Options

Options are a type of derivative. The following pages are designed to communicate the basic concepts of how they work and are priced

The subject of Options is a large one: there are many books entirely devoted to explaining how Options work and are priced and the many strategies that can be employed when trading Options. It is beyond the scope of TradeSense to go into any further detail than an introduction to what they are and how they work and a cursory explanation of pricing.

The definition of an Option

An Option is defined as being a contract that grants the right, but not the obligation, to buy or sell an asset at a specified price on or before a specified date.

Options terminology

The right to buy is known as a Call Option.

The right to sell is known as a Put Option.

When someone buys a Call, he gains the right to buy the asset at the specified price; the person who has sold the Call is obliged to provide the asset at that price, should the buyer choose to exercise his right to buy.

The seller is known as a writer.

The amount paid for the option by the buyer is known as the premium. The writer receives the premium that is paid by the buyer. The premium will change according to the price of the underlying asset. With exchange-traded options the premium is usually paid for up-font.

It is important to note that when dealing with us on Options, you are speculating on the price of the Option, where the price is the premium.

You therefore cannot exercise an Option with us. You can choose to close your deal at any point against the current price we are making for that Option, or simply leave the Option to expiry at which point your position will be settled against the value of the Option as defined by the price of the underlying at the expiry point.

The price at which the holder (that is, the buyer) of an option can buy/sell is known as the exercise or strike price.

So let’s look at an option: a FTSE® December 6500 Call.

The underlying is the FTSE®100 Index future; the Option will expire in December (specifically the third Friday of in December); the exercise price is 6500.

The Option is the right to buy the FTSE® at 6500 – the right will expire on the third Friday in December.

It is clear that the value of the Option is influenced by the price of the underlying (the level of the FTSE® in this case).

Common sense suggests that — all other things being equal — the right to buy the FTSE® at 6500 should become more valuable as the FTSE® rises, and less valuable as the FTSE® falls.

If this is not immediately apparent, consider the two scenarios.

Now at any single moment in time, the right to buy the FTSE® at 6500 is more valuable in the first scenario than in the second.

Basic Strategies

There are four elementary trades that can be placed with Options: