Investment portfolios are usually conformed of different financial instrument classes, including fixed income, stock, investment funds, or even derivatives and options. These more advanced investing assets are highly versatile, giving investors value that other instrument asset classes cannot. If you can follow these essential points, you can learn how to make use of these powerful tools and take your business to the next level in profits and risk management.
- An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a specific price on or before a certain date.
- The value of a derivatives security is going to fluctuate based on the market value of an underlying asset.
- Options are used for leverage, speculation, risk hedging, or to take short positions.
- The value of a derivative contract is going to be higher the further out the expiration date is. Because the chance that the price of the underlying asset has a favorable move for the investor is higher.
What Are Options?
Options belong to the larger group of financial securities known as derivatives.
The value of a derivatives product depending on the price changes of an underlying asset. That is because the contract allows the options trader to fix the price of a given asset during a certain time-lapse. Or vice versa, they allow for a fixed rate to fluctuate freely.
Underlying assets in formal stock-exchange markets usually are commodities (gold, corn, oil, coal), currencies, stock shares, or even interest rates. But since these products are also traded in free-markets, the underlying asset can be anything with value.
Examples of derivatives are futures, forwards, swaps, structured notes, or options.
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Options are contracts that give the purchaser, for a price, the right, but not the obligation, to buy or sell an asset at a fixed rate on or before a future date in exchange for a premium. We’ll get into details later in the article.
An option for buying stock is referred to as a call, and an option for selling stock is known as a put.
The power of the options resides in the fact that they are leveraged by nature. They grant the investor the possibility to take a huge stake in an asset with minimal investment and controlled risk.
Options contracts are usually traded in a stock exchange that is dedicated to derivatives products. These contracts typically represent 100 shares of the underlying asset. The options can also be purchased outside the formal markets in what’s known in the financial world as an over-the-counter (OTC) market. These contracts traded directly between the interested parties and the conditions of the contract adapted to their needs. These informal contracts are known as warrants.
Because of the complex nature of these instruments, brokerage firms often require you to invest in other products first and to sign an agreement disclaiming that you understand the risks and how these instruments work.
Call vs. Put Options
There are only two types of option contracts calls and puts.
A call option gives the buyer of the contract the choice to purchase a particular asset at a fixed rate known as the strike price at a specific date in the future or at any moment during the defined period.
A put gives the buyer of the contract the choice to sell a specific asset at a fixed price at a particular date in the future or at any moment during a defined period.
As you can see, both of these products are similar. The difference is that the call gives the owner of the contract the right to buy a specific asset and the put the right to sell the asset. The price that the buyer of the contract pays to the seller is called the premium.
The market price of the underlying asset is known as the stock price, which is always changing in value.
The profits/losses that these instruments can generate can be analyzed from two different perspectives The buyer of the contract perspective and the seller of the contract perspective. The buyer’s position is known in the financial world as a long position, and the seller’s perspective is known as a short position.
People who buy options are called holders, and those who sell options are called writers. These are the essential distinctions between holders and writers:
- The holder of the option has the choice to buy or sell the asset if the agreement is beneficial to them. The writer will be obliged to obey the holder’s decision.
- The holder faces the risk of losing only the money they invested, while the writer can face technically unlimited loss.
Taking these concepts into account, these are the four things that you can do with options:
Now that we have the basics, let’s get to how the options actually work.
Call Option Example
A call option gives the holder the right, but not the obligation to buy an asset at a specific price at a defined time in the future.
The most common use of the long call strategies is for speculation. This strategy is applied for bullish markets when an investor thinks that the market price of a stock is going to rise.
Purchasing a call is a safer alternative to buying the stock and waiting for the price to rise. Here, if the investor is wrong, and the share price falls instead, the investor would only lose the premium.
An investor wants to invest in a new technology company. The investor thinks that the company is going to be the next social media hit, and the shares price will increase sharply over the next year.
The investor can buy a call option for that company to take advantage of the leveraged nature of the options. Here the investor can make a small investment and use the rest of their capital on other enterprises.
Instead of buying the stock which currently has a price of $25, The investor approaches a derivatives stock exchange to get a 30-strike price call for a fixed rate of $4 per contract, extending one year out. He decides to buy 5 contracts that control 500 shares of the company.
Summarizing our investment data looks like this.
- Strike price: $30
- Current underlying stock price: $25
- Time frame: One year
- Premium per contract: $4
- Number of contracts: 5 (500 shares)
- Total investment: $4 x 500 = $2000
This is how our investment profile looks for each contract:
As you can observe, the investor starts with a debit that represents the price that he had to pay to enter the trade.
One year later, he can face three different scenarios:
- He is wrong about his prediction, and the stock price fails to reach the strike price
- He partially hits his forecast, and the stock rate goes a little over the strike price
- He was right, and the stock price has a huge appreciation
Let’s start by analyzing the first scenario.
In this case, the contract would fall in the “out of the money” range. But because the investor is the holder, he wouldn’t have an obligation to continue with the trade. Exercising the call wouldn’t make sense since he would be buying the stock above the current market value.
So here, the investor would end up losing the $2000 premium they paid.
The trader that wrote (sold) the call would win the trade. The perspective of the call option writer would look like such:
The objective of the option writer is to set a premium advantageous enough that would be very unlikely for the contract holder to profit from the deal.
Let’s look at the second scenario, the stock goes a little over the strike price.
If our investor was right in their prediction and the shares of the company increases, but only to $34.
If the share price at expiration date surpasses the strike price, the investor will find himself “in the money.” As a call holder, the investor would exercise his right to buy the shares at the strike price, and the seller of the call would be obliged to fulfill the contract.
