What is an option? Investing explained

What is an option? 

An option is a type of derivative, a financial product that derives its value from another asset. Derivatives were first used by merchants in Mesopotamia (today’s Southern Iraq) in about 8,000BC and have evolved through the centuries. If you buy an option, you enter into a contract that gives you the right (but not the obligation) to either buy or sell a share, or a bond at a future expiration date at an agreed or ‘strike’ price.

What types of option are there? 

A ‘Call’ option grants the right to buy a bond, a commodity, an index or a share. A ‘put’ option gives the right to sell. 

A ‘premium’ or fee is payable to the bank or brokerage firm that ‘writes’ or sells the options. You are ‘in the money’ from a call option if the price of the share or bond rises above the strike price. With a put option, you are ‘in the money’ if the price of the share or bond falls below the strike price. 

How risky is this type of trading? 

Hugely risky. The attraction lies in the possibility of scooping a jackpot for a small initial outlay, but this gamble may not pay off. It is possible to limit your downside by placing a stop-loss order on your trade at a defined price. This provides some protection, although if the order is triggered at a time when share or bond prices are plummeting, you may still be left out of pocket. 

How is a strike price determined? 

There are various formulae. But the price depends on factors such as the current asset price; the intrinsic value, that is the value of the option if it were exercised immediately; the length of the period until the expiration of the option and the volatility of the underlying asset. 

Can you buy a call and a put? 

Yes. The combination of a call and a put option with the same expiration date is called a straddle, for which you pay two premiums. The hope is the share price will move sharply either upwards, or downwards on good or bad news, meaning that you profit from either the call or the put. It is still a big gamble, however, as the share price might not move.

How popular is options trading? 

It is growing with people apparently undeterred by the potential losses. The CBOE (Chicago Board Options Exchange) says that, in the US, more than $450billion worth of options were traded in 2021. This compares with about $405billion worth of shares. 

Are more private investors becoming involved? 

Yes, particularly in the US where many got into options during the pandemic, relying on commission-free trading apps like Robinhood. At first, the focus was on ‘meme’ stocks like Gamestop, but it is now major corporations like Nvidia and Tesla. In the UK, various online platforms offer options trading. But anyone who cannot afford to lose should steer well clear.