FinNexus Blog

FinNexus Blog

Getting started with options

Michele PennaDecember 30th 2020

What are options?

Options belong to the wider category of derivatives. Just like futures, swaps, forwards, etc, their value changes according to price movements in the underlying assets - i.e. their value is "derived" from that of the underlying.

The latter could be a stock, a commodity, a currency, or a cryptocurrency, as is the case with options traded on FinNexus now, which allows traders to choose from a variety of crypto assets in a simple and immediate way. Furthermore, we are evaluating whether to include other assets, like commodities, stocks, etc., as the options' underliers in the future.

Compared to other derivatives, however, options usually require newcomers a bit more work to be understood, as they are inherently complex. This can be a put-off for some but given the great possibilities for profit, it is an effort worth making!

To begin with, an option is a contract that involves two sides - a buyer and a seller - whose obligations are not symmetrical. When an option is exchanged, the seller, or option writer, will pocket a sum which is called a "premium" from the buyer. This entails an obligation to buy or sell an asset if certain conditions are met by a specified time.

The buyer, in exchange for paying a premium, obtains the right, but not the obligation, to buy or sell such asset if conditions materialize by the date of expiry.

These conditions revolve around the so-called strike price - the price at which an option can be exercised by the buyer. For instance, let us assume a trader buys an option for 100 stocks with a strike price of 3,300 and an expiration date set on the 31st of January 2021.

The buyer pays a $50 premium and in return will be able to buy those 100 stocks at 3,300 even if the price rises above such level, pocketing whatever difference there is between 3,300 and the price at which the option is exercised. In other words, he/she may end up buying at a discount.

Let us assume that the price goes to $3,500 - in this case, the buyer will have the chance to gain $200, which, if one subtracts the $50 premium, will return a nice $150 profit. The seller would lose the exact amount of money gained by the buyer.

What if the price had not reached 3,300 and stopped, let's say, at $3,223 by January 31st? Then the option contract would have expired worthless and our buyer would have lost $50, while the writer would have gained $50.

To sum up, options entail a certain price for the buyer - the premium paid to secure the contract. But aside from that, the buyer will not pay anything even if he/she does not get to exercise the option.

The seller, by contrast, enjoys immediate gratification but has a potentially infinite downside to face. In our previous example, had the price gone to $83,300, the option writer would have lost a whopping $50,000 for only $50 of the initial premium.

Put or call?

Options are further divided into two categories: put and calls, referring to whether they confer the right to buy or sell an asset.

Calls give the buyer the right, but not the obligation, to buy the underlying asset at the strike price specified in the option contract. This means that as a general rule, a call option is bought when a trader expects the price of the underlying to rise, for they will give him/her the right to buy an asset at a discount price and score a profit.

Puts give the buyer the right, but not the obligation, to sell the underlying asset once the strike price specified in the contract has been met. A put option is bought when traders expect the price of the underlying to fall, for they will be able to sell assets at the agreed price, even though current prices may well have fallen lower.

One final observation concerns the risk-reward profile of the two products. Theoretically, call options have an infinite upside - there is no end to where the price can potentially soar - put options are capped by the fact that the price of an asset cannot sink below zero.