What is an exchange option: simple explanation
The concept of an Option could seem something difficult and above understanding for traders, that meet it for the first time. Despite the fact that Internet is full of option trading strategies, the question still remains unanswered: What is an “option”?
From one hand, option is a deal that means the right, but not the obligation to buy an asset for the certain price in certain period of time. But this definition is pretty rough, so if the trader decides to go deeper, even more questions appear, and some of them could compare to solving the Poincare theorem.
- What is common between all options?
- How to define a price for an option (example from real life)?
- Why to trade options?
So, let's look at the options as an example of real life, and then we will transfer it to the financial markets.
Imagine you own a car. As a law-abiding citizen, you are obliged to have an insurance for your vehicle. In this case, insurance can be considered as an option! Here is why:
- the price of an insurance is less than the price of an insurable event;
- purchased "option" has a duration of validity, that was set in advance (usually, it is a year);
- it has straight conditions of accomplishment: it accomplishes in case of road traffic accident.
So, when buying the insurance, you transfer the risk of accident to insurance seller. But in case your insurance was not used – the insurance company will get its profit (the cost for an insurance itself).
What is common between all options?
1) Expiration date. Any optional contract is concluded for certain time period or relies on the certain event in the future. For example: Will it rain tomorrow? or Will TSLA stock price grow above 400$ next year (2018)? – these are the examples of options.
2) Conditions of execution. As soon as option means the choice (vagueness about a certain event in future) any option should have specified criteria, according to which the winning side could be defined.
Lets come back to the options on the financial markets. Just like in real life, exchange options are kind of agreement between two sides, but the matter of deal is where will the price of an asset will be set in the certain moment in future. The result of this agreement can give four basic parameters of options:
- The matter of deal – is the so-called “underlying asset” basing on which sides will close a deal;
- The expiration date – the moment in future, when option contract will expire and sides will not have any obligations to each other;
- The strike price – depending on whether the current asset price (lower or higher) in relation to the option strike, it is defined what side won;
- The price of an option itself – the price of an agreement, that depends on two previous characteristics: option's strike and it's expiration date. In fact, option pricing is a topic for a scientific research with thousands of hidden rocks. We will talk more about pricing models in the future articles.
How to define a price for an option (example from real life)?
Imagine that technologies of insurance companies have moved forward and every car driver has a special device. The purpose of the device is to recalculate the price of an insurance (option) in real time, and, depending on your driving style, it sets the final price for the insurance. The basic price of an insurance has a minimum of 1$.
For example, if the device has caught a driver for speeding, then the basic price of and an option has grown for 10$; driving through a red light – the price has grown for 30$ and so on. That means that non-safe driving will increase the price of the insurance.
In simple words, the option price is a constant recalculating of the probability of a certain event to happen. The number of parameters is used for that – volatility, underlying price, term of the contract and type of option. We will talk about these characteristics in the next articles.
Why to trade options?
Options is a separate kind of instrument with a set of unique properties, that can not be repeated while trading on an underlying asset. Different from an underlying asset, option has nonlinear profile of profit and loss. That nonlinearity allows flexible conforming to the market condition and create different options strategies, that earn on different market cycles.