Equity and Index Options Explained

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Summary

Options are called “options” because they convey choice, which is why they command a price. Options give us the right to do something without an equivalent obligation. Options may be bought or sold; they are freely tradable.

The risk/reward profiles of options are similar to those of insurance policies. When we buy options (take out insurance), we can only ever lose the premium paid and have significant profit potential (like an insurance claim). When we sell options (write insurance), we can only ever make the premium received and have significant risk (the counterparty making a claim). Options, just like insurance, are neither inherently good nor inherently bad. It all depends on how they are used. Options, just like insurance, were originally designed to manage price risk, to be used as hedging tools. But options are equally well suited to speculation, because of the potential for gearing that they offer.

If we are using options to speculate, then we need to address two key questions. First, do we perceive the options to be “cheap” (because market volatility is relatively low) or “expensive” (because market volatility is relatively high)? Second, what is our view on the underlying? Are we bullish, bearish or neutral? The answers to these two questions allow us to determine the appropriate option strategy.

If we perceive the options to be relatively cheap, then our life is relatively simple. We may choose to buy calls if we are bullish, puts if we are bearish and both ...