What are options
If an investor is confident that a stock will rise, he can make money on the price change without buying the stock directly. It is enough to conclude a contract with someone who already owns these securities. Such contracts are called option contracts. They are regularly entered into between investors and are traded on an exchange like stocks, bonds and ETFs.
The option costs less than the stock itself. At the same time, the profit remains the same.
Let's imagine that a stock is traded on the stock exchange at a price of $100. David believes that in the next few days the stock will increase in value by 5%. If he buys the stock for $100, he will receive a profit of $5. If he had bought the option, David could have made the same profit with a much smaller investment.
Ability to earn more with less investment - one of the advantages of trading options.
However, the high earning potential comes with high risks, because buying an option does not make the investor the owner of the security. If the market goes against the investor, the investor will be left without shares, and the investment in the option will not be returned.
Option - is a contract that gives the right to buy or sell a security at a certain price within a certain period.
How an option works
Suppose that David has a coffee shop near his house called Your Coffee, where he often goes for a coffee with his friend Louise. The shares of this coffee shop are traded on the stock exchange at $50 per share. Louise has 100 shares of Your Coffee, but David does not.
After a detailed study of the coffee shop business, David concluded that Your Coffee shares are undervalued. In a couple of weeks, the company will publish a strong report and the quotes may go up.
Louise doesn't think so and, on the contrary, expects Your Coffee's quotations to decline in the near future.
David doesn't want to miss the opportunity to capitalise on the price rise and is ready to buy Your Coffee shares from Louise right now, at $50 per share. But he doesn't have the money to pay for 100 shares at once. In this case, David and Louise can enter into a call option contract.
What is a call option
Since both parties to the deal, David and Louise, are convinced of their forecast, they can agree on the following terms:
- David pays Louise a lump sum bonus, for example $100, which is non-refundable.
- If Your Coffee's stock rises to $55 a share in a fortnight, Louise will sell it to David at the old price of $50 a share.
- If quotes don't rise, David is under no obligation to buy back shares from Louise.
On the stock exchange, this type of contract is called a call option. It is purchased when the price is expected to rise базового актива. In our example, the underlying asset is shares of Your Coffee.
Call option - a type of contract that entitles the buyer of an option to buy shares at a predetermined price within a specified time.
If the terms of the option are met, David has the right to buy shares at $50 each, regardless of Your Coffee's current market price. This price is referred to as strike, or the strike price of an option.
Strike - the price at which the buyer of an option has the right to buy and the seller has the obligation to sell the underlying asset.
Depending on market movements, both parties to an option contract can benefit. If the buyer's expectations are fulfilled, he will make money on the change in quotations. In the reverse situation, when the seller's expectations are met, he will be left holding his shares with a premium on his hands. Let's consider two variants of David and Louise's option contract.
If the stock price rises
Let's imagine that David's expectations are fulfilled and in a fortnight Your Coffee's shares have risen from $50 to $60 per share. He can fulfil the contract by buying 100 shares of Your Coffee from Louise at $50 per share.
Once David has the shares, he can sell them on the market for $60 each and earn $10 on each security sold. After deducting the $100 premium paid, David's income will be $900.
Louise will have to sell 100 shares of Your Coffee to David at below market value. She will lose the opportunity to make a $1,000 profit on the appreciation of the stock, but will receive a $100 premium in return.
If the stock price falls
Now let's imagine that David's assumptions are wrong and Your Coffee's stock drops from $50 to $40 per share just before the contract expires. In such a case, David could refuse to honour the contract.
It makes no sense to buy the shares for $50 from Louise, as the securities are traded cheaper on the market, but no one will return the $100 premium - it is a direct loss from buying the option.
At the same time, Louise is doing well - she still owns 100 shares of Your Coffee, although they have fallen in value. Some of the losses were compensated by a $100 premium from the option sale to David.
How the amount of the premium is formed
The value of a contract, as in any market, is determined by the ratio of supply and demand. For example, if David and Louise are joined by a third party, the option seller can choose who is willing to pay more.
To determine whether to buy a contract, participants weigh the risks and the projected profit from the transaction. The decision takes into account the time until expiry, the magnitude of the expected price movement and market fluctuations during the term of the option contract.
What is a put option
Now let's imagine that David owns shares in Your Coffee and Louise has her eye on the papers.
The current share price is $50 per share. David read the company's news, studied the financials and decided that the stock might correct in the near future. In the next two weeks, when Your Coffee publishes its report, the quotations may drop to $40 per share. David does not want to sell the shares - he is convinced that in the long term the securities will grow, but it is better to be on the safe side.
Louise, on the other hand, believes that Your Coffee's shares will rise after the report is released. She spoke to the manager of the coffee shop, who said that the company is doing well.
In that case, David can arrange the following with Louise:
- David pays Louise a lump sum bonus, for example $100, which is non-refundable.
- If Your Coffee's shares fall in value in a fortnight, Louise must buy back the securities from David at the old price of $50 per share.
- If Your Coffee's stock price rises during this time, David may not sell his securities to Louise.
This type of contract is called put option. It is purchased when the price of the underlying asset is expected to fall.
Put option - a type of contract that entitles the buyer of an option to sell shares at a predetermined price within a specified time.
What to remember when trading options
David learnt that with options, you can make money on movements in the market price of a stock. You do not have to be the owner of the security.
When the stock is expected to rise, a call option can be exercised. When the stock price rises, the investor will receive income from the difference between the contract price and the market price of the stock.
If the quotes of the underlying asset are expected to decline, you can use a put option to insure your investment against possible losses.
Both of these types of options can be combined in different ways. By buying and selling options, investors can make money when the market moves in different directions.