An option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a certain price and date. There are two basic types of options; a call and a put.
Call options: the mechanism
In a call option, you have the right, but not the obligation, to buy the underlying asset at a specified price on a specified date. Let's use a simple example: you have a cake shop and only make apple pies. You want to make sure that the price of the ingredients remains constant, so you can sell the pie at the same price. You can enter into a contract with someone to buy their apples in one year, always at a price of €10c per apple. Usually this contract has a cost for you, as the buyer. For example, if the cost is 10% of the contract’s value and you are looking to buy 10,000 apples, the value of the contract is 10,000*0.10 = €1,000, and thus the cost of the option is 1,000*10% = €100. This percentage which you pay the option on the value of the contract is known as the Premium.
By buying a call option you are sure that if there is a shortage of apples and at the market they now cost €20c per apple, you have still secured them at a price €10c per apple, thus without increasing your costs.
If the price of the apples falls to €5c then you can chose to throw that contact away and loose the €100 you paid for it, but buy the apples for €5c, costing you 10,000*0.05 = €500. The full price will be €600: the €500 for the apples plus the €100 premium, which is still lower than €1,000.
In the stock market, these options are used to secure a price on shares, when you believe the price of the underlyings will rise. For example, let's say you think the value of the BMW stock will go up. You can spend €60 and buy one share, then wait until it goes up. If after one year the price is €100, you make €40. If, instead, the share price goes down to €20 you will have lost €40.
Alternatively, instead of buying the share you can buy an option, where you will enter into a contract for one year to buy a share of the BMW stock for €60. This contract costs you, for example, 10% of the value of the contract, so €6. This may help you to mitigate the risks for two different reasons:
- You spend €6, not €60, to buy exposure to the BMW stock.
- If the share price increases to €100 in one year you can use the contract, or exercise the option as it is said in finance, to buy one share for €60 and sell it immediately in the market for €100. Your profit will be 100-60-6 = €34. On the other hand, if the share price falls to €20 you can choose not to use the contract, so to not exercise the option to buy the share for €60, and you will have lost only €6.
Put options: the mechanism
A put option is exactly the opposite, as you have the right, but not the obligation, to sell the underlying asset at a specified price on a specified date.
Let's say you have a farm with cows and you want to make sure you can always sell your milk at a specific price, to make sure you know what your revenues will be. You enter into a contract with someone that in one year you can sell them your milk for €1 per litre. Your contract is for 10,000 litres, so the value of the contract is 10,000*1 = €10,000. The cost, or premium, of this contract for you is 10% of it’s value, so 10,000*10% = €1,000.
If during the next year demand for milk is much lower due to increased drinking of alternative milks, and the price per liter has fallen to €50c, then you will use your contract to still sell it at a price of €1 and your total profit will be 1*10,000 liters - 1,000 = €9,000.
If instead in one year’s time the amount of milk consumption increases significantly and the price becomes 2€ per liter, you will just decide to sell directly on the market without the pre-agreed contract making a profit of 10,000 liters * 2 -1,000 = €19,000.
Let's go back to the stock market, just as you can buy a call option, you can buy a put option. In this case you are betting that the price of the underlyings will fall.
Let's say you think the share price of a single stock, Tesla, will decrease. Today the price is €1,200, and with a put option you will pay a premium of 10%, which is €120, hoping that in one year the price has gone down. If in one year the price is €800, then you have the right to use the contract, thus exercise the put option, and sell one share of Tesla at €1,200. You will buy one share in the market for €800, and sell it for €1,200 immediately after. This will give you a profit of -800+1,200-120 = €280. On the other hand, if the Tesla stock price increases in one year and reaches €1,600 then you can choose not to use the contract but you will only have lost €120.
A few terms when talking of options.
Long: Means you are buying the option and you have the right to choose if to use it or not.
Short: You are selling the option. If the buyer chooses to use it you have the obligation to exercise the contract.
Strike Price: It is the pre agreed price in the option contract in which you can buy (for a call option) or sell (for a put option) the share.
Payoff: This is the curve that determines the difference between the actual share price and the strike price.
Premium: It is the % you pay the option on the value of the contract. In the examples above it was 10% but it can change depending on how probable the contract is. It works just like in insurance, where your insurance premium for example in health care is higher if you are old or sick because there is a higher probability that you will use the coverage.
Profit: This is the Payoff minus the Premium.
Your capital is at risk and past performance may not be a real indicator of future results. Oval Money is not authorized to provide financial advice, expert advice is recommended if you have further questions.