What are Options?
Options are financial derivative instruments that specify the terms of a contract between two parties (a buyer and seller), to be executed at a reference price in the future.
Several financial assets or instruments can be traded as options. These include stocks, exchange traded funds (ETFs), currencies, commodities, spot metals, etc. Some of the characteristics if options include the following:
1) There is a reference price that is set for the future execution of the options trade. This is known as the strike price, and it is not adjustable. It serves as a pricing tool to guard against price fluctuations that may be brought on by inflation or other adverse circumstances that could affect pricing of the asset.
2) Options contracts do not last ad infinitum. They have an expiry date that is set to a maximum of three months. When the options expire, they are without value.
3) There are two varieties of options known as call and put options. A trader can take long and short positions on both varieties of options.
Transaction Costs of Options
As is usual for any type of financial trading, options trading carries transaction costs. Aside from the commissions paid on transactions, there is also a net debit which is accrued on purchasing an option. The net debit is only erased if the option contract is exercised or sold at a profit before expiration.
The situation is different when you sell the options. On selling, you are paid a premium, which you get to keep if the option contract expires. If the contract is exercised, then the profit/loss derived from the act of exercising the contract has to be added to the premium to work out if the trader makes a profit or suffers a net loss at the end of the trade.
End Value of the Options Contract
In option terminology, we speak of a trade contract being in-the-money, at-the-money (breakeven) or out-of-the-money (loss).
A trade is in-the-money when:
– The current price of the asset is above the strike price (call option).
– The current price of the asset is below the strike price (put option).
A trade is out-of-the-money when:
– The current price of the asset is below the strike price (call option).
– The current price of the asset is above the strike price (put option).
In order to participate in the options market, the trader must open an options trading account with an options broker, and supply his government-issued ID and proof of residence. Option trading is a risky form of investment, and as such a trader must have not just the trading skill but also the financial muscle to take on the option trades. Some options trade types require hefty collateral in the form of margin, and margin requirements for options trading is far above what obtains in forex.
Due to the high-risk nature of this type of investment, it is not suitable for those without an appetite for risk. Option trading requires very intense demo trading practice before a live account can be traded.