Diversifying an investment portfolio is a key step towards successful performance. While choosing which entities to explore, it’s beneficial to take a closer look at options contracts. While these are arguably the most complex investment, they can significantly reduce risk when properly managed.
What is an option contract?
An option contract gives the buyer or seller the right to buy or sell an underlying asset at a later date, at a predetermined price. Frequently, option contracts are used to buy or sell commodities, stocks and securities, which are referred to as the underlying asset. There are several factors that contribute to the movement of the price of options, and they are represented by Greek letters. “The Greeks” (These letters are something every investor should understand before investing in options contracts.)
What is a put/call?
Trading option contracts is the art of generating money based on the prediction of future price movements. Or to protect an underlying position. If an investor believes a certain underlying asset is going to decline in price or wants to protect a position from a decline , then that buyer will purchase a put contract. Conversely, if you believe the underlying asset will increase in value, then you purchase a call contract. Options contracts can be purchased as a call or a put depending on the direction a buyer believes the underlying asset will move or the direction they want to protect against.
How are options valued?
Option contracts are priced based on their intrinsic and extrinsic value. Their intrinsic value is determined – for call contracts – by the difference between the price of the underlying and the strike price. The opposite is true for puts, meaning the difference between the strike price and the price of the underlying. Extrinsic value is largely determined by implied volatility and time value. The simplest way to calculate the extrinsic value of an options contract is to subtract the intrinsic value from the total option premium. Which equals the actual premium the market has priced into the option.
How is an option contract priced?
There are many factors that influence the price of an option, such as time, movement of the underlying asset, implied volatility and much more. If the underlying market doesn’t approach the strike, an option contract should always lose value as it approaches expiration. This means that the price of an option contract should be highest when it is furthest from expiration, and it should be cheaper when it is close to expiration.
When you purchase a call option contract, you are estimating or protecting against the price of the underlying asset rising above the strike price and into a zone called “in-the-money”. The opposite is true when you purchase a put option contract, as you are estimating or protecting a long position from the price of the underlying asset falling below the strike price and going in-the-money.
Where’s the money?
It’s important to understand these three phrases: in-the-money, at-the-money and out-of-the-money.
- A call option contract that is “in-the-money” means that the underlying market is above the strike price. The opposite is true for a put option contract, meaning the market is below the strike price. (Remember, for put options should gain in value if the underlying asset decreases in price.) Due to the initial cost, or the premium to purchase an option contract, being in-the-money does not guarantee a profit.
- A contract that is “at-the-money” means the underlying asset is the same price as the strike price. (Strike price is the name and level of the option bought or sold).
- Out-of-the-money means the underlying contract is below the strike price of a call or the underlying market is above the strike price of a put option.
When trading options, it is important to remember that this investment thrives when it is actively managed. Trading futures is a lot like checkers, whereas options contracts are like chess. There are far more moving parts to trading options with significantly more complex strategies.
To decrease risk in your portfolio, it is recommended that you consult a professional advisor, as they are best suited to create a tailored strategy to diversify your portfolio and reduce risk.