Equity Option

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Equity options definition

Equity options are a form of derivative used exclusively to trade shares as the underlying asset.

In essence, equity options work in an extremely similar way to other options*, such as forex or commodities. They offer the trader the right, but not the obligation, to purchase (or sell) a set amount of shares at a certain level (referred to as the ‘strike price’) before it expires. To buy an option, traders will pay a premium.

Equity option example

Let’s say that Alphabet shares are trading at $730. You buy an option to purchase shares of Alphabet before the end of the week at $800, and pay a premium of $25 to do so. If Alphabet’s share value exceeds $825, then the trade is in profit, and you are free to execute the trade.

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Equity options are just one of many derivatives that traders can use to trade shares. Find out more in our shares trading section.

*Options are only available via spread betting accounts and professional CFD accounts.

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The risks of loss from investing in CFDs can be substantial and the value of your investments may fluctuate. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how this product works, and whether you can afford to take the high risk of losing your money.

CFD Accounts provided by IG International Limited. IG International Limited is licensed to conduct investment business and digital asset business by the Bermuda Monetary Authority and is registered in Bermuda under No. 54814.

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The information on this site is not directed at residents of the United States and is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

IG International Limited is part of the IG Group and its ultimate parent company is IG Group Holdings Plc. IG International Limited receives services from other members of the IG Group including IG Markets Limited.

The Intercontinental Exchange

Equity options, which are the most common type of equity derivative, give an investor the right but not the obligation to buy a call or sell a put at a set strike price prior to the contract’s expiry date. Brokers and traders can access options listed on NYSE American and NYSE Arca through a single technology platform that offers a dual options market structure. By combining both markets, investors benefit from NYSE American’s pro-rata, customer priority model that encourages deep liquidity and NYSE Arca’s price-time priority model that provides enhanced throughput and encourages market makers to offer the best possible price.

Additional Option Types

Index Options

Index options make it possible for investors to seek either profit or protection from price movements in a market as a whole or in broad segments of a particular market.

Learn More About Index Options

ETP Options

Options on ETFs allow investors to gain exposure to the performance of an index, hedge against a decline in assets, enhance portfolio returns, and/or profit from the rise or fall of a leveraged ETF.

Learn More About ETP Options

FLEX and LEAPS

FLEX and LEAPS options offer investors increased flexibility in terms of contract customization (such as expiration date, exercise style, and exercise price) and time frame (with expirations of up to three years out).

Equity Derivative

What is an Equity Derivative

An equity derivative is a financial instrument whose value is based on equity movements of the underlying asset. For example, a stock option is an equity derivative, because its value is based on the price movements of the underlying stock. Investors can use equity derivatives to hedge the risk associated with taking long or short positions in stocks, or they can use them to speculate on the price movements of the underlying asset.

Basics of Equity Derivative

Equity derivatives can act like an insurance policy. The investor receives a potential payout by paying the cost of the derivative contract, which is referred to as a premium in the options market. An investor that purchases a stock, can protect against a loss in share value by purchasing a put option. On the other hand, an investor that has shorted shares can hedge against an upward move in the share price by purchasing a call option.

Equity derivatives can also be used for speculation purposes. For example, a trader can buy equity options, instead of actual stock, to generate profits from the underlying asset’s price movements. There are two benefits to such a strategy. First, traders can cut down on costs by purchasing options (which are cheaper) rather than the actual stock. Second, traders can also hedge risks by placing put and call options on the stock’s price.

Other equity derivatives include stock index futures, equity index swaps, and convertible bonds.

Using Equity Options

Equity options are derived from a single equity security. Investors and traders can use equity options to take a long or short position in a stock without actually buying or shorting the stock. This is advantageous because taking a position with options allows the investor/trader more leverage in that the amount of capital needed is much less than a similar outright long or short position on margin. Investors/traders can, therefore, profit more from a price movement in the underlying stock.

For example, buying 100 shares of a $10 stock costs $1,000. Buying a call option with a $10 strike price may only cost $0.50, or $50 since one option controls 100 shares ($0.50 x 100 shares). If the shares move up to $11 the option is worth at least $1, and the options trader doubles their money. The stock trader makes $100 (position is now worth $1,100), which is a 10% gain on the $1,000 they paid. Comparatively, the options trader makes a better percentage return.

If the underlying stock moves in the wrong direction and the options are out of the money at the time of their expiration, they become worthless and the trader loses the premium they paid for the option.

