Derivatives - What Are Options?

The exam will have a lot of questions about options. So, what exactly is an option? It is a contract that grants its owner the right, but not the obligation, to make a transaction in an underlying commodity or security at a certain price within a set time in the future. The underlying commodity or security could be anything.

If you are unfamiliar with options, the Options Basics tutorial is an excellent primer.

Additionally, watch this video explaining how options work.

For example, let's say the stock of XYZ Company looks undervalued to you. It trades at $20, and you think it is worth at least double that. You could buy the shares today, hold them until they double, and then sell them.

That would be the easy way, but not the most efficient way in terms of time or return on investment. After all, the market is not going to move just because you, one investor, have faith in a stock.

Being realistic, you decide that the share price is not going to move until the current quarter's results are released 60 days from now.

In the meantime, there are other trades you want to make, and you do not want to tie up your money for two months on a buy-and-hold stock that you are confident in, but not 100% certain about.

Instead, you buy an option that gives you the right to buy 10,000 shares of XYZ stock in 60 days at, say, $25. This option costs far less than the underlying stock, so you still have money to pursue other transactions.

Let's say 60 days elapse and XYZ's quarterly report comes out and surprises everyone - except you - with record-breaking earnings per share.

The stock, which had been trading in the $20 to $25 range for months, shoots past $30 and is on its way to your target price of $40.

While other investors are buying XYZ at $30, $32 or $38 a share, you have the option to buy it at $25.

That means whoever sold you the option (the writer) is now obligated to sell you the shares at $25.

You exercise the option, buy the 10,000 shares at $25, and then sell them immediately for almost $40 each.

Types of Assets Underlying Option Contracts
Equity shares are one major type of underlying asset, but others include the following:

  • Fixed-income securities such as Treasury obligations and debt instruments of sovereign nations.

  • National currencies such as euros, British pounds and Japanese yen.

  • Livestock such as beef and hogs.

  • Agricultural products such as corn, soybeans and oranges.

  • Benchmarks such as security exchange indexes and linchpin interest rates.

  • Extracted commodities such as crude oil, gold or copper.

Option Disclosure Document
The Options Clearing Corporation (OCC) publishes a free option disclosure document that is required reading for all first-time options investors. This is meant quite literally: the SEC really does require it, so you must make sure your client reads the option disclosure document before taking the plunge into derivative trading.

It wouldn't hurt to read it yourself, and it would be even better if you did so in advance of the Series 7 exam. The PDF can be downloaded here: Characteristics and Risks of Standardized Options.

Trading Options
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