Financial options are a very popular type of financial derivative, since it is available to all retail investors. We analyze what call and put options are, advantages of using them, their risks, and different strategies we can build with options.
- What is a Financial Option
- Call Options
- Put Options
- Main Characteristics of a Financial Option
- How is the Price of an Option determined?
- Underlying Assets for Call and Put Options
- Most Popular Strategies with Financial Options
What is a Financial Option
Financial options are derivative contracts that give us the right, but not the obligation, to buy or sell an asset, at a future date, at a previously agreed price. Options tend to be known as either call or put options, a distinction we will analyze in the next sections.
Let us look at an example option to understand how they work: it is January 1st, 2023, and Apple shares are trading at $125. If we are optimistic about the future of the company, we can buy Apple shares directly, or buy an option that allows us to buy shares in the future at a certain price.
Let us imagine that there is a call option that gives us the right to buy a share of Apple stock on March 20th, 2023, for $130. That option costs $3.
Why would we buy the option? It costs us $3 and allows us to buy the stock at $130, even though it trades at $125 today. The reason why it is attractive to buy the call option is because we also have the option not to buy the stock in the end.
If on March 20th, 2023, Apple is trading at $70, we will not buy the stock. We will have lost the $3 we paid for the option. But we will have avoided major losses. In fact, we are still optimistic about the future of Apple, now we can buy the stock directly at $70.
Conversely, if Apple is trading at $150 on March 20th, 2023, we will be able to buy the stock for only $130. We will be able to make a very attractive profit. And, while we could have bought the stock for $125 in January instead of the option, that would have exposed us to potential losses.
Therefore, the call option has made it possible for us to benefit from the increase in Apple’s stock price without having to take on any type of risk beyond losing the $3 we paid as a premium to buy the option.
Additionally, the option would have made it possible to take on a leverage bet. Because option prices are much lower than stock prices, we can place big bets to achieve potentially extraordinary returns. However, using options as a leverage play carries a significant amount of risk.
Next, we will discuss the types of options that exist: call and put options.
Call options give us the right to buy an asset in the future at an agreed price, without having the obligation to do so. They are ideal for investors and traders who believe that the price of a stock or another type of asset has the potential to go up.
Therefore, if Adidas is trading at €150 per share, a call option would give us the right to buy Adidas shares at a certain price in the future. This would allow us to make a profit if the stock price goes up but limit our losses to the premium we paid to buy the option.
Put options give us the right to sell an asset in the future at an agreed price, without having the obligation to do so. Put options are ideal for those who think that the price of a stock or another type of asset could go down in the future.
Going back to the example of Adidas trading at €150, a put option would allow us to sell Adidas shares at a certain price in the future. Thanks to this, we could make a profit if the price of Adidas goes down but limit our losses to the option premium if the stock price rose.
Main Characteristics of a Financial Option
These are the main characteristics of financial options:
- Call or Put Option: a call option gives us the right to buy, while a put option gives us the right to sell.
- Underlying Asset: the asset the option gives us the right to buy or sell. For example, shares of a company like Apple, a stock market index like the S&P 500, gold, or US Treasury bonds.
- Strike Price: the price at which we can buy or sell the underlying asset in the future.
- Quantity: the amount of the underlying asset that the option gives us the right to buy or sell. For example, most exchange-traded listed options on stocks give the right to buy or sell 100 shares per contract.
- Expirations Date: the date on which the option expires and we must decide whether to buy or sell the underlying asset at the strike price.
- Option Type: when we can exercise our options. There are 3 main types of options:
- European options: we can only exercise the option on the expiration date. Most options traded are structured as European options.
- American options: we can exercise the option on or before the expiration date. We choose then.
- Bermudan options: we can exercise the option on the expiration date or at pre-determined dates before the expiration date.
- Option Premium: the option premium can also be referred to as the option price. It is the price at which the option itself trades. It is an important factor since it is how much we will have to pay to buy an option, or how much we will receive if we want to sell an option. The option premium is largely driven by its implied volatility.
- Implied Volatility: the implied volatility is a measure that indicates how much the market thinks that the price of the underlying asset will move in the future. It is quoted as a volatility number. We will discuss this in greater detail later.
- Our Trade: whether we buy or sell an option. Since options can be bought or sell, there are different strategies we can build with them.
The most important thing when it comes to trading options is to understand what the potential risks and returns of our options.
How is the Price of an Option determined?
