Why options are used

To explain an option’s use, it is necessary to understand exactly what an option is.

An option is either the right to buy an asset (a ‘call’) or the right to sell an asset (a ‘put’) for an agreed price on or before a predetermined date.

Each option has a seller (also known as a ‘writer’) and a buyer (also known as a ‘taker’).

The buyer has the right, but not an obligation, to exercise the option. The seller of the option has an obligation to fulfil the requirements of the contract if called upon by the buyer of the option to do so. For this obligation, the seller of the option receives a payment, referred to as the ‘premium’.

The insurance parallel

Sometimes it is helpful to explain products by comparing them to other products that we are more familiar with. Consider a policy to insure a car:

- The insurance policy is a contract between the person insuring the car — the buyer, often called the ‘taker’ as this person is taking out insurance — and the insurance company.
- The insurance company is the seller, often called the ‘writer’ as the company has written the contract.
- The buyer of insurance can trigger an action (claim compensation) under certain circumstances. Th e buyer must elect to do so.
- The insurance company receives money (insurance premiums) for taking the risk that certain events happen and the buyer makes a claim that requires compensation.

The valuation (cost) of an insurance policy also has parallels in the options market. The longer the period the buyer is insured for, the higher the premium. The amount insured for will also affect the price, and — importantly — the level of risk associated with the event being insured against is also taken into account.

An insurance company will want more money to be paid as a premium if it considers the risk higher. Compare a young person insuring a fast car versus a sedate senior driver in a little runabout. Who would you prefer to insure? Insurance companies employ actuaries to assess risk, and insurance is priced accordingly. Assessing risk and prices is highly relevant to the options market.

This is an extract from 'Trading ASX CFDs, options and warrants — the ASX way'.  

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Reproduced with permission from Wrightbooks and John Wiley & Sons Australia.