What are options?
An option is a type of derivative contract that gives the holder the right to buy or sell the underlying asset at a predetermined price – the exercise or strike price – at or before a certain date. Options exist on a wide variety of underlying assets, like single stocks, indices, ETFs, bonds, currencies, commodities. These contracts can serve as tools to protect a portfolio against potential losses or to express an opinion about the direction of the market.
There are two broad categories of options. A call option represents the right to buy the underlying asset at the strike price, while a put option represents the right to sell the underlying asset at the strike price. Each option contract has an expiration date, or expiry, which is the date when the contract lapses. On a single underlying asset there can be many options trading with different strike prices and different expiries.
In an option trade, the party that buys the option contract enters in the long position and pays an option premium to the seller of the option (the option “writer”) who is in the short position. The writer of the option is obliged to fulfil his/her side of the contract when the option buyer decides to exercise the option. Options use leverage and the option contract multiplier defines how much of the underlying asset the option controls. For example, an option contract on a share typically has a multiplier of 100, meaning 1 option contract represents 100 shares of the underlying.
What do options mean for the markets?
Options, like other derivatives, can be used to hedge, which is to eliminate or reduce the risk of adverse price movements. They can also be used to take a position or to express an opinion on the future direction of the market. The leverage effect allows investors to get a relatively large exposure for a small initial investment.
As the option contract represents a right and not an obligation, the downside risk for the holder of the long position is limited to the premium paid. In contrast, while the option writer holding the short position earns a fixed premium from selling the option contract, he/she faces a bigger downside risk. The short side of the contract represents an obligation, i.e. this party has to sell or buy at the agreed upon price if the contract is exercised. The option seller therefore stands to lose an infinite amount on money if they are not hedging a position.
An investor buys a Unilever PLC call option with a strike price of EUR 65 for a premium of EUR 1. The current share price of Unilever PLC is EUR 60. The option has a multiplier of 100 and expires in 3 months. The investor pays the premium to the option writer at the time of trade, equal to EUR 1 x 100 = EUR 100. Two potential scenarios at expiry are: The share price of Unilever PLC has fallen to EUR 50. The investor does not exercise the option and it lapses. Though the investor loses the EUR 100 premium paid for the call option, if he/she had bought the shares instead, the loss would have been EUR 10 per share and EUR 1000 in total.
The share price of Unilever PLC has risen to EUR 70. The investor exercises the option and pays the seller of the option EUR 65 x 100 = EUR 6500 in exchange for 100 shares of Unilever PLC that are worth EUR 7000 at the current market price. With an initial investment of EUR 100 the investor has made EUR 500 on the difference between market price and strike