The price of an option, also known as the option premium, is determined by its characteristics, obviously. However, it is key to understand the relationship between these characteristics and the option premium. After all, the price of an option can be calculated with a mathematical formula that takes all these characteristics into consideration:
- Strike Price: The strike price is a key variable. For a call option, a low strike makes the option more expensive since it allows us to buy the underlying asset at a lower price. For a put option, a higher strike price makes the option more expensive as it allows us to sell the underlying asset at a higher price.
- Current price of the underlying asset: The price at which the underlying is trading at any given time has a major impact on the price of options at that time. For call options, a higher price for the underlying asset makes the option more expensive. For put options, a lower price for the underlying asset makes the option more expensive.
- Expiration Date: The further into the future the expiration date, the more expensive the option will be. This is because there is more time for the price of the underlying asset to move, either up or down. Because the risk for the option buy is limited to the premium, whereas the potential return is very high or even infinite, larger potential movements in the price of the underlying asset make the option more expensive.
- Option Type: this refers to whether the option has European, American or Bermudan exercise type. For all practical purposes, the option type does not affect the option premium.
- Implied Volatility: it is the most difficult element to understand, as it is in fact derived from the price at which the option is trading. Conversely, it tells what the fair price of the option should be based on our estimate of the future volatility of the underlying asset. The higher the implied volatility, the more expensive the option.
Implied Volatility of Options
The price of an option is determined by a mathematical formula known as Black-Scholes. In this formula, we find variables such as the strike price, the current price of the underlying asset, the time to expiration, the level of interest rates and the implied volatility.
Implied volatility is the term for how much the market thinks the price of an underlying asset will likely move between today and the expiration date of the option.
As you can imagine, implied volatility is the only variable that cannot be observed in the real world. The rest of the variables are readily available. Consequently, the only way to know what the implied volatility of an option is, is by looking at the price of the option and the rest of its characteristics.
Looking at the implied volatility of options is extremely useful to understand market sentiment. Are large price movements expected? Is the implied volatility for put options higher than for call options? That would indicate the market thinks that large price movements to the downside are more likely than large price movements to the upside.
The reason more volatility is good for options is because, with an option, the losses we can suffer are limited to what we have paid for the option. In other words, once we have purchased and paid for the option, we cannot lose anything else.
However, the potential return from buying an option can be several times what we paid for it. For call options, the potential return is theoretically unlimited. And the more volatility there is, the more likely it is that we will achieve a high return.
Think of the following example: Apple is trading at $125, and we pay $3 for a call option that gives us the right, but not the obligation, to buy a share of Apple stock for $130 within 3 months.
The following potential scenarios indicate why we, as option owners, are interested in large movements in the stock price:
- Low volatility scenario: Apple can fall to $115 (in which case we will lose the $3 we paid for the option option) or rise to $130 (in which case we will have a gross profit of $5 on the option, minus the $3 we paid for it, resulting in a net profit of $2)
- High volatility scenario: Apple can fall to $70 (in which case we will lose the $3 we paid for the option option) or rise to $155 (in which case we will have a gross profit of $30 on the option, minus the $3 we paid for it, resulting in a net profit of $27)
As you can see, the potential losses are the same whether there is little or much volatility. However, the potential returns are much greater in times of elevated volatility.
The only thing you have to keep in mind before buying an option is that, if the market is already anticipating a lot of volatility, the implied volatility of the options will be high, making them expensive and requiring large movements in the price of the underlying asset for us to end up making money.
The best-case scenario is one in which we know there can be a lot of volatility, but other market participants think otherwise. In those instances, the implied volatility would be low, making the option cheap, but the potential returns would be very substantial.
Underlying Assets for Call and Put Options
There really are endless assets on which options can be traded, as options can be custom made by investment banks for investors. However, the most traders and investors trade options listed on exchanges which are very accessible. We can find call and put options on the following underlying assets:
Stock options are probably the most common in the market. They are traded for many companies, both calls and puts, with several expiration dates and many different strikes.
Stock Indices and ETF
It is also very common to buy and sell options on stock indices and ETF funds. These options are available with even more expiration dates and strikes. They are often used by institutional investors to hedge macroeconomic risks.
Some of the most common stock indices used to construct options are the S&P 500 in the United States and the Eurostoxx 50 in Europe. We can also find options on interesting ETFs such as the GDX of gold-mining companies, or TLT for long-duration US Treasury bonds.
Whether it is gold, silver or oil, commodity options are very popular. They can also be found in the form of options on gold ETFs, such as the famous GLD.
Government bond options are mostly used by professionals, but they are available to everyone. Of course, it is important to be familiar with the dynamics of the bond market.
