People encounter options every day. They are constantly faced with the choice of making a decision for or against something. This is exactly the point in options trading. The buyer of an option can, but does not have to, exercise the option. However, the writer, his opponent, is forced to meet the buyer’s request if necessary. Options are a type of forward transaction based on a contract that provides for the purchase of a specific item at a later date at a previously agreed price.
- The goods that options trading is about buying or selling are called underlying assets. Often it is securities, but it can also be goods or, for example, electrical energy.
- Example: Anyone who assumes that the purchase price for the underlying will increase in the future concludes a purchase option. In return for an option premium, he or she acquires the right to purchase the underlying good at today’s price in the future and to sell it at a profit. If the underlying is not to rise, he does not have to exercise the call option and makes a loss equal to the option premium.
- Options trading involves a high level of risk and is only suitable for experienced investors.
This is how options trading works
In options trading, a distinction is made between two variants: the purchase option (call option) and the sell option (put option). According to abbreviationfinder, OTS stands for Options Trading System.
The purchase option
Investor A assumes that the value of a share will increase. He therefore buys the share from investor B today at a fixed price with the transfer date in two months. For this he pays the option premium to B. If A exercises the option, the purchase price is due in two months. If the share price rises, A exercises the option on the due date, pays the purchase price, receives the shares and can immediately resell them at a profit. B remains the option premium. However, if the share price falls, A does not exercise the option. B has the bonus as the profit on the transaction and remains in possession of the shares.
The put option
In the case of a put option, the buyer of the option has the right but not the obligation to deliver the underlying asset, in this case shares, at a specific point in time. While call options assume rising prices, a put option is based on the assumption of falling prices.
Underlyings in options trading
Basically all tradable goods are eligible for option trading. For private investors, however, stocks play the most important role in options trading. In addition to shares there are still options
- Raw materials,
- Exchange Trading Funds,
- electrical power
and other goods completed. Speculations with grain and other foods have meanwhile led to massive criticism of those involved.
The types of exercise in options trading
The exercise of an option is based on one of three previously agreed types of exercise. The American option is the least imperative. It stipulates that the option can be exercised on each trading day before the expiry date. While the Bermuda option does not allow every trading day to be exercised, it does offer several dates to choose from. When taking out a European option, there is only one fixed date – the contractually fixed expiration date – available.
The influencing factors in options trading
The volatility of the underlying asset and the term have a major impact on the course of an option: the longer the term and the higher the volatility (susceptibility to fluctuations), the greater the risk of a trend reversal in the price of the underlying asset.
In addition to these two factors, other variables play a role in the pricing of an option, such as
the price of the underlying asset, a possible dividend payment if a share was chosen as the underlying asset, the interest rate if a discounted payment is to be made. For example, the buyer of a purchase option will never pay 60 euros for the option as a premium if he can purchase the base value for 50 euros. Likewise, the holder of the underlying will not pay 50 euros for the right to sell if the underlying is also at a price of 50 euros.
The progression possibilities of an option
If the option is “in the money”, the buyer has made a profit as if it was going according to plan. If the option runs “out of the money”, the buyer of the option had to realize a loss. If the option expired “at the money”, there was no significant change in price and the buyer will forego exercising it.
The risks in options trading
Options are derivatives trading in the largest risk class. The buyer of an option can lose all of his stake if it goes “out of the money”. The riskiest option, short selling, has now been banned. Here the buyer of a put option promised to deliver the base value on the reporting date. However, if the price of the underlying rose in the meantime, it had to stock up on the underlying at a more expensive price than it would then deliver to the counterparty.