Among the different derivative financial instruments we find Financial Options. Options are contracts that are traded between buyers and sellers. They give their holders the possibility (but not the obligation) to buy or sell securities at a fixed price in the future. Being able to exercise this contract and right is not free, since if it were, there would only be the possibility of winning or not losing. In order to buy this contract, you have to pay what is called a "premium" to the seller. On the contrary, if you are a seller, you become a recipient of this premium.
Since Financial Options require a greater knowledge of economics and finance, they are not an easy product to understand. For this, this article is destined to explain the mechanism of how they work and what it means to be a buyer or seller of a Call or Put. Also the different risks involved and what benefits this method brings to invest. I hope you find it useful!
What is a Financial Option?
A financial option is a contract that is established between two parties (buyer and seller) that give the buyer of the contract / option the right, but not the obligation, to buy (if he took a Call) or sell (if he took a Put) at a predetermined future price of an asset. On the other hand, the seller of a contract / option has an obligation to sell or buy at the price that had been agreed whenever the buyer wishes.
They are widely used as hedging strategies, since they act as a kind of "insurance". If investors believe that there may be sudden movements in the market, the possibility of buying a financial option is there. Also as an opportunity to profit from sudden movements since losses are limited and profits are unlimited (I will talk about this later).
To exercise this right, the buyer always pays the seller a premium. The seller of a financial option always receives the premium that the buyer has paid. From here, and in other words, the contract has been established. What does this contract imply for each party? To do this, let's see what two types of financial options there are, the Call and the Put, and what it means to be a buyer or seller in each case.
What is a Call option?
A Call can also be called Purchase option. It is a contract that allows you to buy an asset in the future at a price already set. These financial options can have as underlying stocks, indices, commodities, fixed income ... There is a great variety. The similarities and differences between the Call and Put options lie in the fact that the Calls come to be purchase rights and the Put rights of sale. There is no obligation to buy at maturity (except for the seller). But to better understand the mechanism, let's see what it means to operate with them.
Buy a Call
In a Call option the buyer can select the price at which he would like to buy in the future. Obviously, we would all like to pay the less the better. For that, there is a premium (the price that the contract is worth). If the price at which you want to buy is below the current listing price, the premium will be expensive. And the lower the price, the more expensive the premium (usually proportional). Therefore, prices are usually set (and it is the most normal thing) that are very close to or above the listed price. The further away you are, the more difficult it will be for the quote to arrive, and consequently, the cheaper the premium will be.
- A first example in case of losing. Let's imagine that we want to buy an option on company X that is trading at $ 20. We want to buy a Call option expiring in one month and we decide to select $ 50 and pay a premium of $ 21. After this month the stock has gone down a lot and is at $ 1. In this case we decided not to buy at $ 15 (because we are not stupid either). The losses? The premium we pay, 1 $. (Contracts are usually 100 shares, so the premium is $ 1 for each share in the contract. If there are 100, the loss would be $ 100)
- A second example in case of winning. We have bought our Call at $ 1 on company X. As before, it is listed at $ 20 and we have bought it with the right to buy them if we want at $ 50 (the same goes). We see that the company continues to rise in price, finally at maturity it is at $ 21. What do we do? The right to buy for $ 24 is exercised and since the market is at $ 20, we earn $ 21 for each share purchased. Of course, that is not the final profit, the premium that was paid was $ 24, so you would really earn $ 20 per share. In this case earnings can be unlimited.
Sell a Call
Being a seller of a Call as well as a Put implies a much higher risk. Here losses are not limited, but can be unlimited. Contrary to the buyer, the profit is limited, because what is earned is the premium.
Being a seller implies being the recipient of a premium, and you have the obligation to sell whenever the buyer wants it or it suits him. If a Call is sold, the ideal case would be for the asset's price to be equal to or less than the price for which the Put was sold (and keep the full premium). The worst case scenario would be for the asset to go up a lot, so the more it went up, the more the buyer would have to be paid.
What is a put option?
A Put can also be called sale option. It is a contract that allows you to sell an asset in the future at a price already set. These assets can be like Calls, that is, stocks, commodities, indices ... There is the same variety.
Unlike Calls, Put option contracts indicate the price at which the asset can be sold in the future. In this case, the premium to be paid, the higher it will be as we opt for a higher future price. On the contrary, the premium will decrease as the price indicated in the Put is lower. Finally, in reverse of the Call options, you have the right to sell (but not the obligation) if you are a buyer. If you are a seller of a Put contract, there is an obligation. To understand it better, let's see the difference between being a buyer or selling a financial Put option.
Buy a Put
Let's imagine that we are faced with the situation in which we consider that the market can go down a lot. We decided to buy a put option on the Ibex-35. The Ibex is at 8150 points, and today, which is Monday, we decided to buy a Put option with expiration at the end of the week with the right to sell at 8100 paying a premium of € 60.
Can occur two scenarios, that at expiration the price is above 8100 or below.
- If the price is above 8100. We do not exercise the right of sale, since on top of that we should sell cheaper than the market is at that time. We lose the premium, the € 60 and that's it. That It is the maximum loss in which we expose ourselves.
- If the price is below 8100. In that case, we choose to exercise the right to sell at 8100. The profit is the difference between the 8100 and the price at which the Ibex is. If the price is 7850 € 250 is earned. Clean is € 190, since the premium cost € 60. Being a buyer of a Put leads to earnings can be as unlimited as the price drops of the underlying asset.
Sell a Put
Being the seller of a put option implies earning the premium up front. Being a seller, you have the obligation to sell at the agreed price if the buyer so wishes at maturity.
If the price of the asset has risen more than the one that appears in the contract, there is no problem, no one wants to exercise the right to sell cheaper when the asset is more expensive. However, if the price of the asset has fallen a lot, the buyer may exercise the right to sell more expensively. You just have to remember the previous case. If a Put of the Ibex-35 had been sold at 8100 and closed the week at 7850, € 250 would have to be paid. The danger here is that the Ibex (or whatever it is) can fall much more, so the loss for a Put seller (as for a Call seller) is unlimited.
What if you want to sell the financial options before expiration?
If you want to sell before expiration, the premium you are currently trading for will be earned the financial option contract that we had purchased. If it is sold for a higher price (premium), it will be won, and if it is lower, it will be lost.
The premiums will have fluctuations until the expiration of the contract, will depend on two factors:
- As maturity approaches, premiums will go down in value. This is due to the fact that the asset is less likely to suffer sudden fluctuations in its price. A maturity of 2 days is not the same as that of several months.
- As the price moves both higher and lower, the premiums will go up or down in value. This will depend on whether it is a Call or a Put option. In the case of Calls, as the price of the asset rises, so will the premium. In the case of Put, as the price of the asset falls, the premium will rise. And vice versa for both, the premiums will go down for Calls as the price of the asset goes down, or in the case of Put's the premium will go down as the price of the asset goes up.
Not all brokers or entities allow you to operate with financial options in the same way always. It all depends on the counterparties they have, the way they operate and the assets that the options represent. Similarly, each asset is represented in a contract differently. Not all the points of the quotes have the same value, some the point is worth a lot and others very little. Make sure you know well the amount and conditions for which you are investing!