Introduction
Options are a type of derivative security that gives holders the right to buy or sell a particular asset at a predetermined price for a particular period of time. Options are becoming increasingly popular among investors, traders and speculators for a variety of reasons. Not only do options give the holder the chance to “call” and “put” an asset based on their speculation of its price movements, but they also reduce the risk of trading, provide greater levels of liquidity, and offer different strategies when used properly. Most importantly, they offer the chance of leveraged returns – meaning that the potential returns of any given option is greater than the potential gains of a plain vanilla asset.
The different strategies put into action by those trading options are reliant on the type of rights the contract provides the holder. Call options give the holder the right to buy an asset, whereas Put options give the holder the right to sell. As such, options can be used to speculate on the direction of a particular asset’s price, limiting risk by capping the options’ downside but giving investors the chance to take advantage of time decay through the existence of the contract. The option strategy to take advantage of time decay is known as the “Long Straddle”.
Options and their Pricing
Options are, essentially, derivative securities in that they derive their value from an underlying asset. Options are traded, bought and sold on exchanges, and as such, their prices are determined by a number of factors. These include the demand for and supply of the option, the market’s perception of the underlying asset, and the option’s time decay or “theta”.
The demand for an option depends on the perceived potential of the underlying asset and the option’s strike price – the price at which the underlying asset can be bought or sold. If an option is perceived to have an expected upside, more people will buy the option, and its price will rise. The supply of the option is determined by the number of contracts that are listed on the exchange, and the option price will therefore adjust depending on the availability of contracts.
Option pricing is also influenced by the time decay factor, or “theta”, which represents the amount of value an option loses each day as it gets closer to its expiration date. When options are close to expiration their prices often decrease as the likelihood of them being profitable diminishes. As such, investors must be mindful of the “theta” when trading options as it can have a significant impact on the option’s price.
Using Options in Trading
Options are used by traders and investors alike in order to take advantage of favourable movements in the price of an underlying asset or to speculate on potential price movements. For example, a trader may hold a call option on a stock, expecting the stock to rise in price. Should the stock increase in price, the trader will profit from the gains generated by holding the call option.
Options can also be used as part of more advanced trading strategies, such as the Long Straddle. The Long Straddle is a strategy which allows investors to take advantage of time decay, whereby an investor will purchase both a call and put option on the same asset at the same strike price. This gives the investor the potential to make a profit from both options if the asset’s price moves in either direction.
Conclusion
Options have become an increasingly popular investment and trading vehicle for those seeking to reduce risk and take advantage of leveraged returns. Used properly, options offer investors the opportunity to invest with greater levels of liquidity, as well as different strategies to generate profits. While there are a number of factors that affect the price of options, one of the key advantages of trading options is the ability to take advantage of time decay, either through the purchase of a call or put option, or through the use of the Long Straddle strategy.
