What is an option and how does options trading work?
Dirk Donker, Head of Euronext Retail Services, explains what an option is, how options trading works and what to look out for when trading options.
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What is an option?
One of the types of derivatives offered at Euronext is an option. Options can be a useful strategy, like shares, ETFs or indices, especially for advanced investors.
An option is a contract that gives the buyer the right, but not the obligation, during a fixed period of time, to buy or sell an underlying asset, such as a stock or an index, at a specific price or before a specific date. In exchange for this right, the buyer pays a premium.
Placing an option functions like an insurance policy, or like a down payment on a future purchase.
Example of buying an option
The process of buying an option can be compared to the process of buying a house in some countries.
If I see a nice house, but I'm not sure yet whether I should buy it, I can come to an agreement with the real estate agent and take an option on the house.
This gives me more time to think about the purchase. In return for this option, I pay a premium (fee) to the estate agent.
If I eventually decide to buy the house, I will still be able to buy it for the initial agreed price, thanks to this option - even if there has been a price increase in the meantime.
However, should I decide not to buy the house, I will lose the premium I paid to the real estate agent.
This same mechanism applies to financial options.
At Euronext, options are traded on various underlying assets such as shares, indices and commodities.
What is the history of options?
The first options were apparently used in ancient Greece, to speculate on the olive harvest. But the options that we know now, as investors, first premiered on the Chicago exchange.
In Europe, the first options exchange was founded only a few years later and this is part of Euronext's history: in 1973 the European Options Exchange was born in Amsterdam.
How does options trading work exactly?
Options trading can be an interesting investment strategy, especially for more advanced investors. Options are complicated instruments, but when used correctly, they offer many advantages that trading, for instance, stocks or ETFs alone cannot.
To have a well-founded knowledge base in options trading, it is important to start by getting familiar with the different types of options you can trade.
The two basic categories of options to choose from are calls and puts.
- Call options give the investor the right to buy a stock.
- Put options give the right to sell a stock.
All options contracts have an expiry date and a price at which they can be exercised, also known as a strike price.
At Euronext, we provide an enormous range of options. This way investors can choose the one that works best for them and their investment strategy. They can use them in the way that best suits them, for instance in a more risk-averse way, or with a focus on returns.
What should you look out for when trading options?
There are risks involved in buying and selling options. For instance, an investor should not buy options unless they can afford to lose the premium they have to pay. Therefore, it is important to read all about options trading before embarking on this adventure.
The basic concepts of options are not difficult to understand. And when used correctly, options can provide investors with opportunities for their investment strategy. But they can be harmful when used incorrectly.
Where can I get more information on options trading?
To enable investors to gain a thorough understanding of options trading before starting, Euronext have created a video series called "Options Investing E-Learning". This e-learning course is available through our Euronext Knowledge Centre. It provides investors who are considering starting to trade options with all the in-depth information they need, divided into six topics.
You can also liaise with your bank or broker, and ask for more information about trading options.