Option (in Derivatives Trading)

What Is an Option?

An option is a type of financial contract that gives the buyer the right (but not the obligation) to buy or sell an asset at a predetermined price within a specific time period. Options are considered derivatives because their value is based on the price of an underlying asset, such as stocks, commodities, or cryptocurrencies.

How It Works

1. Types of Options:

• Call Option: Gives the holder the right to buy an asset at a set price (strike price) before a certain date (expiration date).
• Put Option: Gives the holder the right to sell an asset at a set price before the expiration date.

1. Premium: The buyer pays a price known as the premium to purchase the option. This is the cost of having the right to buy or sell, but without the obligation to do so.
2. Exercise or Expire: The buyer can choose to exercise the option (buy or sell the asset), or let it expire if it’s not beneficial to do so. If they don’t exercise it, they lose the premium paid.

Example Scenario

Suppose you buy a call option for Bitcoin with a strike price of $30,000, which expires in one month. You pay a $500 premium for this option. If the price of Bitcoin rises above $30,000, let’s say to $31,000, you can buy it at the set price of $30,000 and sell it for a profit. If the price stays below $30,000, you can let the option expire and only lose the $500 premium.

Alternatively, if you buy a put option for Ethereum with a strike price of $1,500, and Ethereum’s price drops below $1,500, you can sell it at the higher price and profit. If it doesn't drop, you let it expire, losing only the premium you paid.

Key Takeaways

• Leverage: Options allow traders to control a larger position with a smaller investment (the premium).
• Risk: The risk for the option buyer is limited to the premium paid, but the potential gain can be significant if the price of the underlying asset moves in their favor.
• Hedging: Options are often used as a way to protect (hedge) against price fluctuations in an asset.

In simple terms, options are like making a bet on an asset's price movement. You pay a small fee to have the right to buy or sell it at a specific price, but you don’t have to if it’s not worth it.