike price and the expiration date at the time of purchase of the option.
Example of Options in Finance
There are two types of options: the call option and the put option. Let us understand these with the help of examples.
Call Option: An investor purchases the call option at the strike price of $100 per contract; the underlying asset market value for this option is $70 per contract. The expiration period is nine months. In nine months, suppose the underlying asset price goes up to $120 per contract, then the investor will exercise the option at the strike price of $100 and make a profit of $20 per contract. But if the price goes below $100, the buyer of the option will not exercise the option since the strike price would be higher than the market price in such a case. The options contract would then lapse.
Put Example: A trader buys a put option for the strike price of $70 per contract, and the underlying asset’s current price is $85 per contract. The expiration period is six months. The buyer expects that the price will go down below $70 before the expiration date, and if this happens, let’s say the price goes down to $60 per contract, the buyer of the option will make a profit by selling the option at the higher price of $70 per contract. But if this does not happen and the price stays at $75 per contract, the buyer of the option will not exercise the option, and the contract will lapse.
Types of Options in Finance
In a broader sense, there are two options: the call and put options. Both of these types of options are discussed below:
- Call Options: In a call option, the buyer of the option has the right to buy the underlying asset at the agreed price at or until the expiry date. The call option owner speculates that the underlying asset’s price will go above the strike price in the future.
- Put Options: The put option provides the buyer of the option with the right to sell the underlying asset at the agreed price at or until the expiration date. Contrary to the call option, the buyer speculates that the underlying asset’s price will go down below the strike price in the future.
Valuations of Options in Finance
Valuation of the options in finance depends upon certain factors like the current price of the underlying asset, the strike price as agreed by the option owner, the cost of holding the option, including interest or dividend payment, expiration date, and future volatility. At the time of the purchase of the option, the trader pays a premium price which is the sum of intrinsic value and time value. Option premium i.e.
Intrinsic value is the difference between the current value of underlying assets and the strike price. Time value is the amount a trader is ready to pay in expectation of favorable market movement. Thus, to sum up, we can say that option valuation can be affected majorly by the below components:
- Fluctuation in the current market value of the underlying assets can increase and decrease option pricing.
- The strike of the exercise price, as agreed by the contract parties at the time of purchase, also impacts the option’s value. For example, if the option buyer expects to make huge money, keep the strike price higher (call option) or lower (put option). This will also impact the option premium the owner must pay at the purchase time.
- Market volatility also plays a vital role in options valuation. The higher the risk of fluctuation in the price of underlying securities, the higher the fluctuation in the option value.
Uses of Options in Finance
The option traders use options in finance for the following uses:
- The traders use options to hedge or manage adverse financial market risk.
- They are used for avoiding or managing potential losses.
- Options facilitate their traders a means to speculate over positive and negative market movements.
- A trader with less initial capital for investment can also diversify his / her portfolio with the help of options.
Advantages
Some of the advantages are:
- Options in finance are most advantageous in terms of their ability to hedge risk.
- As options are considered the most reliable form of risk hedging, they are less risky than direct stock investment.
- They are more cost-efficient when compared to direct investment in underlying assets like stocks.
- They generally provide a higher return than stocks and offer various investment alternatives.
Risks of Options in Finance
- If the investors do not understand this complex investment alternative properly, they can lose their entire money.
- Options are a time-sensitive investment; therefore, the options can expire worthlessly if not exercised in time.
- Some options do not offer liquidity, which becomes a problem for investors who need ready cash.
- Options trading involves high commissions, thus, is costly.
Conclusion
Options in finance are an excellent form of alternative investment, giving traders with low initial capital to diversify their portfolio. It is also the most dependable form of hedge traders used to manage the risk-averse market. Its limitations can certainly be managed with in-depth knowledge and expertise.
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