Equity and Index Options Explained

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Option Basics

An option contract is a financial instrument; specifically, a type of derivative. But what is a derivative?

The clue is in the name. A derivative derives from an underlying asset, such as an equity, an interest rate or a commodity. The price of a derivative is derived from the price of the underlying asset.

So a coffee futures contract (a coffee “future”) is a derivative of physical coffee.

A dollar/euro option is a derivative of the spot or cash dollar/euro rate. BP futures or options are derivatives of cash BP shares, as traded on the LSE.

Derivatives, whether options or futures, are contracts. When we trade a future, we are trading a futures contract. When we trade an option, we are trading an options contract. In the context of derivatives markets, the word “future” is an abbreviation of the term “futures contract”. The word “option” is an abbreviation of the term “option contract”.

These contracts are transferable, they are tradable between market participants. We can buy an option from one person and sell it to a different person. Trades are executed via the exchange and the related clearing house, such as LIFFE and LCH Clearnet, respectively. Trading is anonymous. We don't know who we have traded with and nor do we care; it is irrelevant.

When we buy 5 futures and then sell 3 of them, we do not have two positions. We are not long of 5 futures and short of 3 futures. Rather, we have a net position of long 2 futures. There may also be a profit or loss, depending ...