What are Options?
Take an option is to make a choice!
To manage a portfolio is also to make choices, to arbitrate between several possibilities, to take advantage of one alternative over another. Equity and index options will be particularly effective financial tools for implementing management decisions.
Thanks to their flexibility of use, the options are perfectly adapted to the most specific needs of investors, as well as to protect a portfolio from a market downturn as well as to obtain an additional return on an equity investment.
To learn more about these contracts we recommend reading this section, but several resources are also at your disposal.
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Why investors use options?
Trading options, and combining them with a stock portfolio, can allow an investor to boost the performance of his portfolio.
Indeed, the options offer:
A significant leverage effect
The price of an option is always well below the price of the underlying which allows for higher rates of return than if the investor had directly invested in the underlying.
Unique opportunity to cash in additional yield
In fact, the options allow investors to open a short position without needing to be buyers beforehand. The seller of an option collects the premium paid by the buyer at the time of the conclusion of the contract. It is important to note that this is a risky position and is not recommended if investors do not have the underlying securities in the portfolio.
A cover tool
Options can be an effective instrument for protecting an equity portfolio in a bear market environment. For example by buying a put, the investor guarantees a sale price. If the price of the underlying falls, it can sell its securities more expensive than the market price. If his expectations do not come true and the price of the underlying rises, he will not exercise his right of sale, since his securities have appreciated. In this case, the premium paid at the time of the purchase of the put will have functioned as an insurance against a fall in the price of the underlying.
Physical delivery of securities
The options allow you to buy securities or sell securities already in your portfolio.
It is important to note that investments in options carry risks, and it is essential to control their operation before investing.
How do the options work?
An option is a RIGHT (contract) to BUY (or SELL) an ASSETS (share, index, currency, commodity …) at a given PRICE, during a given PERIOD on payment of a PRIME.
The buyer of the option acquires a RIGHT and pays in return a premium to an option seller who will have a BOND.
As an option buyer, you have a right, which you can use for a specified period of time (until maturity or maturity).
As a buyer, you bought this option from a counterparty, the seller.
The seller grants a right to the buyer of the option and agrees to honor his obligation as soon as the buyer makes the request.
Options contracts (optional commitment) must not be confused with futures contracts whose definitive nature constitutes a firm promise.
In effect, the buyer of a futures contract undertakes on the expiry date to buy the underlying asset at the agreed price and will have to execute even if the market conditions have not been favorable to the realization of his expectations.
It is important to note that option contracts, as their names indicate, are optional, that is, until the expiry date (or the expiry date only cases), the buyer of the contract has the option to buy or sell the underlying asset at the agreed price.
If the market conditions are favorable to the realization of the expectations of the buyer, then he will decide to exercise his should to the purchase or sale.
In this case, the seller of the contract will have the obligation to sell or buy the underlying asset, according to the standards of the negotiated contract. The buyer of the option pays a premium to the seller who is definitively acquired to offset the obligation.
There are two types of options: call options and put options.
A call option allows the buyer to purchase a certain amount of underlying asset for a period and at a price agreed upon in advance. When the buyer exercises his call and asserts his right of purchase, the seller of the call is obliged to deliver the underlying assets at the price fixed in advance.
A put option allows the buyer to sell a certain amount of underlying asset for a period and at a price agreed upon in advance. When the buyer exercises his put and asserts his right of sale, the seller of the put is obliged to buy the underlying asset at the price fixed in advance.
An investor who buys a put option (also known as a put option) acquires the right to sell a certain amount of underlying asset for a period and at a price agreed upon in advance. In return for this right he pays a premium (the price of the option) to the seller.
During the life of the option if the market conditions are favorable, the buyer of the put may decide to exercise his put, that is to say to assert his right of sale, and the seller of the put will be thus the obligation to purchase the underlying assets at the price fixed in advance.
Thanks to the puts, the buyer definitively sets the selling price of the underlying asset.
The buyer of the put pays a premium to the seller to remunerate his purchase obligation. It remains definitively acquired to the seller even if the buyer decides not to exercise his option.
The buyer of a put generally anticipates a fall in the underlying. It will exercise its put option if the price of the underlying moves in a direction favorable to its expectations and is below the strike price.
The seller of the put anticipates it stagnation see a slight rise in the price of the underlying. During the life of the option, if the buyer exercises his option, he will be obliged to buy the underlying if the buyer exercises his option, even if the market conditions are not favorable to him.
Suppose you are in possession of 100 X shares worth 11 usd each. You expect a drop in the price of the stock, but you hesitate.
