Let’s talk about your finances and your money options out there. There are so many and there’s so much more than just depositing your money in the bank.
What are your Money options?
In finance, money options or an option gives its owner (holder) a right, but not an obligation, to carry out a pre-determined transaction.
- This options gives its holder the right to purchase 100 shares in Company AAA for 25 USD per share on the option´s expiry date, which is the 1st of July, 2022.
- This option gives its holder the right to purchase 100 shares in Company AAA for 25 USD per share on any date until the option has expired. The option expires on the 1st of July, 2022.
- This option gives its holder the right to sell 100 kilograms of silver for 850 USD per kilogram on the option´s expiry date, which is the 1st of July, 2022.
Traders and investors can use options for pure speculation and for managing risk for their other investments (hedging). If you are a novice when it comes to options trading and investing, exchange-traded options are recommended, since they follow strict standardization requirements. Also, all exchange-traded options are cash-settled, so the underlying asset never changes hands. If you buy options outside the exchanges (over-the-counter / OTC) you run a higher risk of encountering non-standardized options contracts and you will need to do more due diligence prior to each purchase.
1. Holder vs. Writer
The entity that creates (issues) an option is called the writer. The writer is obligated to honour the option if the holder (owner) elects to exercise it (use it).
Example: You, the holder of an option, elect to exercise that option on the expiry date. This option gives you the right to purchase 100 shares in Company AAA for 25 USD per share. The current market price on the expiry date is 30 USD per share. It is the writer of the option that is required to make sure you can exercise your option.
Important: Nowadays, most options are cash-settled, which means that you will not actually be able to buy 100 shares in Company AAA. Instead, the option writer will pay you the difference between the option´s strike price (25 USD) and the current market price (30 USD).
(30 USD minus 25 USD) x 100 shares = 500 USD.
If you don´t want the option to be cash-settled, you have to be very careful when you purchase the option and make sure it is not of the cash-settled variety. All exchange-traded options are cash-settled, so you will have to buy it over-the-counter (OTC).
2. Put option vs. call option
An option that gives the holder a right to sell is a put option, while an option that gives the holder a right to buy is a call option.
To put it simple:
- If you think that the value of the underlying is going up, buy a call option (”right to purchase”). If you exercise the option when the option´s strike price is lower than the market price of the underlying, you profit.
- If you instead think that the value of the underlying will be going down, buy a put option (”right to sell”). If you exercise your put option when the market price of the underlying is lower than the strike price of the option, you profit.
3. American-style options vs. European-style options
Most (but not all) options are either American-style or European-style. This pertains to when they can be exercised.
- European-style option
A European-style option can only be exercised on its expiry date.
(Options based on an index are usually European-style.)
- American-style option
An American-style option can be exercised at any time until it has expired. Since this gives the holder more room to manoeuvre, American-style options tend to cost a bit more than European-style options (cerises paribus).
4. Bermuda option
One example of an option that is neither American-style nor European-style is the Bermuda option. A Bermuda option isn´t as flexible as American-style options, but also not as restricted as the European-style options. Instead, it can be exercised on certain pre-determined dates throughout its lifetime. The most common version of the Bermuda option can be exercised on one specific day per month, until it expires.
Generally speaking, a Bermuda option costs less to buy than an American-style option (cerises paribus).