Options are powerful financial instruments that provide traders and investors with unique opportunities to manage risk and capitalize on market movements. At its core, an options contract grants the buyer the right—but not the obligation—to buy or sell an underlying asset at a predetermined price on or before a specified expiration date. The underlying asset can range from stocks and commodities like gold to bonds, currencies, or indices such as the Hang Seng Index.
As a buyer, you pay a premium to the seller for this right. Sellers, in turn, collect this premium but assume the obligation to fulfill the contract if the buyer exercises their option. Options can be traded on exchanges through standardized contracts or over-the-counter (OTC) via customized agreements with dealers.
Key Terms in Options Contracts
Before diving deeper into how options work, it's essential to familiarize yourself with these fundamental terms:
- Strike Price: The pre-agreed price at which the underlying asset can be bought or sold.
- Expiration Date: The final date by which the option buyer can exercise their right.
- Exercise Style: Defines when the option can be exercised. American-style options can be exercised on any trading day up to and including the expiration date. European-style options can only be exercised on the expiration date itself.
- Contract Size: The quantity of the underlying asset that one options contract represents. For a stock option, this might be 1,000 shares.
- Settlement Method: How the transaction is finalized if the option is exercised. Settlement can be made by physically delivering the asset (physical delivery) or in cash (cash settlement).
Types of Options: Calls and Puts
There are two primary types of options, each serving a different strategic purpose.
- Call Options: These give the buyer the right to purchase the underlying asset. A call buyer typically anticipates that the asset's price will rise above the strike price, making the right to buy at a lower price valuable.
- Put Options: These give the buyer the right to sell the underlying asset. A put buyer generally expects the asset's price to fall below the strike price, allowing them to sell at a higher, pre-set price.
How Options Trading Works
Buying Options
When you buy an option (whether a call or a put), you pay the premium upfront. Your maximum potential loss is limited to this premium amount if you are unable to exercise the option profitably. This defined risk is a significant advantage for buyers.
Selling Options
When you sell (or "write") an option, you receive the premium income. However, you also take on an obligation. As a seller, you are required to buy or sell the underlying asset if the buyer exercises the option. Because of this unlimited risk potential, sellers are required to maintain a margin deposit in their brokerage account.
If the market moves against your position, your broker may issue a margin call, requiring you to deposit additional funds to cover potential losses. It's crucial to understand that potential losses from selling options can far exceed the premium received. Brokerage firms often have margin requirements that are stricter than the minimums set by exchanges.
👉 View real-time margin requirement tools to better understand the capital needed for different options strategies.
Liquidity Risks in Options Trading
Many exchanges, including the Hong Kong Exchanges and Clearing Limited (HKEX), employ a market maker system to provide liquidity for options contracts. Market makers are obligated to provide bid and ask prices.
However, investors should be aware that the quoted prices may not always be favorable. Furthermore, liquidity can dry up under certain conditions, such as during periods of extreme market volatility. In these scenarios, market makers may be unable to fulfill their obligations, making it difficult to open or close positions at desired prices. Investors must be mindful of this liquidity risk.
Transaction Costs and Fees
Trading exchange-listed options involves several costs, which can impact overall profitability. These typically include:
- Brokerage Commissions
- Securities and Futures Commission (SFC) Transaction Levy
- Exchange Fees
- Exercise Fees (payable when an option is exercised)
It's important to note that the Investor Compensation Levy has been exempt since December 19, 2005. Fee structures can vary depending on the specific type of option being traded. Always review the latest fee schedule provided by your broker and the exchange.
Frequently Asked Questions
What is the main difference between options and futures?
Both are derivatives, but a key distinction is obligation versus right. A futures contract obligates both parties to transact on the settlement date. An options contract gives the buyer the right, but not the obligation, to execute the trade, while the seller is obligated if the buyer exercises.
Is options trading suitable for beginners?
Options can be complex and carry significant risk, especially for sellers. Beginners should start by thoroughly educating themselves on the mechanics and risks, perhaps beginning with strategies that involve buying options where the maximum loss is known upfront, before advancing to more complex strategies.
How does time affect an option's price?
Options are "wasting assets," meaning their value erodes as time passes—a phenomenon known as time decay. This is a critical factor for option sellers (who benefit from it) and buyers (who are harmed by it), especially as the expiration date approaches.
What does 'in-the-money' mean?
A call option is in-the-money if the underlying asset's price is above the strike price. A put option is in-the-money if the asset's price is below the strike price. These options have intrinsic value.
Can I lose more money than I invest when buying options?
No. When you buy a call or put option, the maximum loss you can incur is limited to the total premium you paid for the contract plus any transaction commissions.
What is implied volatility and why is it important?
Implied volatility (IV) reflects the market's forecast of the likely movement of the underlying asset's price. It is a critical component of an option's premium. Higher IV generally leads to more expensive options because the potential for larger price swings implies a greater chance of the option expiring profitably.