Do you have to keep your shares or sell them?
To dispel this uncertainty, you can buy a put that will give you the right to sell 100 shares of Title X at 11 usd each on a date you have chosen. In the same way as for the purchase of a call, in return for the acquisition of this right of sale, you will have to immediately pay a premium to the seller of the option.
If the price of X falls, you simply exercise your right and sell the shares at the agreed price of 11 usd. In this way, you sell the shares at a better price. So are you protected against a decline.
If on the other hand the price should rise to 12 usd you keep your actions and you do not exercise the option: it is enough in this case to let your right of sale to extinguish itself on the day of the expiry.
An investor who buys a call option (also known as a call option) acquires the right to purchase a certain amount of underlying asset for a period and at a price agreed upon in advance. In return for this right he pays a premium (the price of the option) to the seller.
During the life of the option if the market conditions are favorable, the buyer of the call may decide to exercise his call, that is to say to assert his right to purchase, and the seller of the call will thus be obliged to deliver the underlying assets at the price fixed in advance.
Thanks to the call, the buyer himself determines the purchase price of the underlying asset.
The buyer of the call pays a premium (the price of the option) to the seller to remunerate his obligation to sell. It remains definitively acquired to the seller even if the buyer decides not to exercise his option.
Thus the seller acquires additional income, but will have an obligation to sell the securities at the agreed price, also known as the strike price.
The buyer of a call usually anticipates a rise in the underlying. It will exercise its call option if the price of the underlying moves in a direction favorable to its expectations and exceeds the strike price.
The seller of the call anticipates a stagnation or even a slight decline in the price of the underlying. During the life of the option, if the buyer exercises his option, he will be obliged to sell the underlying if the buyer exercises his option, even if the market conditions are not favorable to him.
Suppose that the X action displays a value of 10 usd.
Convinced of the upside potential of the stock, you want to buy a certain amount. But for now, you are not able to release the funds needed to buy 100 X shares. Do you have to give up the opportunity to benefit from an increase in the price? No.
You just have to buy a call that will give you the right to buy 100 X shares at 10 usd each on a date you have chosen. Remember that in exchange for the acquisition of this right you will have to immediately pay a premium to the seller of the option. Note that the premium is only a fraction of the overall investment.
If the stock price rises to 12 usd you can exercise the option and buy the shares for 10 usd. You thus acquire the shares at a better price.
If on the other hand the price should drop to 8 usd, you will not exercise the option; In this case, you only have to leave your purchase right to extinguish itself on the day of the expiry date.
Why buy options?
You know the financial world well and the actions have no more secrets for you? Are you ready to risk more to earn more? The options might interest you. Their performance can be very high, provided they understand their mechanics and aim correctly.
- A right of purchase or sale
Like stocks and bonds, options are transferable securities whose terms and characteristics are defined very precisely.
An option gives you the right, but not the obligation, to buy or sell an underlying asset at a specified price and time. To clarify this jargon, let’s take an example out of the financial market.
You one day discover the house of your dreams (the underlying asset). You want to buy it, but you will not have the necessary funds before 3 months. You discuss with the owner and negotiate a contract (the option) that gives you the right to buy this house in 3 months, at a price of $ 200,000. In return for this privilege, the landlord demands that you pay him $ 3,000.
During the next 3 months, 2 extreme scenarios could occur.
- A bet on the market value
A celebrity falls in love with this house and absolutely wants to buy it. As a result, the market value soars to $ 1,000,000. Since you bought the option, the homeowner is forced to sell you the $ 200,000 home. But if that famous person then buys you the $ 1,000,000 home, you make a profit of $ 797,000 ($ 1,000,000 – $ 200,000 – $ 3,000). Not bad!
A journalist who has been investigating the neighborhood for six months, discovers that the ghost of Henry VIII haunts the master bedroom and a family of super-intelligent rats has built a fortress in the basement … Hum, not too much of your gender, this dream house. With your option, you do not have to buy it. Of course, you lose the $ 3,000 you paid to buy the option. It’s tough on your wallet, but your peace of mind is well worth it.
- Options on the financial market
The options are considered derivatives because their value derives from another element, called the underlying asset. In our example, the house represents the underlying asset. In the case of options, the underlying asset is generally a stock or set of assets (stock index). It can also be a currency or a commodity.
The options are versatile instruments. A good knowledge of their characteristics, possibilities and risks will enable you to make the right investment decisions.
We hope this publication will help guide you through your first steps in the world of options. However, we advise you to find out from your financial intermediary before investing.
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