Option definition

Options are financial derivatives. They give the owner, known as the holder, the right, but not the obligation, to buy or sell a set quantity of an underlying asset on a set price and on a specific date. Different option styles, such as European and American, exist with slight variations, usually allowing greater variability about the date or range of dates where you can exercise the option. Options are traded in all markets but are especially popular in the forex and equity markets.

Types and styles of option

Discussion of options nearly always deals with the option style known as European. Despite the name, these are traded equally worldwide, though American, Asian and even Bermudan styles also exist. These other styles are relatively thinly traded. In a European option the contract can only be exercised on a single set date, whereas an American option can be executed at any time. Asian options can be traded on a range of fixed dates.

The two basic or ‘vanilla’ options are calls and puts. From these two simple derivatives, much more complex strategies such as collars, condors and straddles can be formed. Options are either at-the-money – with a current market price near or at the strike price, out-of-the-money – when the current market price is either far above (for a put) or below (for calls) the strike price, or in-the-money – when the market price is below (puts) or above (calls) the strike price, and so assuming no market movements, can be usefully exercised.

Uses of options

Options are some of the most versatile financial instruments available, with complex strategies created by layering calls and puts to form unique payout profiles. Some of the most common uses are below:

Hedging: Options can be used to protect against market downturns, e.g. buying out-of-the-money put options on a single stock or relevant index to offset potential losses in an equity portfolio. Far out-of-the-money options are often relatively cheap, particularly in less volatile markets.

Speculation: Options are ideal tools for expressing views on future market directions as combinations of calls and puts can be used to create very precise payout profiles. For example a trader who expects an index to trade between a certain range can use options to create a condor or straddle strategy that will pay when the market remains rangebound. This type of strategy is otherwise very difficult to execute.

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