Financial investment: what is an option?

 What is an option? How does it work? How can I use this derivative? What strategies can be implemented with options? What are the characteristics of this product that you absolutely must master before getting started? Here are some explanations.


What is a stock market option?

An option is a contract that gives its holder the right (not the obligation) to buy or sell an underlying asset at a predetermined price and date.


Unlike a stock or a bond, an option exists only in relation to its underlying asset. An option is therefore a financial product known as a "derivative". Options can be used to invest in a wide range of underlying and therefore in several asset classes, such as stocks, stock market indices, commodities, etc.


It is a contract between two parties, with precise and defined rules, which allows seizing opportunities on the financial markets, whether they are bullish, stable, or bearish. They are similar to futures contracts, but unlike those products, options allow you to buy the underlying asset, without obligation. You are not obligated to buy it if it goes against you.


Vanilla options, often referred to as plain vanilla options, as opposed to exotic options, are classic options with no additional features.


How does an option work?

Imagine that you have a crush on a house and would like to buy it. But you don't have enough money and won't be able to pay the seller for three months. You negotiate with the seller so that he gives you the possibility to buy it in three months for 500 000€. The seller accepts an additional €4,000. In other words, you have taken an option on the house. The deal is done.


During these three months, several unforeseeable events may occur that may affect the value of the house.


Scenario 1: Making a quick profit with an option

Angelina Jolie decides that this is the perfect home to raise her six children. The market value of the house skyrockets and is now estimated to be worth $1.2 million. That's a big break for you. Because you have exercised an option on the house, the owner must sell it to you at the original price of $500,000. You, therefore, make an immediate capital gain of $696,000 ($1.2 million - $500,000 - $4,000).


Scenario 2: the option to limit the risk

A tornado worthy of a big-budget disaster movie ravages the house. All that's left is the bathtub, which may be pretty, but it's still not worth €500,000. Don't worry, the option does not oblige you to finalize the sale and you only lose the $4 000 you paid for your option.


When you buy an option, you have the right, but not the obligation, to do anything. You can even wait until your option expires. Your option then loses all of its value and you lose your entire investment in that option.


An option is actually a contract between two parties, a buyer and a seller, that fixes future cash flows based on those of an underlying asset. An option is said to be a "derivative" financial product because its value is usually derived from another asset. In the example used above, the house is the underlying asset. In the financial markets, the underlying asset is most often a stock or an index.


2 types of options: call option and put option

Call and put options: 2 distinct strategies

A call option, also known as a "call", gives its holder the right to buy an asset at a fixed price for a limited period of time. Investors who buy calls believe that the stock, and therefore the option, will eventually be worth more.


A put option gives the holder the right to sell an asset at a given price for a limited period of time. Investors who exercise put options hope that the value of the stock will fall before the expiration date of the option.


Option buyers and sellers

So there are four types of options for investors: call buyers, call sellers, put buyers and put sellers.


The distinction between buyer and seller is very simple:

  • the buyer (also called "taker" or "holder") of a call or put option has no obligation to sell. He can decide to keep his option until the end of the term without selling it.
  • The seller (also called "writer") of a call or put must buy or sell one or more options. This means that an investor can require a writer to honor a promise to buy or sell.

This may sound complicated and for good reason. Managing options is easier (and riskier) for a buyer than for a seller. Remember, however, that there are two parties in an option contract, a buyer and a seller. But don't worry about the seller's business right now.


How is an option valued, calculated, and traded?

The pricing of options is particularly complex because there are so many criteria involved, such as the price of the underlying asset, its volatility, and the time remaining before the option expires. These criteria are called "the Greeks" because of the letter to which each is attached. Thus, Delta refers to the sensitivity of a vanilla option to the price of the underlying, Vega measures the sensitivity to the volatility of the underlying market, and Theta measures the impact of time on the option.


For option investments, the price (and therefore the risk, since it is the amount you could lose if you don't exercise your option) is calculated by multiplying the premium by the order size. The broker will also charge you a small opening and closing commission.


Note: Options are leveraged products since the cost of the option is much less than the cost of investing directly in the underlying asset.


