Options are complex financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset by a set date in the future at a fixed price.

An option is a type of derivative because it derives its value from an underlying asset, which could be a stock, bond, currency, commodity or interest rate. Derivatives involve risk and are not suitable for all investors. What’s more, these instruments are not insured, carry no bank or government guarantee, may lose value, and may be subject to significant volatility.

There are two types of options, “calls” and “puts,” which offer different benefits and risks when bought and sold. 

European-style options can only be exercised at the preset expiry date.  American-style options can be exercised at any time until expiry.

Options magnify exposure to the underlying asset. If the underlying asset price goes up or down, the option rises or fall by more. If the price of the underlying asset moves in the other direction than the investor expected, losses are magnified. The riskiest is selling a call, as there is no limit to how high a stock’s price can go. So, an investor could have to pay an unlimited price to buy the stock they are committed to deliver. 

Most options expire worthless. This means that the option holder loses the money paid for the option, called the premium. They get no benefit from the underlying asset. 

An option’s value decreases as it approaches the expiry date, a feature known as time decay. This happens as there is less time for the price to move in the option holder’s favor.

Market factors such as interest rates and volatility can also affect the value of options.

If you buy options, the maximum loss is the premium. If you sell put options, the risk is the entire notional below the strike. If you sell call options, the risk is unlimited. The actual profit or loss from any trade will depend on the price at which the trades are executed. Option trades in general are not appropriate for every investor. Because of the importance of tax considerations to all option transactions, the investor considering options should consult with his/her tax advisor as to how their tax situation is affected by the outcome of contemplated options transactions.

Here’s an example of how an investor might use options to try to profit from a potential rise in the price of an underlying asset. (This is illustrative only and is not an example of a real option trade or a recommendation.)

An investor pays $2 to buy a call option, giving them the right to buy a stock at $50 six months later.

(Typically, an option gives the investor the right to buy or sell 100 shares, but we’ll keep it as one share here for simplicity.)

If the stock price reaches $55 by the maturity date, the investor can exercise the option and buy the stock for the preset fixed price $50, even though its market price is now higher. 

This allows them to realize a profit of $5 per share, minus the $2 they paid for the option, giving them a net profit of $3 per share.

However, if the stock price never reaches $50 during the one-year period, the option expires worthless, and the investor loses the $2 they paid for the option. 

What about when the investor sells an option?

Say the option stays below $55 by expiry. The seller then keeps $2 premium, which is their profit.

But if the stock price rises to $55 by maturity, the buyer exercises the option. 

The seller must therefore buy the stock at $55 but is paid just $50 for it.

This gives a loss per share of $5. The premium received of $2 means their net loss is $3.

However, let’s consider another scenario. Just before expiry, the company that issued the stock receives a takeover approach at $100 a share, causing the stock price to rise to that price.

The seller is then obliged to pay $100 a share, leaving them with a $50 loss per share, and a net loss of $47 per share.

In these ways, options are risky investments. Not all investors are suitable and even sophisticated investors need to carefully consider market conditions and potential outcomes.

Options may serve a variety of purposes, such as seeking returns, generating income or mitigating risks through hedging and insurance strategies, like covered calls when trading shares.

Option strategies range from buying a call option, to more complex, involving multiple options and advanced trading techniques.

Option trading allows investors to gain significant exposure to an underlying asset without investing the full amount it would cost to buy the assets outright, but with a greater amount of risk. 

One way investors may seek income through options trading is by selling options. When an investor sells an option, they receive a premium payment from the buyer in exchange for taking on an obligation. 

While most options expire worthless – with the sellers thus keeping the premium received as profit – options that are exercised can result in outsized losses to the sellers.

The greater the distance between the underlying price and the strike price (the price at which an option can be exercised to buy or sell an underlying asset), the cheaper the option premium.

This is because as the distance between the underlying price and strike price increases, the option is less likely to be exercised, which reduces its value and can make it worthless, leading to loss of the investment.

As volatility increases, the price of options also increases. This is because higher volatility increases the likelihood of large price swings in the underlying asset, which can result in bigger potential gains or losses for the option holder. 

Because of this greater risk, more volatile options tend to be more expensive than options with lower volatility.

Generally, options with longer expiry periods tend to be more expensive than options with shorter expiration periods. 

This is because longer expiry periods allow more time for the underlying asset's price to move in the desired direction, increasing potential of the option being profitable.

Interest rates can also affect options prices, as they impact the cost of carrying the underlying asset. 

If interest rates increase, the cost of carrying the underlying asset increases, leading to higher prices. 

Conversely, if interest rates fall, the cost of carrying the underlying asset decreases, leading to lower option prices.