Another popular equity options technique is trading option spreads. Traders take combinations of long and short option positions, with different strike prices and expiration dates, for the purpose of extracting profit from the option premiums with minimal risk.

Equity Index Futures

A futures contract is similar to an option in that its value is derived from an underlying security, or in the case of an index futures contract, a group of securities that make up an index. For example, the S&P 500, the Dow index, and the NASDAQ index all have futures contracts available that are priced based on the value of the indexes. However, the values of the indexes are derived from the aggregate values all the underlying stocks in the index. Therefore, index futures ultimately derive their value from equities, hence their name “equity index futures”. These futures contracts are liquid and versatile financial tools. They can be used for everything from intraday trading to hedging risk for large diversified portfolios.

While futures and options are both derivatives, they function in different ways. Options give the buyer the right, but not the obligation, to buy or sell the underlying at the strike price. Futures are an obligation for both the buyer and seller. Therefore, the risk is not capped in futures like it is when buying an option.

How Options Compare to Equities

Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.

O ptions are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.

Options are derivatives, which means their value is derived from the value of an underlying investment. Most frequently the underlying investment on which an option is based is the equity shares in a publicly listed company. Other underlying investments on which options can be based include stock indexes, Exchange Traded Funds (ETFs), government securities, foreign currencies or commodities like agricultural or industrial products. Stock options contracts are for 100 shares of the underlying stock – an exception would be when there are adjustments for stock splits or mergers.

Options are traded on securities marketplaces among institutional investors, individual investors, and professional traders and trades can be for one contract or for many. Fractional contracts are not traded.

An option contract is defined by the following elements: type (Put or Call), underlying security, unit of trade (number of shares), strike price and expiration date.

Although options share many similarities with regular equities, there are also some important differences. Two main differences of trading options rather than regular equities are that options trading can limit an investor’s risk and leverage investing potential.

Limited Risk for Buyer

Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. This is not true for the seller of an option.

Leverage Investment

An equity option allows investors to fix the price, for a specific period of time, at which they can purchase or sell 100 shares of an equity for a premium (price) – which is only a percentage of what they would pay to own the equity outright. This leverage means that investors may be able to increase their potential reward from a price movement by using options.

Leverage Example:

For an investor to purchase 100 shares of a stock trading at $50 per share would cost $5,000. On the other hand, owning a $5 Call option with a strike price of $50 would give the investor the right to buy 100 shares of the same stock at any time during the life of the option and would cost only $500.

Remember that premiums are quoted on a per share basis; thus a $5 premium represents a premium payment of $5 x 100, or $500, per option contract.

Let’s assume that one month after the option was purchased, the stock price has risen to $55. The gain on the stock investment is $500, or 10%. However, for the same $5 increase in the stock price, the Call option premium might increase to $7, for a return of $200, or 40%. Although the dollar amount gained on the stock investment is greater than the option investment, the percentage return is much greater with options than with stock.

Leverage also has downside implications. If the stock does not rise as anticipated or falls during the life of the option, leverage will magnify the investment’s percentage loss. For instance, if in the above example the stock had instead fallen to $40, the loss on the stock investment would be $1,000 (or 20%). For this $10 decrease in stock price, the Call option premium might decrease to $2 resulting in a loss of $300 (or 60%). Investors should take note, however, that as an option buyer, the most you can lose is the premium amount paid for the option.

Other key differences between options and regular equities are in how the investment is structured:

  • Regular equities can be held indefinitely by a buyer, whereas options have an expiration date. If an out-of-the-money option is not exercised on or before expiration, it no longer exists and expires worthless.
  • There are no physical certificates for stock options as there are for regular equities.
  • Regular equities are issued in a fixed number by the issuing company, while there is no limit to the number of options that can be traded on an underlying equity. The number of options that are traded is based only on how many investors are interested in trading the right to buy or sell that particular equity.
  • Unlike equity ownership, owning an option does not confer voting rights, dividends or ownership of any share of a company unless the option is exercised.

The greatest similarity is the way in which option and stock transactions are handled:

  • Options are listed and traded on national SEC-regulated marketplaces similar to regular equities.
  • Orders for options are transacted through brokers with bids to buy and offers to sell just like equity buy and sell orders.
  • Buyers and sellers of options and equities can track performance and follow transactions through the marketplaces on which they trade.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Equity options

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Equity Option

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