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Options

What are they?

Part one  |  Part two| Part three

Options are financial contracts that give the buyer the right, but not the obligation, to purchase a given quantity of an underlying financial asset (securities, indices, currencies etc...) at a certain exercise or “strike” price on a specific date or up until such date.  In cases where the option can only be exercised at expiry we have the so-called “European” style options, whereas the “American” style options allow the holder the possibility to exercise at any time up until the expiry date.

Call options guarantee the holder the right to receive, at expiry (or up until expiry) and at a predetermined price, the underlying or, wherever this is not possible (for example, in the case of options on indices), the equivalent amount in cash.  Exercise clearly only makes sense if the price of the underlying is more than the strike price and the profit realised will be equal to the difference between the market price and the strike price. 

The chart summarises the profit and loss profile associated with the use of call options.  The chart’s horizontal axis indicates the price of the underlying: towards the right there is a rise in price, towards the left, i.e. towards the starting point of the axes, the price falls.

On the other hand, the vertical axis indicates the option buyer’s profits (or losses).  As already mentioned the option will become meaningful only insofar as the market price of the underlying will be greater than the strike price.  Since the purchase of a call option has a cost (this is the premium to be paid to the party writing the option, namely whoever accepts to guarantee the buyer’s right to purchase the underlying at the predetermined price) the call option payoff chart starts in negative territory.  In the event of a fall in prices, the value of the call will tend towards zero and the investor’s maximum loss will be the premium paid.

This instrument is ideal for anyone wishing to speculate on a rise in the market without running the risk – in case of a fall – of incurring the capital losses associated with direct possession of the underlying.  It is also useful for investors who wish to buy the underlying security, but prefer to delay the financial outflows that direct purchase of the security would entail.

Put options guarantee the holder the right, at expiry, to sell the underlying at a predetermined price.  In this case, exercise only makes sense if the price of the underlying is below the strike price; the profit realised will equal the difference between the strike price and the market price.

A Put option is an instrument that allows a profit to be made if the market falls.  The buyer of a put option wants to speculate on a fall in the market without the costs associated with either “short selling” (i.e. the selling of securities that the seller does not own) or the losses incurred if the market moves in the opposite direction to that hoped for (in case of a rise in the price of the securities it will be costly to recoup).

Furthermore, a put option is often used by anyone wishing to hedge his/her portfolio against falls in the market.  Buying a security and the related put option guarantees a capital gain on the security in the event of a bullish market and at the same time avoids losses if the  market should fall.  In fact in the second case the losses on the security would be balanced by the appreciation of the option; the maximum loss would in any case be limited to the value of the strike price, in other words the value at which the holder of the put option has the right to sell his/her securities.

This strategy, known as the “protective put strategy” is used to avoid the portfolio dropping to below a minimum threshold and is a kind of insurance against a fall at a cost equal to the premium paid to purchase the put option.  It should be noted that the same profile of returns would be had by purchasing a call option with the same underlying, strike price and expiry date.

In brief, with “long” option positions it is possible to take a position by speculating on the rise and fall of the market with potentially unlimited earnings and the risk of a loss limited to the price of the premium paid.

But what is the profit and loss profile as regards the option seller?

It needs to be emphasised that, while the option buyer at expiry (or up until expiry in the case of an American style option) has the option not to exercise the right (which is what gives rise to the limit on the potential losses) the seller always has the obligation to honour the commitment provided for in the option he/she has written.

In the case of a call option seller, the payoff will be as follows:

The initial set profit (the premium received) decreases as the price of the underlying rises: the option seller therefore hopes that the market will remain stable or fall.  Against a limited immediate profit, the loss is potentially unlimited

In the case of a put option:

In this case, on the other hand, the erosion of the initial premium received occurs if the price of the underlying decreases: the maximum profit is obtained if the price remains stable or rises.  Also for the seller of a put option the profit will be limited, whereas the loss is “almost” unlimited (in fact, the underlying cannot have a negative value, so the maximum loss occurs if the value of same is equal to zero).

To take a short position in options implies an undoubtedly greater risk profile compared to the same transaction with a long position, and this is why very often the sale of these instruments is combined with the purchase and sale of other financial assets (for example ETFs, futures and equity and index options) to implement more structured investment strategies that make it possible to pursue differentiated objectives, such as for example hedging positions in shares or derivatives, enhancing the performance of a portfolio or pure speculation.