What are options?
Options are financial contracts between buyers and sellers that allow market participants to speculate on large price movements. The buyer of an option purchases the ‘right’ to exercise that option if the price rises or falls to the desired price, at a given time in the future. The seller of that option, therefore, takes the other side of this trade and assumes the risk. Let’s have a look at how one might trade this type of contract.
The current price of Gold (XAUUSD), is 1216.86 as of March 25th 2016. Trader 1 speculates that the price of gold will rise to 1315.00 over the next 3 months, and purchases an option contract with the ‘right’ to exercise this option on June 25th 2016. If the price rises to or above 1315.00 by that date the buyer will realise his right to exercise the option, making a profit. The seller is thus obligated to pay.
Calculating the risk on this trade he makes a market for this trade speculation and creates the option’s price. This price is known as the option ‘premium’, and is the price the buyer paid for purchasing the option contract.
There is now an agreement between buyer and seller of that option. Again, the buyer will make a profit if the price reaches the desired ‘strike price’ on expiration date, or will lose the cost of the premium paid if the desired price is not reached.
They offer a unique method for market participants to speculate on large price movements. As an agreed contract between two parties they have a fixed cost and offer a cheaper way for traders to take positions within the financial markets. From a risk perspective, option contracts are well defined and are standardised by the issuer. In accepting the ‘premium’ cost of the contract the trader is aware how much they are liable to lose if the trade is unsuccessful.
The structure of the options contract means that is fundamentally a speculative bet. As such, many market participants and traders alike, view options trading as simple ‘gambling’. There is very little information, both from a fundamental and technical trading standpoint to support trading decisions. Although they are widely used by the world’s leading financial institutions, many misconstrue their use as outright bets. Their prevalent use in the banking and hedge fund industry is more often than not to hedge large open trading positions taken on by the savvy institutional investor.
There are several types of options which clarify, exactly whom, will either buy or sell the option, who will reserve the right to exercise the contract, and which party assumes the liability risk and will be obliged to pay if strike price is reached on expiration date. These conditions define the option and will describe the contract as a Long Call, Short Call, Long Put, and Short Put. Remember as a speculative bet, the greater the price move expectation on the option; the cheaper the cost of the option contract. This reflects the risk to reward calculation of options trading.