Options on government bonds allow us to benefit from changes in interest rates. If we think rates are going to fall, bond prices will rise, and we will be interested in buying call options. If we think interest rates can go up, bonds prices would fall, and we would want to buy put options.
Options on currencies are very interesting. They can be used to trade, to reduce some of the risks of our portfolio, or simply to express our view about what can happen to different currencies.
For example, the Japanese Yen and the Swiss Franc tend to strengthen in times of economic crisis and financial distress. Therefore, we could look into their options as a potential hedge for a stock market crash.
Most Popular Strategies with Financial Options
Next, we discuss the most common strategies we can implement when buying and selling call and put options:
Buy Call Options
We can buy call options if we think that the price of an asset may rise significantly in the future, but we also think that it could fall.
That would allow us to make a lot of money if the price of the asset really goes up. At the same time, if the price of the asset falls, our losses would be limited to the premium we paid to buy the call option.
Buy Put Options
Put options are very interesting when we believe that the price of an asset can drop substantially. That would allow us to sell that asset at a higher price and make a profit.
There are two distinct scenarios in which we may want to buy put options.
If we own the underlying asset for which we buy put options, we do it to reduce risk. These put options act as a form of insurance.
For example, if we own a lot of US stocks, we could buy a put option on the S&P 500 if we think there might be a crash. If there is a market crash, the profits on the put option would offset the losses in our portfolio. But if the market rallies, we will only lose the option premium while retaining the profits from the higher stock prices.
The second scenario is one in which we simply believe that the price of an asset may fall. We do not have to own it; we simply want to be against it. This could be done with individual stocks if we believe that a stock valuation is not justified, or if we think that the entire stock market is expensive and can correct.
When we sell options, we must understand that we are on the other side of the equation. We will be the ones getting paid for selling the option. But we are also the ones who can suffer heavy losses if the market moves against us.
If we decide to sell call options, we will most likely have one of the following motivations.
On the one hand, we can sell call options on assets we already own. This strategy is known as selling covered calls. It can be done when we think the upside potential of those assets is limited in the short term, but we still believe in their long-term potential and therefore do not want to sell them.
It is a good way to generate extra income, since we do not really expose ourselves to additional losses by selling those call options. The only bad thing that could happen is that the price of those assets rallies.
In such a scenario, we would simply miss out on any profits above the strike price of the call option we sold, as that would be the profit of the person who bought the call option from us.
On the other hand, we can also sell call options on assets we do not own. That has a lot of risk, since the losses can be unlimited. This is because there is no limit as to how high a stock can trade. This is known as selling naked calls and is one of the riskiest trades you can make.
Sell Put Options
If we sell put options, we are also taking a considerable amount of risk since our losses could be much greater than the premium we received when selling the option.
However, the potential losses in this case are not infinite as the lowest price an asset can trade is 0 and not negative.
An advantage of selling put options is that they usually have a higher implied volatility than call options, so their prices will be higher, and we will receive more money. This is because there is usually more interest from investors in buying put options than call options, as many investors buy put options as an insurance policies, pushing put option premiums higher.
Historically, the best time to sell put options is precisely when there has already been a stock market crash and the market is down 30-40%. In those times, most investors are still in panic mode, eager to buy protection in the form of put options, pushing implied volatility and put option premiums to extremely high levels.
Under those circumstances, we would receive a lot of money for selling those put options. Coincidentally, since the market would already be down a lot, the potential for further large drops is smaller.
The other situation in which we may want to sell put options is when we really want to buy an asset, but that asset has risen a lot in price recently. Consequently, we prefer to buy it at a lower price.
In that situation, we would receive money by selling put options. If the price of the asset falls, we would experience a loss in our option but could buy those assets at a lower price. If the price of the asset does not fall, we will keep the option premium.
Complex Strategies with Financial Options
Much more complex strategies can also be carried out with options, such as call spreads, put spreads, collars, straddles and strangles. All these options have to do with buying or selling two options on the same underlying at the same time. We will talk about them in another post.
Call and put options on stocks and other financial assets are great instruments for carrying out a multitude of investment and trading strategies. We can protect our portfolio, express our views on the market, or speculate by controlling the risks we are taking.
At the same time, we must be aware that options are financial derivatives. They can be complex to understand and lead to great losses if we do not know what we are doing.
One good rule of thumb is that, if you only buy option, your losses will always be limited to the premium you pay for those options. Selling options, if done without proper analysis, is what can cause us significant losses.
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