Terms to know about options

To trade an option, there are some jargon terms you need to know.


The strike price of an option

A "strike" or exercise price is the price at which a financial asset can be bought or sold. For the buyer to make a profit, the price of the stock must exceed the strike for the call, or be lower than the strike for the put. All this before the option's expiration date.


An option traded on a nationally organized market, such as Euronext in Europe or the CBOE in the United States, is a listed option. The listing includes a strike and an expiration date. Each listed option typically represents 100 shares.


In-the-money option

For call options, the option is said to be "in the money" when the price of the underlying asset is higher than the strike price. A put option is in the money when the price of the underlying asset is below the strike price. An option is in the money when its value is intrinsically positive.


What are the advantages of options?

Exposure to an extensive variety of economic markets

Options are derivative products that allow you to invest in a wide variety of underlying assets. The range of options on offer varies significantly from broker to broker and can be used to position yourself in the equity markets with underlying stocks or stock indices, but also in the commodities market with commodities such as gold or oil for example.


Positioning in all market circumstances

It is possible to invest in options in a stable, rising, or falling market. It is up to you to define your investment strategy and seize all the opportunities that options offer.


Controlled leverage for appropriate risk-taking

You control your leverage at the time of purchase by choosing the strike price, the expiration date, and the premium, in order to invest in a product adapted to both your investment scenario and your risk profile.


What are the risks of investing in options?

Possible loss of capital

Options trading is subject to a risk of capital loss. This means that in case of bad anticipation, you can lose the entire amount invested (the premium + brokerage fees) and even more in case of option selling. If with this type of derivative product, the gain is potentially unlimited, so are the losses. As a result, vanilla options are not available for sale in the Limited Risk accounts of the brokers who offer them.


Misunderstanding the product

Therefore, in order to be on the safe side, it is essential that you understand how vanilla options work before you trade them, especially since the pricing of this product and how it works are eminently complex. In particular, make sure you understand the differences between vanilla options and other leveraged derivatives, such as turbos.


Poor knowledge of the underlying asset

Even if you understand everything about options trading and are very good at trading the CAC 40 index if you decide to invest in oil on a whim and without any training, without knowing much about the subtleties of oil trading, you will probably end up in disaster. It is important to know the underlying asset well in order to develop the most likely investment scenario.


Our tips for trading options

To be successful in investing in the financial markets with vanilla options, it is important to understand the product and to be very knowledgeable about the underlying asset you have chosen. To do this, it is essential to be well-trained and informed via the many educational materials made available to you by specialized media and also by most stock brokers, especially online brokers, who often offer demo accounts that allow you to practice trading derivatives such as options for free and with virtual funds.


Some questions about options?

What is an option?

An option is a contract that gives the holder the right (not the obligation) to buy the underlying asset on which the derivative is based at a given price during a given period.


Why use an option?

Options make it possible to position oneself in a large number of financial markets (stocks, indices, commodities, etc.) thanks to the variety of possible underlying. These derivatives allow you to seize opportunities on bullish, bearish, or stable markets, thanks to a leverage effect that you can adapt to your risk profile. Be careful though, the capital loss is potentially unlimited.


How to invest and trade with an option?

If you expect the price of the underlying asset to rise, choose a call option, which will allow you to buy the underlying asset before the expiration date for less than the price you expect. If you expect the price of the underlying asset to fall, choose a put option that will allow you to sell the underlying asset before the expiration date at a higher price than you expect. With options, a multitude of trading strategies can be implemented.


All of our information is, by nature, generic. It does not take into account your personal situation and does not constitute in any way personalized recommendations for the realization of transactions, nor can it be considered as financial investment advice, nor as an incentive to buy or sell financial instruments. The reader is solely responsible for the use of the information provided, without any recourse against the publishing company of Cafedelabourse.com being possible. The publishing company of Cafedelabourse.com cannot be held responsible for any error, omission, or inappropriate investment.


Any trading activity involves risks. The order execution service through a limited risk account presents a risk of loss of the invested capital.


Options are complex financial instruments with a risk of capital loss. Losses can be extremely rapid.

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