On this website we are always talking about binary options, but but what actually are options? 'Ordinary' (stock) options have been around much longer than binary options. They come from the world equity investing and are traded on the stock market. Options are so-called 'derived' financial products. That is, their value is derived from another product (for example, a stock). In this article we explain how options work and what different types of options there are.

Options come from the world of equities, and are so-called 'derivative' financial products. That is, their value is derived from another product (the 'underlying sset'), normally a stock. The reason for this is that an option gives the holder the right to buy (or sell) a share of a stock at a certain price (the 'strike price') on a certain date (the 'expiration date'). The value of this right depends on the value of the share on the expiration date.

For example, suppose you have a call option on a share of Tesco PLC. This option gives you the right to buy a Tesco share on March 31, for 280 pounds. What is this option worth?

This question is easy to answer on 31 March. If the share price of Tesco is lower than 280 pounds, the value of the option is 0. After all, if you want to buy a Tesco share, you're better off buying it directly on the stock exchange (for less than 280 pounds) than using your 'right' to buy the stock for 280 pounds. If, on the other hand, if the rate is higher than 280 pounds, then the value of the option is the rate minus 280. Basically, you can use your right to buy the share for 280 pounds, and then sell it immediately on the stock market, where you profit by the difference between the sales price and the 280 pounds you have paid for it.

As long as it is not yet 31 March, it is more difficult to determine the value of an option. There is still a lot of uncertainty about what the price of Tesco is going to do in the meantime. A lot of financial theory has been devoted to the question of how much an option is worth. The most commonly used method is the so-called 'Black-Scholes formula', but it is too complex a topic to discuss here right now. (For a good explanation see Wikipedia).

Why buy options

Why would anyone want to buy an option, and not just the underlying asset itself? The main reason is that options are cheaper, which gives an investor with less money the chance to speculate on changes in the share price.

For example, if the price of British Petroleum's stock is $50 a share (on the New York Stock Exchange, NYSE), the cost of a call option with a strike price USD 50 and an expiration date one month from now is approximately $1.50 (fictional values).

If you expect that BP's shares will rise to $52 by the end of the month, and you have $150 to invest (about 90 pounds), you can do two things:

1. Buy 3 shares BP on the NYSE. If at the end of the month BP is indeed worth $52, then he would earn six dollars (3x52 - 3x50).
2. Buy a call option on 100 shares. At the end of the month you would have earned $50 on your investment (100x(52-50) - 100x1.50)

The option trader earns a lot more than the stock trader with the same investment capital. At the same time, it is important to realise that his risk is also greater. If he is wrong and the share drops to 48 pounds, then the stock trader loses only $6, whereas the call options become completely worthless. Options are a risky investment, with great upside potential and great downwards risk.

Different types of options

There are different types of options. Firstly, there is the difference between a call option and a put option. A call option gives its holder the right to buy a share at a certain price (the 'strike price'). The investor who buys a call option, speculates on a rise in value of the underlying asset. A put option gives the investor the right to sell a share at the strike price. Anyone who buys a put option, expects the share price to decline.

Secondly, there is the difference between option buying and an option writing. The buying of an option gives you the right to buy share (or sell in the case of a put) at the expiration date. You pay the price (or the 'premium') of the option. Traders who write options take up the obligation to deliver the share at the strike price at the expiration date (or to take over the share in case of a put). They are in fact on the other side of the trade than the buyer, and they receive the premium. Writing call options is very risky, because your possible profit is certain, but your potential loss is unlimited.

Thirdly, there are option contracts available with different strike prices and expiration times. The shortest contracts typically expire within the current month, while the longest contracts may be up to two or three years in the future. Available strike prices for short-term options are typically close to the present day price of the underlying asset. For the long run there are options with a strike price far removed from the current rate, making it possible to speculate on the small chance that a share would experience a large price increase or decrease.

Fourthly, there are options available on different underlying assets. The best known are options on shares. But there are also options contracts available on indices, such as the FTSE100. And there are options on foreign currencies, on gold, silver and commodities. In theory, there could be an option on any underlying asset with uncertain future value. But in practice there are only a few common option contracts.

Binary options

Besides regular options there is a different financial product called binary options (the topic of this website). Binary options are a type of option with only two possible outcomes at expiration: the option either yields a (predetermined) high return or becomes worthless. Binary options are therefore also called 'all or nothing' options. To learn more about binary options, you can read the articles 'What are binary options' and 'The difference between binary options and stock options'.

Just like ordinary stock options, binary options are sold on various underlying assets. Usually, the time to maturity of a binary option is much shorter. Because of the differences between stock options and binary options, you need different strategies to make a profit. It is especially important to learn to predict whether an underlying asset is going to rise or fall by a small amount in the short term. Read more on how you can learn to trade binary options successfully.