WHAT ARE OPTIONS?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price and time. Like stocks and bonds, options are securities. They are also compulsory contracts whose conditions and characteristics are defined very precisely.
The concept still seems a little nebulous? Yet it is quite present in everyday life. Let’s take an example. You one day discover the house of your dreams. You want to buy it, but you will not have the necessary funds for three months. You talk to the landlord and negotiate a contract (the option) that gives you the right to buy that house in three months, for $ 200,000. In return for this privilege, the landlord demands that you pay him $ 3,000.
Now, let’s see two possible outcomes to this scenario:
- Someone discovers that Elvis was not born where we thought, but precisely in this house! As a result, the market value of the house soars to $ 1,000,000. Since you bought the option, the owner is forced to sell you the house for $ 200,000. In the end, you make a profit of $ 797,000 ($ 1,000,000 – $ 200,000 – $ 3,000).
- While visiting the house, you discover not only that the walls are filled with asbestos, but also that the ghost of Henry VII haunts the master bedroom; moreover, a family of super-intelligent rats built a fortress in the basement. You who thought you had found the house of your dreams, do not want to hear about it anymore. Luckily, with your option, you do not have to buy it. Of course, you lose the $ 3,000 you paid to buy the option.
This example demonstrates two very important points. First, when you buy an option, you have the right, but not the obligation, to do something. You can always miss the due date, from which the option is worthless. In this case, you lose your entire investment, that is, the money you paid to purchase the option. Second, an option is only a contract for an underlying asset. The options are therefore considered derivatives because their value derives from another element. In our example, the house represents the underlying asset. In the case of options, the underlying asset is generally a stock or index.
CALL OPTIONS AND PUT OPTIONS
There are two types of options: call options and put options:
A call option or option to purchase entitles the holder to purchase an asset at a specified price and within a specified period. Investors who hold such options are in a similar position to investors holding the shares themselves. Buyers expect that the price of the underlying stock will rise sharply before maturity.
A put option gives the holder the right to sell an asset at a specified price and within a specified time. Investors holding such options are in a very similar position to investors who have sold short stocks. People who buy a put option are hoping that the price of the underlying stock will fall before maturity.
STAKEHOLDERS IN THE OPTIONS MARKET
Participants are classified into four categories in the options market, depending on the position they take. It exists:
- Buyers of call options
- sellers of call options
- Buyers of put options
- sellers of put options
Buyers are also called takers or option holders. They have a so-called “long” position, while the sellers have a “short position”.
The most important difference between sellers’ buyers is:
- Holders of call options and put option holders (buyers) are not required to buy or sell. They exercise their privilege only if they wish.
- However, call option sellers and put sellers may be forced to buy or sell. As a result, a seller may be forced to keep his promise to buy or sell.
Do not worry if it all sounds confusing – it’s a complex subject. So we will look at the options from the buyers’ point of view. Selling an option is a more complex operation and can be much riskier. For the moment, just know that there are two parties to an option contract.
To trade options, you need to know the related terminology.
The price at which an underlying stock can be bought or sold is called the exercise price (or strike price).
This is the price that must be exceeded (for call options) or below which must fall (for put options) the share price, before the option expiry date, for that the buyer can make a profit if he exercises his option.
The expiry date, or expiry date, is the third Friday of the expiry month of the option. A “June 60” call option, for example, means that the exercise price of the option is $ 60 and the option will expire on the third Friday in June.
Options traded on a domestic options market, such as CBOE, are said to be quoted. They carry a specific exercise price and maturity. Each option (we are talking about a contract) listed represents 100 shares of the company.
In the case of call options, the option is called within (or in play) when the share price is higher than the exercise price. A put option is in if the stock price is below the strike price. When an option is in, the difference between the exercise price and the share price is called the intrinsic value.
The total cost (price) of an option is called the premium. This price is determined by several factors, such as share price, strike price, time to maturity (time value) and volatility. Calculating the premium of an option, which must take all these factors into account, is quite complex and goes beyond the objective of this course.