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What Are Options and How Are They Used?
By: A Sweeney | Updated Feb 28th, 2021


If you have an interest in finance or ever sampled a demo account its quite probable you have heard of the options market. It can be slightly overwhelming for beginners, however there are different application methods in the options market, some of which don't require a PHD to understand. Sure, if you dive deeper into the numbers, the market becomes incredibly dynamic and fairly complex. However, as this may be better suited or more profitable for some, there are also more basic hedging and speculation strategies available to everyone in using options. 

Options are a type of financial security providing a contract between two parties that gives option holders the right (but not the obligation) to buy or sell assets at a pre-determined date and price. The embedded date on the contract is known as the expiry date in which the contract is no longer active and the right to buy or sell the asset is terminated. Options are part of a larger group of financial securities knows as derivates; because options derive their value from another underlying asset ie: stocks, currencies, commodities. 

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There are two participants in every option contract, a buyer and a seller (also known as writers), but each participant has their own liabilities and rights. For instance, the seller carries the obligation to buy (with puts) or sell (with calls) if the buyer decides to exercise the option or if the option expires in the money. Whereas buyers have the right but not the obligation to buy or sell the security at the predetermined price or date.

There are two types of options available to the investor knowns as calls and puts. Much like any other financial security, it's possible to buy or sell both calls and puts, so effectively there are four choices for investors to chose from, all of which have distinctly different characteristics.



If an investor is bullish on a specific asset, they can turn to the options market where they can either buy calls or sell puts. Both scenarios will result in profit if the asset price appreciates however the difference is in the rights, obligations and risks. 

Buying a call is straight forward - for instance, if buying call options on Apple costs $500, otherwise knows as the premium, then this is the total risk exposure for this trade as the premium is paid upfront and deposited to the person who wrote the call (seller). The benefit to this type of position is that the risk is limited to the premium paid but the upside potential is unlimited - as the profits will depend to the extent of the move of the underlying asset. 

Selling a call comes with additional risk - as mentioned above, the buyer pays a premium upfront which is deposited to the writer of the call option, and therefore would collect $500 upfront without the possibility to make additional profit, regardless of what the asset does. However, the downside is unlimited, in the same way the buyers profit is unlimited the sellers losses are unlimited as they hold the obligation to fulfil the predetermined contract. So if Apple stock rallies, the option writer is liable for the everything above the strike price - which is unlimited.


If an investor is bearish on an asset, they could buy naked puts or sell naked calls. Both strategies will profit from a bearish move in the underlying asset. The same principles apply for buyers and sellers (see above), the premium is paid upfront for buyers and collected for sellers, the risk exposure is also the same.


The measure of this time decay is known as Theta, one of the greek formulas used in the options market. Theta is always negative and immediately when the buyer purchases the option and pays the premium, the clock starts ticking. Furthermore, as Theata is negative, buyers lose money if:

  1. The asset stays still, ie: sideways price action

  2. the asset moves in the predicted direction but the move is slower than the daily time decay

  3. If the asset goes the wrong way

Therefore, although the risk for those selling uncovered calls is unlimited, there are several scenarios working in the sellers favour; furthermore, under the scenario when the asset price moves in the direction that is against the sellers position, instead of being exposed to unlimited losses, they can also enter into other contracts to limit their losses, adopting some more advanced hedging techniques. 


There are four main different variables of risk measurement in the options markets, otherwise known as 'The Greeks'. With names derived from Greek symbols, the primary variables are 'Theta, Delta, Vega and Gamma', which are partial derivates of options pricing.

Options pricing often does not move in correlation with the underlying asset therefore it becomes very useful for investors to understand the greeks and quantify the market in a mathematical context.


After reading that sellers are exposed to unlimited losses you may be wondering why anyone would want to be a seller of an option as the risk is so high for a capped return. Well, option writers can benefit from a loss in volatility, and as the market goes sideways, the option will depreciate losing its time value and eventually expiring worthless. This process is knows as time decay - the rate of decline of the options premium as it approaches expiration. The closer options get to expiration the faster time decay becomes as there is little time left for the asset price to move allowing investors to profit. This is why option sellers want high premiums with low volatility - the likelihood of keeping the premium paid upfront is high.



Understanding the options market can be an extremely beneficial tool for investors. It allows for different and more complex strategies with higher leverage maximising rewards than traditional assets. Furthermore, options offer excellent means of risk management when used properly helping investors manage portfolios utilising capital employed to its full potential. Click here for more information on option strategies.

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