Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date.
Understanding options contracts
Options contracts fall into two primary categories: calls and puts. A call option gives the holder the right to buy the underlying asset. A put option gives the holder the right to sell the underlying asset. The predetermined price at which the asset can be bought or sold is the strike price, and the specific date the contract ends is the expiration date. Options trade on various global exchanges, including Eurex in Europe and the Osaka Exchange in Japan.
To acquire an option, the buyer pays a fee known as the premium to the seller. If the buyer chooses not to exercise the contract before expiration, they lose the premium paid. The seller keeps the premium as their maximum profit in this scenario. Unlike buyers, sellers take on the strict obligation to fulfill the terms of the contract if the buyer decides to exercise it. This dynamic creates different risk profiles for market participants.
Investors use options primarily for speculation or hedging. Speculators attempt to profit from price movements in the underlying asset without taking direct ownership of it. Hedgers use options to protect existing portfolios from adverse price changes. Options trading carries specific risks, particularly for sellers who face theoretically unlimited losses if the market moves against their position.
Contract specifications and rules vary globally. Standard equity options often represent 100 shares of the underlying stock, but this multiplier changes based on local exchange rules or corporate actions. Options are also classified by their exercise style. European-style options can only be exercised on the exact expiration date. American-style options can be exercised at any point up to and including the expiration date. These style designations refer to the contract mechanics and do not restrict where the options are traded geographically.
Example
Elephants managing an investment portfolio might consider a scenario involving a publicly traded agricultural company that supplies peanuts. Suppose shares of PeanutCorp are currently trading at $50. An elephant investor believes the price will rise after the upcoming harvest report. The investor buys a call option with a strike price of $55 and an expiration date one month away, paying a premium of $2 per share. Because a standard contract covers 100 shares, the total premium costs $200.
If PeanutCorp shares increase to $65 before the expiration date, the elephant can exercise the call option to buy the shares at the $55 strike price. The elephant can then sell those shares on the open market at the $65 current price. The profit is the $10 difference per share minus the $2 initial premium, netting $8 per share or $800 total. If the stock price stays at $50 or drops lower, the elephant simply lets the option expire. The financial loss is capped at the initial $200 premium.