FAQ on Option Trading
Options trading is a variant on futures contracts. The futures contracts involves two parties making an agreement that one will sell an asset to the other at a fixed price on a future date. With options trading, the deal is made in advance, but one party will have the right to decide whether or not to go through with the deal.
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How does options trading work?
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Futures contracts involves two parties making an agreement that one will sell an asset to the other at a fixed price on a future date. With options trading, the deal is made in advance, but one party will have the right to decide whether or not to go through with the deal.
What is the asset?
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Any financial asset can be used as the basis of an options contract. The simplest example is a company stock, but commodities or a market index can also be used.
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Is the options contract an asset in itself?
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Yes. The buyer of an options contract can, at any time before the contract's completion date, sell it on to another investor at a price agreed between the pair. An options contract can change hands multiple times before it comes due. Because the contract itself doesn't have any inherent worth, and thus its value derives from the underlying asset, it is classed as a derivative.
What are the main terms used in options contracts?
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A standard options contract, where one party has the option to buy an asset, is known as a call. In contrast, a variation where the first party has the option to sell the asset is known as a put. In both cases, the party holding the option is still known as the buyer -- this refers to buying the options contract itself, not the underlying asset. The fixed price at which the final purchase or sale is made (if the buyer chooses to go ahead) is known as the strike price. The action of the seller in agreeing to the options contract is known as writing the option.
How is the premium price decided?
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In simple terms it is a case of demand and supply. In more complex terms, many investors will analyze the terms of a contract, decide upon an "objective" price, and then either make the original deal or buy out a contract from another investor if they can get a better price than the "objective" price.
There are many formulas designed to produce such an objective price. The best known is the Black-Scholes model, which takes into account the strike price, the current market price of the underlying asset, the time left until the option comes due, the volatility of the underlying asset (how much its price varies from day to day), and the return that could be made by putting the relevant money into a risk-free investment instead.
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