What are financial options?
Financial options, like futures and CFDs, are a derivative product. Therefore, it is a contract signed by two parties, buyer and seller.
In the case of options, this contract gives the buyer the right (not the obligation, as in futures) to buy or sell a certain amount of underlying asset (shares, commodities, …), at a certain price called strike, in a stipulated period or expiration.
As we can see from the definition, it is very similar to a future with the great difference that, in futures, both members of the operation (buyer and seller) were committed to execute the operation. In other words, they were mutually obliging. However, in options, only the seller has the obligation, in exchange for which he charges a small amount called a premium.
Ultimately, the buyer of an option has the right, but not the obligation, to buy or sell (depending on the type of option) on the expiration date. Conversely, the seller of the option is obligated to buy or sell if the buyer chooses to exercise his right.
Parameters of an option
- Name of the underlying or Ticker
Like any derivative product, the transactions are made on another underlying product that we have to specify. There are options on stocks, bonds, indices, currencies, commodities. In the stock market, all assets are identified through an abbreviation of their name.
- Expiry date
Maturity is the cut-off date for our operation. At maturity, the buyer must choose whether or not to exercise the right to buy or sell. Normally the expiration date is the third Friday of each month.
- Strike price
The stipulated price at which the buyer of the option has the right (but not the obligation) to buy or sell the underlying on the expiration date.
- Option type (Call/Put)
There are two main types of options that we’ll look at in more detail below. The options of purchase or CALL and the options of sale or PUT.
The premium is the price of the option, it is what the buyer of the option pays for having the right to exercise it at maturity. At the same time, it is the amount charged by the seller of the option in exchange for assuming that obligation.
The buyer of options, as he only pays the premium for having the right to decide, has his losses limited to the premium paid. On the other hand, the seller, who collects the premium in exchange for forcing himself to execute the transaction, has unlimited losses. Or rather, uncontrolled. It would be impossible for the price of the underlying to go to infinity on the expiration date, both above and below.
Types of financial options according to the right they grant
Throughout this post you have already read to me some times that the comprador has the right to BUY or SELL. Indeed, just as in futures, in options you can also “wager” downwards. That is to say, to sell or to become short.
That is why there are two types of options:
- Purchase Options (CALL)
It is the option that gives the buyer the right to BUY the underlying at the strike price on the expiration date.
- Put Options (PUT)
It is the option that gives the buyer the right to SELL the underlying at the strike price on the expiration date.
Types of options depending on the exercise period
- European Options: Can only be exercised on the maturity date. Before that date, they can be bought or sold if there is a market where they are traded.
- American options: can be exercised at any time between the day of purchase and the day of expiration, both inclusive, and regardless of the market in which they are traded.
Types of options according to their generic category
- In the money (ITM): We will say that a Call option is in the currency or In the money, when the market value of the underlying asset is higher than the strike price. In the case of a Put option, the market value of the underlying must be below the strike price.
- Currency options – At the money (ATM): We will say that a Call or put option is in the currency or at the money, when the strike price equals the price of the underlying asset.
- Out of the money (OTM): We will say that a Call or Put option is out of the money when it is not exercisable. In other words, the price of the underlying is lower than the strike price of a Call option and higher than the strike price of a Put option.
Basic Positions with Financial Options
When can an investor be interested in buying a CALL?
- When you anticipate that the underlying will have an uptrend.
- When the underlying has had a strong uptrend, the investor has not bought and believes it can continue to rise. It allows the investor to take advantage of rises if the underlying continues to rise and limit losses if it falls.
- When you want to buy the underlying in the near future because you think it will go up but today you do NOT have the necessary funds. The call option allows you to secure the right to buy the underlying in the future in exchange for a premium, not the full value of the underlying.
Purchase of PUT
Now let’s deal with the options of sale or PUT. That is, those that resemble getting short.In this case, the buyer acquires the right to sell an underlying at a certain price at maturity. And that’s why he pays a premium.
When can an investor be interested in buying a PUT?
- When you are convinced that the price of the underlying is going to fall and you want to take advantage of that fall to make a profit.
- When the underlying is in the portfolio and a bearish period is expected. The profits obtained with the purchase of the PUT compensate the losses generated in the underlying of our portfolio.
Uses of the options
As we have said at the beginning of the post an option is a financial derivative, and with any financial derivative three types of operations can be carried out: