There are many types of derivatives used in the finance world. What are their characteristics? What are they used for? This blog goes over one of them – options!
An option is a right (but not an obligation) to transact an asset at a later date, at a specified price. These act like contracts, giving the option-holder greater flexibility and power rather than if they chose to transact today. As a result, options are priced at a premium to the underlying security.
There are two types of options:
A call option gives you the right to buy an asset. If you buy a call option, you are betting that the price of the asset will rise. This is favourable, because you paid the lower, pre-specified price when you bought the option, and will have already made money when you exercised the option to own the asset later. In effect, you will have bought at the low point.
A put option gives you the right to sell an asset. If you buy a put option, you are betting that the price of the asset will fall. This acts like hedging, where you pay the higher, pre-specified price when you bought the option, but the asset only transfers hands when you choose to exercise the option. In effect, you have sold at the high point.
There are also two types of positions:
A long position means you are the option buyer.
A short option means you are the option writer (selling the option).
Let’s now define some common terms related to options:
Intrinsic value is the value gained from the option:
If you exercised a call option, this is equal to (asset price minus exercise price).
If you exercised a put option, this is equal to (exercise price minus asset price).
‘Out of the money’ means the option has zero intrinsic value, and is unexercisable.
The exercise price (also called the strike price) is the price at which you agree to buy or sell the asset, as specified in the contract.
The time premium is the value of the option above the intrinsic value. It is equal to the time until the expiry date of the option, which is specified in the contract.
The expiration date is the last date on which you can exercise the option.
Hopefully that has given you a broad overview of how options work! Note, however, that this is only an overview and meant to give you a taste of one of many areas you could work in finance. For more information on finance work placements with F3, visit here!
Disclaimer: The intent of this blog is to provide careers advice, not financial advice. It does not take into account individual circumstances. For financial advice, please see a financial adviser.
