About Options

An options contract is the right, with no obligation, to buy or sell a specified quantity of an underlying instrument (for example company shares) at a fixed price on or before a specified future date.

The right to buy is a "call option", and the right to sell is a "put option". For both types of options there is a buyer and a seller on each side of the option contract.

You would buy a call option if you thought the price of the underlying instrument was going to go up. You would buy a put option if you thought the price of the underlying instrument was going to go down. Different strategies can be created by buying and selling puts and calls in varied quantities, at different exercise prices, with differing expiry dates.

Insurance policy

In its simplest form an option is similar to an insurance policy, say on your car. For your car insurance you pay a premium. The policy has a limited life, usually expiring in one year. You have the right to sell your car to the insurance company if it becomes worthless in an accident, at a value set in the original policy. You would not be required to pay anything more on the policy during the year. If you don't claim on your policy during the year it will lapse, giving you the choice of renewing your policy for another year. The most your insurance will cost you is the premium, the potential benefit however is almost unlimited, covering not only the value of your car but also other cars and objects that may get in your way.

Like a futures contract, price is the only variable (the price paid for the option, which is known as the premium). Unlike the futures contract, however, option buyers have no obligation to buy or sell the commodity or financial instrument.

Closing out

Because all details except price are standardised, buying the right to buy (call) can be offset by selling the right to buy and vice versa, and buying the right to sell (put) can be offset by selling the right to sell and vice versa.

Pricing of options (premiums)

Option prices (premiums) are determined in the marketplace, just as share prices themselves are. The price of an option is a function of supply and demand. All other things being equal, strong demand will tend to lift the price.

The premium of an option can be made up of intrinsic value and extrinsic (time) value. Most options have extrinsic value until they expire. Intrinsic value is the positive difference between the strike price of the option and the market price of the underlying security. If this difference is not positive, the option has no intrinsic value.