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Precious metals investment terms A to Z

Options

"If something rallies, options rally many times more but the price for this leverage is that you have to be right on time."

Eric asks:

Eric, Jill and John are in a car going outside the city for a weekend trip. They’re in the middle of a fierce storm. Jill’s driving while the rain batters hard against the windscreen.

Prof. Jill, the Investor

Prof. Jill, the Investor

Some weekend trip, eh?
Eric, the Beginner

Eric, the Beginner

Maybe it’ll clear up later on?
Prof. Jill, the Investor

Prof. Jill, the Investor

Maybe… I don’t get it. All the forecasts said it would be a sunny pleasant day…
Read the whole discussion

An option is a derivative financial instrument, a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset plus a premium based on the time remaining to the option’s expiration

An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price. Most options have an  expiration date. If the option is not exercised by the expiration date, it becomes void and worthless. When that happens the originator of the option collects a payment, the premium, from the buyer. The writer of an option must deliver the asset at the agreed upon price if the option is exercised.

Definition
An Option is a derivative instrument that enables speculation or hedging. In this sense options are similar to futures, however, there is one extremely important difference. With a futures contract, the two parties are obliged to complete the deal. In the case of an option, it is only the selling party that is obliged to complete the deal – the buying party may or may not choose to exercise the option in the future.

This means that if the price of the asset connected with the option (the underlying asset) changes in favor of the option, the seller will have to carry out the deal. On the other hand, if the price of the underlying asset changes in favor of the seller, the buyer will not need to carry out the deal. In this case buyer loses the price of the option that he paid when he bought the option and the seller gains it. (This price is called “the premium.”)

Options enable leverage in a similar way that futures do, however, you have to remember the basic difference between options and futures that we just mentioned. In case of the options the deal is not obligatory for the buyer. Another difference is that the options are usually a lot more expensive than futures as the selling party takes on much more risk than the buying party (Hi sir, we would like to offer you an option but you will need to pay for it and pay through the nose, because this premium is the only profit that we can possibly get from this deal). This fact can limit the use of options as a leverage tool.

Because of its features an option might be perceived as an insurance policy against disadvantageous changes in the price of a given asset. A precious metals investor may buy insurance against the rise or fall of the price of gold in exchange for a fixed amount of money (the premium). For this reason options can be used for hedging your positions in case you are not able to dispose of assets or buy them easily.

We have highlighted the practical applications of options and now it is important options in greater depth. An option contract is an agreement between two parties to do a deal, for example to exchange currencies, or exchange metals for money etc. The asset which is exchanged for money is called the underlying asset. This exchange is obligatory for the party that sells the option (this party cannot pull out of the deal unless the buying party decides not to exercise the option).

The difference between a usual deal and an option is that in the option the parties agree on the price now with the currencies, stocks or commodities etc. to be delivered in a specified future time. This implies that the market prices are subject to change in the time span between the agreement and the agreed upon delivery date.

There are four types of options:

  • Long call – this is a situation in which one buys an option giving them the right to buy an asset in the future for a price fixed today (this is a right, not an obligation). The buyer is betting on a rise of the price of the underlying asset.
  • Long put – a situation in which one buys an option giving them the right to sell an asset in the future for a price fixed today (once again, this is a right, not an obligation). The buyer is betting and hoping that the price of the underlying asset will decline.
  • Short call – one sells an option giving another party the right to buy an asset in the future for the price fixed today (the seller is obliged to complete the deal if the buyer decides to use their right). The seller may profit from a decline of the price of the underlying asset (they get to keep the premium that was paid by the other party).
  • Short put – one sells an option giving another party the right to sell an asset in the future for the price fixed today (the seller is obliged to complete the deal if the buyer decides to use their right). The buyer may profit from a rise of the price of the underlying asset (they cash in the premium).

Options give the opportunity to speculate or to hedge. For instance, if you believe that the price of gold will rocket, you can buy a call option for gold. You are purcht that you will only asing the right to buy gold in the future for a price close to the current price. (You are, of course, hoping that the price will go up) If gold actually performs well, than you pay the agreed price on the delivery date and in exchange receive gold, which is now worth more than you paid for it – this is speculation. What is more, if gold does not perform well, the only thing the buyer risks is the price of the option (the premium).

On the other hand, if you believe that gold will correct sharply, you can buy a put option for gold – the right to sell gold in the future for a price close to the current price. If the price of gold does fall, then you deliver gold on the delivery date for the agreed price, which is higher than the actual price (and the seller cannot deny you the right to do so – the trade is obligatory for the seller). Once again, if the price of gold goes in the opposite direction (rises), the only thing at risk is the price of the option.

It is possible to speculate thanks to options and the risk of such an action is limited, especially when compared to the risk of using futures. The price of an option tends to be considerably higher than the price of futures.

The possibility to use options in the precious metals market and the importance of the prices of options are the reasons why Sunshine Profits has looked into the matter of options. One of the results of this ongoing research is the practical application of the Black-Scholes option pricing model. The use of this tool enables you to calculate the predicted value of options for different assets in a simple and swift way. To find out more, visit our Tools section and try our Option CalculatorPyramid Optimizer and Position Size Calculator.

Options as Long-term Investments
We don't view options as a good way to invest one's long-term capital. There are two main reasons for that:

  • Risk of changing rules for the derivatives market. While there is no requirement to maintain a certain deposit like it would be the case with futures, option holders could still be affected by unfavorable regulatory changes.
  • Counterparty risk. This type of risk is minimized on the regulated options market because of the marking-to-market mechanism, however it still exists. In case of a financial meltdown of sorts we would likely see much higher gold and silver prices. However, if the derivatives exchange that you're currently dealing with collapsed as well, then you might have trouble realizing your profits from your precious metals investments.

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