What are options?
Before looking at what options are, it is worth understanding what they are not. Options are often equated or confused with warrants. In fact, options and warrants are two quite different things. In the classic sense, options are genuine, standardised financial products traded on a derivatives exchange. Warrants, by contrast, are usually issued by banks and therefore carry issuer risk: if the issuer – the bank that issued them – becomes insolvent, its warrants can become worthless overnight.
In principle, warrants imitate the behaviour of options – and that is where the similarities end. What remains are the differences, or more precisely the disadvantages of warrants compared with genuine options:
- No standardisation, issuer risk: warrants are not standardised products. Each issuer can design them differently, and, like a conventional bearer bond, they depend on the issuer's solvency. Securities becoming worthless overnight – as happened to many products issued by Lehman Brothers when the bank collapsed in 2008 – cannot happen in this way with exchange-traded options, because these are settled through the exchange's clearing house.
- Less transparent pricing: warrants are not traded on a derivatives exchange like options. Their prices are generally set by the issuer itself, so price formation is not always transparent.
- Fewer strategies: warrants allow only a fraction of the trading strategies available with options. The simple reason is that only the issuing bank can be the seller of a warrant. Unlike with options, a warrant trader cannot take the seller's side – known as the writer – themselves. This is a decisive disadvantage for warrant traders; the reasons are explained under "Why trade options?" below.
The only advantage of warrants – if it can be called one at all – is that they are also accessible to relatively small accounts, because the minimum amounts required are lower than for genuine options. It is no surprise that issuers are keen to make their warrants available to a broad investing public: they earn money on the warrants they sell, including those that expire worthless.
So what exactly is an option?
An option – more precisely, an option contract – is an agreement between two parties about a transaction in the future. Every option is based on an agreement to exchange an asset, such as shares or commodities. The price at which this asset is to be exchanged, known as the strike price, is fixed for the term of the option and cannot be changed. The term of the option is also fixed.
The name "option" already points to the core of this financial instrument. The buyer, or holder, of an option has the right, but not the obligation, to buy the underlying asset at the agreed price – or, in the case of a put option, to sell it (more on this below). Depending on the type of option, the holder can exercise it during or at the end of its term and demand the asset at the agreed price. If exercising does not make economic sense, the holder can also let the option expire worthless. The price of the option, known as the option premium, is comparable to an insurance premium: whether or not the option is exercised, the premium has been paid and is not refunded.
Like futures, options are derivatives – forward transactions based on a trade that will take place in the future. And like futures, they are traded on derivatives exchanges.
The two parties to an option
Since an option is an agreement between two parties, an options trader can take either side. They can act as the buyer, or holder, of an option, who has the right to delivery of the underlying asset at the agreed price. Or they can act as the seller of an option, known as the writer.
The two sides of an options trade can be compared to the relationship between an insurance company and a policyholder. The buyer of the option is the policyholder, and the option is essentially the insurance policy they have taken out. The seller, or writer, takes the role of the insurance company.
When a trade is concluded, the buyer pays the option premium to the writer, just as a policyholder pays the insurance premium to the insurer. In return, the buyer acquires the right (but never the obligation) to buy the underlying asset at the agreed price. At the same time, the writer takes on the obligation to deliver the underlying asset to the option buyer if the buyer decides to exercise the option. The writer has no say in this decision: they can only wait for the buyer either to exercise the option or to let it expire worthless at the end of its term. An option expires worthless if exercising it at expiry would make no economic sense – for example, a call option whose strike price is above the market price of the underlying.
Of course, an option can be bought and sold on the exchange at any time during its term, so neither party has to wait until expiry – a position can be closed early. However, the option premium, which is the option's trading price on the exchange, changes constantly, so traders have to accept both favourable and unfavourable price movements.
Types of options
1. By exercise style
When it comes to exercising an option, a distinction is made between European and American options. The difference lies in when the right to delivery of the underlying asset can be exercised. An American option can be exercised at any time during its term, up to and including the expiry date. A European option, by contrast, can only be exercised at the end of its term; exercise before then is not possible. The names refer only to the exercise style, not to where the options are traded.
2. By position: calls and puts
What positions can an options trader actually take? First, a distinction must be made between options to buy and options to sell. In trading jargon, options to buy are called call options, or "calls" for short, and options to sell are called put options, or "puts". Both calls and puts can be bought and sold, which gives an options trader four possible positions. But first, it is worth clarifying exactly what calls and puts are.
Calls are options to buy. They entitle the buyer to buy the underlying asset – the "underlying" – at the agreed price. The writer is obliged, at the option buyer's request, to deliver the underlying, that is, to sell it at the agreed strike price.
Puts, on the other hand, are options to sell. They entitle the buyer to sell the underlying at the agreed strike price. In this case, the writer does not have to deliver; instead, at the option buyer's request, they must buy the underlying at the strike price and take delivery of it. When this happens, the writer is said to be assigned: the underlying is "put" to them.
