What are Options
How to Trade Rights
Options are a type of financial derivative that combine both "rights" and "obligations" into a tradable product. The advantage of options lies in leverage, allowing one to pay only a portion of the premium while obtaining the right to trade in the future according to the agreement. This characteristic makes options commonly used in hedging transactions.
Here's a simple example of a typical options trade:
Suppose we have two options investors, A and B, and the current price of Banana stock is $100 per share.
- Investor A: I would like to buy the right to purchase at a strike price of $120 in the future!
- Investor B: Sure! I'll sell it to you, but please pay $10 as a premium first.
In the future, there might be two kinds of scenarios:
Scenario One: When Banana stock rises to $135 per share
Investor A, who bought the option, will profit from the increase in Banana stock price; conversely, Investor B, who sold the option, will incur a loss if Investor A chooses to exercise the option.
Scenario Two: When Banana stock falls to $95 per share
When the price falls below the strike price, Investor A will choose not to exercise the option, losing the premium, which becomes Investor B's profit.
Below we will explain the rights and obligations faced by buyers and sellers in options trading.
Rights in Options: Buyer
The buyer in an option pays a premium to the seller to obtain the right to trade in the future according to the agreement. The buyer can choose whether to exercise the option or not. If the option holder believes the trade will not be profitable, they can choose not to exercise it. Since the buyer can decide whether to trade or not, holding an option contract is a right for future trading but not an obligation.
Obligations in Options: Seller
The seller in an option receives a premium from the buyer when selling the option. The seller has the obligation to execute the contract if the buyer chooses to exercise the option. Since the buyer will only exercise the option when it is profitable, the profit the buyer gains from exercising the option is the seller's loss in that trade.
By now, you should have a basic understanding of options. Next, we will introduce the two main types of options: calls and puts.
What are Calls and Puts
Different Rights of Calls and Puts
Options can be classified into calls and puts based on the direction of the right exercised in the future. For an investor buying options, buying a call and buying a put are two entirely different operations.
- Call Option (Call):
Call Option is when the holder has the right to buy the underlying asset in the future. The person buying this right is called the call buyer; conversely, the person selling this right is called the call seller. - Put Option (Put):
Put Option is when the holder has the right to sell the underlying asset in the future. The person buying this right is called the put buyer; conversely, the person selling this right is called the put seller.
Future Profits of Calls & Puts
How Stock Price Trends Affect Option Investors' Profits
Since the option buyer purchases the right to exercise in the future and will only choose to exercise when they can profit, the future profits of an options buyer are relatively straightforward. The call buyer hopes for the stock price to rise to gain from the price difference, while the put buyer hopes for the stock price to fall.
The option seller has a slightly different situation. Since the seller waits passively to see if the contract will be exercised, the future profit of the option seller depends on whether they incur losses from the exercise. If the buyer does not exercise the option, the seller's profit is the premium received at the time of selling the option. Thus, the call seller hopes the stock price remains stable or falls, while the put seller hopes the stock price remains stable or rises.
| Buy | Sell | |
|---|---|---|
| Call | Expects a significant stock rise; the higher the stock rises, the more profit gains | Expects no rise in stock price; profits premium when the stock price remains stable or fall |
| Put | Expects a significant stock fall; the larger the stock drops, the more profit gains | Expects no fall in stock price; profits premium when the stock price remains stable or rise |
Profits and Risks of Calls & Puts
Based on the table above, we can tell that both call and put buyers hope for significant market volatility, as larger price movements are beneficial to them. Call buyers hope for a significant stock rise, while put buyers hope for a significant stock fall. The risk is relatively limited, with the maximum loss being the premium paid to buy the option.
For options sellers, the situation is the opposite. Sellers hope for minimal market volatility, as stability is profitable for them. For options sellers, the future risks can be significant, with potential losses being unlimited.
| Buying Options | Selling Options | |
|---|---|---|
| Profit | Unlimited | Limited to the premium received at the time of sale |
| Risk | Limited to the premium paid at the time of sale | Unlimited |
In summary, buying options is an investment with potentially unlimited profit and limited risk, while selling options is an investment with limited profit and potentially unlimited risk. Buying options demonstrates the leverage in these derivative products, as investors can gain unlimited future profit opportunities by paying a relatively limited amount of risk and money (premium).
