Traders and investors use options for a variety of purposes. They can be used to speculate, taking positions in assets at a lower cost than buying shares. Investors also use options to hedge and reduce risk in their portfolios (hedging).
The buyer of an option has the right to buy (call option) or sell (put option) of an underlying asset (stock, index, commodity or foreign currency) at a specified price (strike price) within a specified period.
Types of options
There are two main types of options: call options and put options. Call options are chosen in bullish markets as investors expect the price of the underlying asset to rise. Conversely, put options are preferred in bearish markets as investors expect the price of the underlying asset to fall.
- Call Option
Gives the holder the right to buy an underlying asset at a predetermined price (strike price) within a specified period. The profit potential of a call option is unlimited, as the price of the asset can theoretically rise significantly. - Put option
Gives the holder the right to sell an underlying asset at a predetermined price within a specified period. The profit potential of a put option is limited to the extent that the price of the underlying asset can fall to zero.
Options can also be categorised according to their exercise style:
- American options
The holder can exercise the right to buy or sell the underlying asset at any time before or on the expiration date. - European options
Can only be exercised on the expiration date itself. Holders cannot exercise these options before the specified expiration date.
