Stratégies Options - Simple Definition Of What An Option Is

I - What is an option?

An option is a financial instrument which is categorized as a derivative product.
It gives the holder the right but not the obligation to buy (for a call) or to sell( for a put) a peculiar asset for an agreed amount (the strike) at a specified time or for a given period in the future.
The holder has to pay a premium, an amount of money given for that contract.

The writer of an option is a person who receives the premium and who promises to deliver the underlying asset for a call, or to buy it if the option is a put.

One can graphically represent in red the value of an option varying according to the level of the underlying. The payoff or final financial result is expressed in blue.

A call

A put

II – Trading

Although one can write or buy an option, one can trade them.

The options are traded in two ways:

a - On regulated markets like CBOE, Liffe, Eurex…
The precise features of an exchange contract are known by everybody and standardized.
It makes things simpler and much more efficient to match buyers and sellers. It improves liquidity.

b - On Over The Counter (OTC) market, where they are trade privately from one counterparty to another. A term sheet specifies precise details and features of the contract. It gives a way to manufacture “tailor made” options to respond precisely to customer needs.

III – Hedging and speculation

1 - Buying options:

Buying an option is buying the right to make a choice.
The holder pays the premium in order to have the possibility to buy or to sell the underlying if it’s sensible. Conversely, one can of course give his option up.

a - Buying a call:
One is bullish on a peculiar asset, say a stock. Today’s stock price is $100.
One can pay $5 to buy a 1 year call, struck at $100. At maturity, if the stock is above 100+5=$105 there would be a profit. Imagine the stock reaches $130 at expiry. One would exercise the option, paying $100 for a stock that is now worth $130, and sell it back for $130: a profit of 130-100=$30. We must take into account that we paid $5 to get this right: final profit of $30-$5=$25.
What if the stock remains at $100, or moves down to $90? It’s clearly not sensible to exercize the call, e.g to pay a stock $100 that’s now worth $90. One would prefer give it up. A loss of $5, limited to the entire premium.

b - Purchasing a put
We are now bearish on a peculiar stock. By purchasing a 3 months put struck at 100 we want the stock price to fall so that we could sell the asset for more than it would be worth. Our put would be exercised only if the stock falls below the strike price. The point is that it could match a loss on a stock previously owned, and finally hedge it. The loss on the stock would be erased by the profit made on the put.

2 - Writing options

For every option that is sold, someone must be liable if the option is exercised. By writing an option, someone promises to deliver (for a call) or to buy (for a put) the underlying asset.
It’s an obligation, and one receives a guaranteed premium for that contract.

Imagine that one owns a particular stock and has a target in order to sell it. Owning that stock represents a risk already taken into account by the holder and he may want to add some extra cash on it.
By writing calls on stocks he already owned, it gets as if he could be paid for entering a limit order on that particular stock.
A - If the stock reaches his target, the calls would be exercised, and the stock would be sold at strike price. Finally a profit on the stock as anticipated plus a guaranteed premium for the call.
B - If the stock remains unchanged or plunged, then the owner would face a potential loss (the same as he had without writing calls) but he would have received an extra cash amount (the call premium) that could lower it.

Next : Volatility : A First Attempt
Previous : Options Trading For Newbies (part II)

OPTIONS 101 - INDEX
OPTIONS 101 - CHAPTER I
OPTIONS 101 - CHAPTER II
OPTIONS 101 - CHAPTER III
OPTIONS 101 - CHAPTER IV
OPTIONS 101 - CHAPTER V
OPTIONS 101 - CHAPTER VI

Strategies Options