In our previous module, we stated that Options are basically Insurance Policies, which under certain conditions, result in the different participants receiving certain positions in the underlying markets. Remember that if the Option remains worthless until the expiry date, it just ceases to exist and that’s simply the end of it but if the price of the underlying was able to overcome the strike price of the option, then the different participants in that option each received a position in the underlying market – the one party went long and the other party went short the underlying market.

These “insurance policies” themselves are tradable and although the initial purpose was for the Insurer to be able to insure his client – when speculators were introduced to the markets – they started buying and selling the policies themselves. Thus the Insurer sold the risk he took off to the speculators, who in turn sold that risk off to other speculators – in the same way that the insured parties were willing to sell their insurance policies off to speculators to gain back some of the premium that they paid, etc.

Remember that the commodity markets once consisted of producers and consumers of commodities only. The Exchange was then created and speculators were allowed to enter into the markets. Speculators brought huge volume, which brought with it price liquidity, which was good for both producers and consumers.

The same applies to Options. Previously the insured party was at the mercy of the insurer who charged whatever premium he wanted for price insurance, but the introduction of speculators brought volume and price liquidity. No longer is the insured at the mercy of the insurer, for if the price of insurance is too high, then there would always be another speculator willing to sell insurance to the insured at a lower premium. A new market was born.

So today – trading options (the insurance business) is a well-regulated market with huge volume and liquidity in trading insurance policies. The price of the option is, of course, the premium you pay for the policy and that premium fluctuates daily. Later on, in this course, we will cover the importance of understanding the factors that drive option premium which will, in turn, allow you to understand what drives option prices. This will then allow you to trade in the options market and to become a speculator in options.

But first – let’s talk about risk and the fact that people say that options are extremely risky instruments to trade. What are insurance policies again?  Insurance policies are instruments used by traders to reduce the risk they are facing in the open markets. When you are exposed to price risk in the commodity markets and you feel that that risk is too high, how do you then protect yourself against that risk? By taking out price insurance.

Now, how can trading in the instrument that was designed to reduce risk in the market, be riskier than trading in the underlying market itself? This does not make any sense!? If this was true, then buying insurance in the market will not reduce the risk you face but drastically increase the risk you face instead.

If buying insurance resulted in the exact opposite of what it was originally designed for, then no-one would buy insurance. We will return to this point a little bit later and prove mathematically why it does not make sense.

You are allowed to buy and sell options in the same way that you are allowed to buy and sell the underlying market. Since the underlying market may be traded up or down (buy or sell) you get two kinds of options (insurance policies) – Call Options that give you protection against rising prices, and Put Options that give you protection against falling prices. We can trade both kinds of options and we can also be buyers or sellers of these options.

However, this is very important: You can simultaneously be trading in the options AS WELL AS the underlying market. Remember that the option, on expiry, may give you a position in the underlying market but by taking an opposite position in the underlying market BEFORE this happens, you can neutralise the effect of the option, should you be assigned an exercise.

Let’s say that you are short a Call option and that option is moving into the money but you are also aware that when the option is exercised that you will be given a short position in the market at the strike price. Nothing then stops you from buying the underlying market when the price moves through the strike price.

This will result in you being long the market at the strike price and still short the option. When the option then expires and you get exercised, you will receive a short position in the underlying market at the strike price, but since you are already long the market at the strike price, shorting the market at the same price gives you nothing – you bought and sold the market at the same price and you will be out of the market without any profit or loss. However, you still received, and was able to keep the premium for when you shorted the option!!

But, before we get ahead of ourselves we need to look at the next lessons to illustrate what we mean better.