What is... | July 5, 2012

What is an option?

The term option is well-known when it comes to buying the right to turn books into movies. But the financial market term – as well as names such as “calls” and “puts” – can be something of a mystery to many.


The Hollywood example can actually help make sense of financial market options.

An opportunity but not an obligation
If a filmmaker buys the right to turn a popular book or theatre production into a movie, they are likely to have a period of time in which they can chose whether or not to go ahead with it. They typically have the right – but not the obligation – to make the movie.
Financial market options are similar in that they are typically the right – but not the obligation – to buy or sell a product or financial instrument at an agreed price on or before a certain time in the future. These market options can be written on a wide variety of financial instruments, such as interest rates, currencies, shares and commodities (such as copper or wheat).

It’s useful to understand options
Options can be difficult to understand because the maths behind them can be tricky. Movements in interest rates and other factors will affect the price of options from one day to the next. As such, options are generally not suited to the vast majority of retail investors. But because options can be used to construct some alternative assets it can be useful to understand how they work.
In an eZonomics poll on options, only a third of respondents knew what financial market options were. The Options Industry Council website is a good resource for information.

When to “call” and when to “put"? 
Options contracts are very detailed with a “strike price” at which the contract can be acted on, an “expiration date” after which it no longer exists and a “premium”, or amount somebody pays to buy it.
At the most basic level there are two types of options – “call” and “put” options.
A buyer of a call option hopes the price of the product will rise above the strike price by the expiration date. If this happens, the owner of the call option can buy the product at the strike price and immediately sell it at the market price for a profit.
For example, someone buying a €100 call option on the oil price may pay a premium of €10. If the oil price rises to €120, the buyer could sell and make a profit of €10 (€120 minus €100 minus the premium of €10). This can be useful to protect against rising oil prices. Alternatively, if the oil price stays below €100, the buyer loses only the €10 paid for the premium. Because of this, option contracts can be thought of as behaving like insurance, with a premium paid to protect against a possible outcome.
The buyer of a "put" option hopes prices will fall below the strike price. This is because they can buy the product at the market price and sell it back to the seller of the option at the strike price, making a profit.

Optional extras
Options may be bought and sold in financial markets simply in an attempt to make money by trading.
However, financial companies can incorporate them into structured products or particular types of mortgages. Because they can provide insurance against large movements in prices and interest rates (sometimes over several years), options can play an important part in the design of products that shield investors against volatility in financial markets. Companies that produce certain products, such as gold or copper, may also buy or sell options to stabilise their future income.
So while book and movie options might be more well-known, the term also has an important and wide ranging use in financial markets.

InvestingOil

eZonomics team
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