This results in four specific positions.
The four basic positions in options trading
1. Buying a call (long call)
Anyone who buys a call option holds a long position in a call (long call). The buyer acquires the right to buy the underlying at the agreed strike price.
2. Selling a call (short call)
Anyone who sells a call option holds a short position in a call (short call). The writer undertakes to sell the underlying to the buyer at the strike price on request.
3. Buying a put (long put)
Anyone who buys a put option holds a long position in a put (long put). The buyer acquires the right to sell the underlying at the agreed strike price.
4. Selling a put (short put)
Anyone who sells a put option holds a short position in a put (short put). The writer undertakes to buy the underlying from the buyer at the strike price on request.
How options work
Now that the basics have been explained, this section looks at how options actually work.
The Greeks
There are many rumours and myths surrounding the Greek letters used in options trading. Many inexperienced private investors have heard of the so-called "Greeks", but hardly anyone understands what lies behind them and why these key figures are so immensely important in options trading. The fact is that an options trader can hardly be successful without understanding how the Greeks work and what they mean.
In options trading, choosing the right option is crucial to success. There are countless different options: different terms (keyword: expiry) as well as different options with the same expiry date (keyword: strike price). In short, anyone unfamiliar with the Greeks has little chance of ever choosing the right option for a planned trade.
Every options trader should know how the following Greeks work and what they mean: delta, gamma, vega and theta.
1. Delta
Delta measures how much the price of an option changes when the price of the underlying changes by one unit. Call options have a delta between 0 and 1, put options a delta between −1 and 0. A call with a delta of 0.50, for example, gains about $0.50 in value if the underlying rises by $1, while a put with a delta of −0.50 loses about $0.50. Options that are deep in the money – whose exercise would already be clearly profitable – have a delta close to 1 (or −1) and move almost in step with the underlying, while options that are far out of the money have a delta close to 0.
2. Gamma
Gamma measures how much an option's delta changes when the price of the underlying moves by one unit. It shows how quickly the option's sensitivity to the underlying changes. If a call has a delta of 0.50 and a gamma of 0.05, for example, its delta rises to about 0.55 when the underlying climbs by $1. Gamma is highest for options that are at the money – with a strike price close to the current price of the underlying – especially shortly before expiry. Option buyers have positive gamma and writers negative gamma: for writers, a high gamma means that their risk can change very quickly when the underlying moves sharply.
3. Vega
Vega measures how sensitive the price of an option is to changes in implied volatility – the market's expectation of how strongly the underlying will fluctuate in future. It indicates how much the option price changes when implied volatility changes by one percentage point. An option with a vega of 0.10, for example, gains about $0.10 if implied volatility rises from 20% to 21%. Rising volatility increases the value of both calls and puts, which benefits buyers and works against writers. Options with a long time to expiry have a higher vega than options that expire soon.
4. Theta
Theta measures an option's time decay: how much value the option loses each day as time passes, with all other factors unchanged. A theta of −0.05, for example, means that the option loses about $0.05 in value per day. Time decay works against option buyers and in favour of writers. It accelerates as expiry approaches and is particularly pronounced for options that are at the money.
Why trade options?
Options are versatile instruments that can be used for very different purposes:
- Hedging: a put works like insurance for an existing position. Anyone who holds shares, for example, can buy puts to protect themselves against falling prices; the premium is the cost of this insurance (see hedging).
- Leverage with limited risk: for a relatively small outlay – the premium – an option buyer can participate in the price movements of a much larger position in the underlying. The buyer's maximum loss is limited to the premium paid.
- Earning premiums: writers receive the option premium upfront and keep it in full if the option expires worthless. This role is only available with genuine options; with warrants, it is reserved for the issuing bank.
- Flexibility: by combining calls and puts, traders can position themselves not only for rising or falling prices but also for sideways markets or changes in volatility.
The risks should not be overlooked, however. Time decay works against buyers, and if an option expires worthless, the entire premium is lost. Writers take on obligations and usually have to deposit margin as collateral. Their maximum profit is limited to the premium received, while their potential losses can be substantial – and with an uncovered (naked) short call, they are theoretically unlimited.
Option strategies
Options can be combined with one another and with the underlying in many different ways, so the range of possible strategies is very broad. Well-known basic strategies include:
- Covered call: holding the underlying and selling a call on it to earn additional premium income.
- Protective put: buying a put to protect an existing position in the underlying against falling prices.
- Spreads: buying and selling options of the same type with different strike prices or expiry dates at the same time – for example a bull call spread, which reduces the cost of a position but also caps its potential profit.
- Straddle and strangle: buying a call and a put on the same underlying at the same time (with the same strike price for a straddle, different strike prices for a strangle) to profit from a strong price movement in either direction.