What Is an Option?
An option (from Latin optio, meaning choice or preference) is a standardized contract that belongs to the category of derivatives or financial instruments. It gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time period. The seller of the option is obligated to complete the opposite transaction with the asset according to the terms of the sold option.
What Are the Types of Options?
There are three main types of options:
- Call option – provides the right to buy an asset at a fixed price;
- Put option – provides the right to sell an asset at a fixed price;
- Double option – a two-sided option.
Depending on the underlying asset and market, options can be exchange-traded or over-the-counter:
- Commodity options;
- Foreign currency options;
- Interest rate options;
- Options on indices and stocks.
The style of an option is another important characteristic. Styles include American, European, and Asian:
- American-style options – can be exercised at any time from the purchase date until expiration;
- European-style options – can only be exercised at expiration;
- Asian-style options – are settled based on the average price of the underlying asset over the life of the option.
Geographic location does not affect the type of option. For example, an American-style option can be purchased on a European exchange.
What Is the Price of an Option?
The price set by the option is called the strike price. Any financial instrument can serve as the underlying asset, such as futures, stocks, currencies, etc.
An option cannot exist indefinitely. It has an expiration date, after which it either expires or is exercised.
Since an option is a service in the financial market, it must be paid for. This payment is known as the option premium and depends on the agreement terms and market conditions.
The larger the difference between the strike price and the actual market price, the higher the premium. As a result, the value of an option can change over time, making it attractive for speculative trading.
How Is an Option Different From a Futures Contract?
Like options, futures contracts are a type of exchange-traded contract. They allow traders to conduct transactions with various assets. Neither party pays additional fees except for the cost of the underlying assets.
However, there is a key difference between futures and options. Futures contracts require both parties to fulfill the agreement, while the holder of an option is not obligated to act.
Depending on their interest, the option holder can choose to execute the trade under the contract terms or walk away if it is not beneficial.
Using multiple types of options on the same asset is not always advantageous, as traders would have to pay commissions for both trades. A futures contract, on the other hand, involves only one commission fee.
What Are Binary Options?
Among the many types of options, binary options stand out as a convenient tool for expanding an investment portfolio.
The unique feature of binary options is that they offer only two possible outcomes: a win or a loss. This is why they are called binary options.
To profit from binary options, traders typically need only to predict the general direction of the market movement. Both qualitative and quantitative factors are usually not considered.
More About Binary Options
Where Can You Buy Options?
Option trading is most common in the United States, with the majority of trading taking place on American exchanges:
- Chicago Mercantile Exchange (CME)
- American Stock Exchange (AMEX)
- New York Stock Exchange (NYSE)
The main platform for option trading in Europe is the London International Financial Futures and Options Exchange (LIFFE).
In Russia, the FORTS section of the RTS Exchange offers the opportunity to trade options.
More About Option Trading
- What Is an Option?
- Options: How to Protect Investments from Market Panic?
- Option on a Future or Future Option
FAQ
What is an option in finance?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price within a specific time frame.
What are the differences between call and put options?
A call option allows the buyer to purchase an asset at a fixed price, while a put option allows the buyer to sell an asset at a fixed price.
How do binary options work?
Binary options are a type of option that offers only two possible outcomes: a win or a loss. Traders predict the direction of the market to profit from these options.