The investor would be able to purchase the stocks cheaper than market price for a total of:
$30 x 500 = $15,000.00
The cost of buying the same amount of shares at market price would be:
$34 x 500 = $17,000.00
So, in this case, the investor would buy the stock at the strike price and sell it immediately at market value for a profit. But considering the price paid for the contracts to begin with was $4 times 500 shares, they paid $2000 for the contacts. They would have to make that up in the stock price.
$17,000 – $15,000 – $2000 = $0
So here the investor made $4 per contract from exercising the call option and selling the stock, but because they paid$4 per contract, they ended up breaking even on this investment.
Now, if the stock price only goes far over the strike and finishes at a price of $45.
As the stock price lands over the strike, the investor would find himself again in the money range. He would exercise his right to buy the shares cheaper than market value.
Stock purchase without the contract:
$45 x 5000 = $22,500.00
Stock purchase with the call:
$30 x 5000 = $15,000.00
Considering the premium:
$22,500 – $15,000 – $2,000 = $5,500.00
As you can observe in this case, the investment would have been extremely profitable, generating a profit of $5500 on only a $2000 investment, or a 275% return.
Put Option Example
In the case that an investor thinks that the stock price of a company is going to have a dramatic drop, purchasing put contracts will be a safer alternative to short-selling.
The current price for a share of a company is $97. An investor expects a bearish trend for the stock price of the company, so he decides to buy a put option contract.
The investor purchases a put option with the following specifications.
- Strike Price: $ 90
- Current underlying stock price: $97
- Time frame: 6-months
- Premium per contract: $5
- Number of contracts: 10 (1000 shares)
- Total Investment: $5 x 1000 = $5,000
This is how the profile of the investment would look.
This profile is similar to buying a call. However, in this case, the contract holder will benefit as the price of the stock falls. If the stock doesn’t follow the predicted path, the investor would only lose the premium they paid. That is why puts are a safer alternative than short-selling. For options traders who wish to sell a stock short, losses are technically unlimited.
For the investment to pay off, the share price would have to fall enough to offset the premium paid at the start of the investment. In this specific case, the breakeven point would be at $85 because the investor doesn’t start making any profits until the stock falls below $90. In addition, they would have to make up the $5 premium they paid when they entered the trade.
As long as the asset price stays above the strike price by the expiration date, the contracts will expire worthless for our investor.
If the stock price lands precisely at the same rate as the breakeven point, the holder will exercise the contract, and neither the writer nor the holder would generate a profit.
For every dollar the stock dropped below the breakeven point, in our example $85, the investor will profit $1 times the number of control shares. So if the investor owned 10 contracts, which controls 1000 shares, and the price dropped to $75, the investor would have a profit of ($85 – $75) * 1000 = $10,000.
The perspective of the put option writer is contrary to our investor, which would look like this:
Why Use Options
Risk hedging is the most common use that’s given to the calls and puts and the main reason for their creation. The long call and long put positions are meant to work similarly to an insurance policy, giving you the chance to ensure your investment against a possible downturn. As seen in the examples above, an investor that’s able to make proper use of options can achieve a great balance between risks and profitability.
An investor can also speculate with options in a similar fashion to traditional stock, trying to predict where the price of an asset is going to land. A long position option can be attractive for speculators as it can allow them to make huge profits with minor investment and controlled risk.
If the decision were already made to invest in a particular asset, it would be a great choice to spend on an option. That will give the investor the chance to make a smaller investment and use the rest of the capital in other instruments like bonds, instead of having all the money compromised into a single investment.
Take Short Positions
Short positions are the preferred strategy of sophisticated traders and may not be suitable for all investors. Even though the option writer is technically exposed to unlimited loss, the premiums are calculated in a way that most of the time, the contracts they sell will be profitable for them.
How Options Work
The potential that the option holder has to profit from the contract is what gives options their value. The higher the probability that the contract has a predictable trend, the more expensive that option is going to be. For instance, if the value of a stock goes up, the price of a call with that underlying asset would escalate accordingly.
The farther the expiration date of the contract is, the more valuable and expensive the option will be. As the contracts moves closer to expiry, the option would lose value consequently. That is because the speculatory value of the option diminishes as the trend of the asset becomes more predictable, and the less time there is for that stock to have a favorable move. With two options with the same conditions but with different expiration dates, the option with the bigger time-lapse is always going to be more valuable.
The option value is also affected by the implied volatility of the underlying asset. That for the same reason as the time factor. The higher the volatility rate of the asset is, the more likely the asset is to have significant price changes, thus being more unpredictable.
Options premiums have two components intrinsic and extrinsic value. Intrinsic value for in-the-money options is the difference between the asset price and the strike. Out of the money options have zero intrinsic value. The extrinsic value represents the potential that the agreement has to be profitable for the holder. The more volatile the stock has, and the higher the time-lapse of the contract, the higher the extrinsic value of the contract is going to be.
Options as any other securities involve risk, but the characteristics and risks can be evaluated and understood using predetermined models.
These measurements are known as the Greek letters:
- Delta: Measures how sensitive the price of the option is to the price changes of the underlying asset.
- Gamma: Measures how sensitive the delta is, to the price changes of the underlying asset.
- Theta: Measures how sensitive the price of the option is to time.
- Vega: Measures how sensitive the price of the option is, to the volatility of the underlying asset.
- Rho: Measures how sensitive the price of the option is to the interest rate.
In conclusion, options trading may seem overwhelming at first. If you are willing to put the work into learning how to make proper use of these powerful tools, they can bring an appropriate balance of risk and rewards to your business that otherwise would not be possible. For investors who take the time to learn how to trade options properly, the gains that they achieve in the market far exceed other investment assets. Here investors can achieve trades that have a huge probability of success, while at the same time, defining an acceptable level of risk. Click here to apply expert research to your own portfolio.