Option Types

Just as with futures contracts, options can be bought on a wide variety of financial instruments, or underlying securities. In this respect, it’s just another way of trading in the financial markets, and your success will depend on your anticipation of price changes.

Equity Options

Possibly the simplest type of option, and the one generally referred to above, is the equity or stock option which has stock in a single company as the underlier. The convention is that each option contract covers 100 shares, so if you wanted to control a 500 shares position, you would take out five option contracts.

If you buy a call option, you are hoping for the share price to increase to bring you into profit. Remember that the option gives you the right to buy the shares at the strike price, so if the price of the shares goes over your strike price, you have profited (once your option premium is covered).

If you buy a put option, you have the right to sell shares at the strike price, so you are hoping that the share price will fall below it, and you will make money that way. How much the price has to rise or fall to make a profit from these options depends on what strike price you have settled on.

If you write an option, then you have immediate income in terms of the premium that you receive. Your hope is that the option does not move into profit, so that at the expiry date it is worthless, and you can simply keep the money with no further liability.

Equity options are exchange traded and usually physically settled. You can take a profit any time before the expiration date simply by trading the option back on the exchange, as long as it has gone up in value. You don’t need to exercise the option to close your trade. The option market makes sure that any options that are “in the money” at expiration will be automatically exercised, so that no trader loses money simply because they were careless.

Index Options

These are similar to equity options, but as with futures, it is impractical to give physical delivery, so they are cash settled with no shares changing hands. In the options market, index options have become the most popular ones to trade. They allow diversification into the overall market, and give a leveraged way to profit from an upturn or a fall in the economy. The actual value received at exercise or expiration is 100 times the difference between the strike price and the index. As noted previously, most index options have the European exercise rights, but some, for example the OEX, have American exercise rights.

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