Options

  • Options
    • Options are an alternative security available for investors to use as part of their portfolio, although, due to their nature, they are usually used by more experienced investors. As opposed to stocks and bonds, an option is actually a contract that enables the buyer the choice to buy or sell an asset at a set price at any time before the options expiration.

      The best way to understand the principle of an option is by using a familiar example:

      If a homebuyer found the perfect home but couldn't afford to proceed with a purchase for 3 months, a deal could be made with the owner to buy the house in 3 months time for an agreed purchase price, for example £170,000. However, for that option to buy there will be a £2,000 fee. 3 months later, there are several scenarios that may have occurred. For example, house prices may have rocketed and the house is now worth £250,000 but the buyer still only pays £170,000. Alternatively, there may have been huge subsidence and the house is no longer worth £100,000 and so at the 3 month expiry homebuyer does not proceed and loses the £2,000.

      The most important thing to note with an option is that the buyer has the right but no obligation to buy or sell. If the situation changes for the worse, as in the house example, the option can be allowed to expire and the cost of the option is the only loss. Another point is that the asset is underlying and therefore directly linked to the option and not physically owned or sold by the purchaser until the option is acted upon.

      The attraction of options is their versatility. Due to the time period and specified price, options allow investors to adapt and respond quickly to any market situation that arises. This could be as diverse as purchasing an option to bet on the upward movement of an index or buying options that bet against an industry or commodities decline. As such, options can be incredibly speculative or very conservative, all depending on how they wish to be played.

      However, with any benefit comes the negative, which may include increased risk of options due to the complicated details involved in the contract.

      Options are regulated in the UK by the Financial Service Authority (FSA) and are created in a standard form and traded through brokers, clearing houses and option exchanges.
  • Types of Options
    • There are two types of options, which are called puts and calls. A put gives the purchaser the option to sell their asset at a specified and unchangeable price within the set time period. Therefore a put involves the buyer wishing for the price of the asset to fall before the option period expires so the option can be sold at the original higher price.

      A call is when the option holder has the right to buy an asset at a fixed price within a specified time frame. This approach is the opposite to a put as it involves wanting the asset price to increase in value before the option expires so it can be bought at a below market price, set within the option.
  • Variety of options
    • Stock - Stock options are solely aligned with a company's stock on the open market.

      Commodity - Commodity options are based on a commodity product for which there is a worldwide demand regardless of A specific producer. Examples of such as sugar, oil and cotton.

      Bonds - A bond option gives the chance to sell or buy a bond at a price before the loan date expires.

      Stock market index - SMI options are directly linked to a whole market, such as the FTSE 100, or to a particular industry's price of index.

      Futures contracts - Futures options work with the price paid for the option is the options price when it's traded, if exercised.

      Employee stock - Employee stock options are used as bonuses or awards to employees for long service or achievements.

      Real estate - Real estate options are used when combining large pieces of land, purchased by different investors.