Options, calls, puts

Options

An option is a type of tradable financial instrument. It is a contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified price on or before a specified date.

The seller (option-writer) incurs the obligation to fulfill the transaction, if the buyer (option-holder) chooses to "exercise" the option before it expires. The price of the option compensates the seller for upholding that obligation.

An option that conveys the right to buy at a specific price is called a call. An option that conveys the right to sell at a specific price is called a put.

Puts are used for short selling, calls are used for going long.

Upon expiry of the deadline or specified period, the option becomes invalid. The price of the option compensates the seller/writer for the risk he takes on.

Options can be used for speculating on the price of an asset. However, this is very risky because both the time factor and the actual price are important.

An example

The stock price of company A is currently at $10. You expect it to rise steeply, so you plan to buy a call option.

You buy a call option for the risk premium of $1. It allows you to buy the stock for $10 (today's price). The option expires after one month.

Three things can happen:

  1. You were correct – after one week, the price of the stock rises to $15 per share. You execute the option and buy the stock for $10, and sell it for $15. After deducting your risk premium of $1, you are left with a profit of $4.
  2. You were wrong and the price drops to $7. You don’t execute your option and end up losing just the -$1 you paid for the option – much less than if you would have bought the stock directly.
  3. There is no significant change in the stock’s price and the option expires after one month because you didn't execute. However, you still have to pay the risk premium and end up with a loss of -$1.

Discuss options in general or for specific asset classes:

Find an options broker

tradimo collaborates with the most popular, regulated banks and brokers which offer options trading:

  • I am interested in spreads North American options. Some experience but need guidance.
    any ideas?
  • Hello moderators,
    I don't know which broker offers option trading. May you tell?
    Thanks.
  • Hi JHTAN,

    IG offers options as a trading asset.

    You can check them out here.

    Hope you find this broker of interest,

    Regards,
    Emma
  • Hello Emma,
    I can't find the IG's support E-mail address.
    May you help?
    Thanks.
  • Hi JHTAN,

    IG has a support portal on their website with a knowledge base and several options to contact them.
    You can find this portal here:http://portal.ig.com/support

    Regards,
    Timothy
  • Hello Timothy,
    The link is not work.
  • Hi,
    I didn't understand what is risk premium of $1 given in the first example??
    Can anyone explain me the example one.
  • Hey,

    Think of the $1 as the price tag that you have to pay for the privilege of choosing whether you want to want to buy the stock or not.

    So, you pay $1 and now you can either buy the stock for $10 or you can decide not to buy the stock for $10.

    However, if the price of the stocks then rises to $20, then you would definitely buy it, because you can buy the stock at $10 and then sell it at $20, making you $9 ($20-$10-$1).

    If the price of the stock never goes above $10, then you are never going to decide to buy it - why would you? You wouldn't be able to see it for a profit. So you don't do anything and the only thing that you have lost is the $1 that you paid - this is the only thing that you risk losing. This is the risk premium.

    So the 'option' is the right to buy a stock (or not buy a stock) at a particular price. The risk premium is the price tag that you have to pay for that option.

    Does that help?
  • Well done Dean
    Why would i buy an option ? i buy the stock woth STOP order of 10 cents below the stock price instead of $1 payment. Is anyone can answer this question?
    Thanks for answering
  • Hi Sharon,
    It all makes sense what you are saying, but what if the price gaps lower $2 or $3 or even more. You would have to take $2 etc. loss, whereas with options you just lose the $1 premium, yet benefit from unlimited upside.
    Regards.
    Peter

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