The concept of “option” is shrouded in a halo of speculation and mysticism. It would not be an exaggeration to say that over the past 30 years, the greatest profits and losses on world markets were associated with them.
Losses because it is one of the most difficult to understand financial instruments, and profits are the same because options allow you to make a profit in any market situation.
Understanding the properties and dynamics of options is not an easy task. But the one who succeeds in this will be rewarded in the most worthy manner: he will be able to manage the risk and get the maximum profit in case of any changes in the market.
The purpose of this article is to show that options are perfect tools for planning investment portfolio profits and effectively managing risk. First of all, it is necessary to break the “veil” of speculativeness and “ingenuity” from options and encourage readers to further study the theory of derivative securities as one of the most professional means to get maximum profit with limited (and pre-planned) risk level.
The concept of an option and its basic characteristics
An option is a derivative financial instrument that gives the buyer the right, but not the obligation to buy (for the call option) or to sell (for the option put) the underlying asset specified by him at a certain price (strike) and in due time or during this period in exchange for awards. In this case, the option seller undertakes to deliver the underlying asset at the agreed price to the buyer in the event of such a request at any time within the specified period. In the event that the buyer requests that the underlying asset be placed, the purchase and sale transaction of the underlying asset is recorded at a price equal to the strike price of the option, that is, the strike price of the option.
The idea and essence of the option can be easily explained with an example. Suppose you decide to buy a house and have already looked after a nice place. The seller voiced a price of 200 thousand dollars, however, at the moment you do not have enough money to buy it and they will appear only after 3 months. In such a situation, you could agree with the seller that you will have the right to buy this house for 3 months, all for the same price of 200 thousand dollars, and for such a right you would pay him 3 thousand dollars a month. Such a contract will be called an option.
What benefits can the conclusion of such an agreement bring? For example, we propose to consider two options:
- Quite by chance it turned out that Elvis Presley was born and grew up in this house! And, as a result, the market value of this house jumped sharply from 200 thousand to 800 thousand dollars. Under the terms of the contract, the seller must give up the house for the promised $ 200,000. In this case, you can make a profit of $ 597,000 ($ 800,000 $ 200,000 $ 3,000).
- You have decided to inspect the home and come to a meeting with the seller. To your great regret, the house turned out to be absolutely unsuitable for life: a poltergeist is operating in the kitchen, and the body of the previous owner is still hanging in the bedroom. Now it has become absolutely clear to you that you will not live in such a house. And since you did not have time to buy this damned real estate, but only bought an option, you can easily refuse the transaction. Yes, you paid 3 thousand for an option, but saved 200 thousand without buying a deliberately illiquid product.
An important point is also the fact that, unlike a stock, an option can be sold without it. This is similar to the release of a new insurance policy by an insurance company. It is necessary to distinguish the sale of the existing (“sell”) and the sale of a new option (“write”). In this case, the seller has a negative number of options in his portfolio, and this is called the SHORT position. The option seller in the SHORT position undertakes to make the option realization on the expiration day (contract close), as opposed to the buyer, who acquires the right to exercise the option at an agreed price.
There are some more option classifiers. The options for which the underlying asset is actually transferred on the day of expiration are called delivery options (for example, options for UX futures). For options without delivery on the day of expiration, only cash recalculation occurs (for example, options for the TA25 index of the Tel Aviv Stock Exchange).
Advantages and disadvantages of trading options
One of the most important advantages of options is the possibility of a fairly accurate mathematical description of their behavior. This allows traders to effectively analyze options positions and create highly profitable trading strategies.
Benefits of options trading:
- The cost of options is much lower than the cost of the underlying asset.
- The risk is limited to the price of the option, while the profit potential is not limited.
- Options allow investors to protect their positions from price fluctuations.
- When purchasing / selling options, there is a large selection of contracts with various expiration dates and strike prices.
- The investor has the ability to use a huge number of option strategies.
Among the disadvantages of options trading, one can only highlight the high requirements for the skills and knowledge of the trader. As we already mentioned, this tool is one of the most difficult in the financial markets. However, to those traders who could master the basics of options trading, they are able to bring a great advantage and, of course, profit.
Types of options
Options are traditionally divided into two main types: the Call option and the Put option.
Call option is called a buy option or a buyer’s option. Such a contract gives the buyer the right to buy the asset at a certain price for a certain period of time. The seller sells the asset and the buyer gets the opportunity to buy it. This is reminiscent of a long stock position: the buyer of the call hopes that before the expiration of the option the value of the shares will noticeably increase in order to make a profit on the difference in rates.
Put option is an option to sell. A put gives the holder the right to sell an asset at a specific price for a specific period of time. A put is like a short position: in this case, the buyer hopes that the stock price will fall before the expiration of the option. The peculiarity of this derivative is that in it one side gets the opportunity to execute the deal, and the other side is obliged to execute the deal. For this the second side and pay a premium.
It was decided to pay special attention to the phenomenon of “binary option”. It is a highly risky tool and is among the leaders in terms of frequency of fraud, along with cryptocurrencies and Forex trading.
What is a binary option? The buyer of such a derivative can predict the course of the underlying asset. Often, under such an asset are currencies, popular stocks or cryptocurrencies. If at the end of the option the price of the asset is higher than the expected level, the buyer receives a profit. Otherwise he loses his money.
Such a “trade” is akin to playing on a tote or roulette. In addition to the 50% chance of losing money, the client also pays commissions, fines, subscription services and additional costs when withdrawing funds. Thus, initially the trader is in a disadvantageous position for himself and can only complain about fortune.
Widespread advertising of this method of trading, the prevalence, availability and ease of entry into the trade for non-professional brokers made the “binaries” a trap. A lot of novice traders who do not wish to study the same stock market deeper begin to look for similar risky tools for quick and easy profit. However, to his great disappointment, only owners of so-called “brokerage companies” receive profits from such trades. In the end, the trader loses all the money that is deposited on the accounts of the owners of various trading platforms, traditionally offering not only options trading, but also trading on Forex and, more recently, cryptocurrency.
Note that the international financial community as a whole has a negative attitude towards such platforms and trading methods. For example, in Belgium and Israel have already banned trade in binary options, the United States, Canada and EU countries are publishing lists of companies that are fraudulent, warning citizens that these sites do not have a license to conduct such activities.
The option has long established itself as an excellent tool for trading and hedging. We firmly believe that any trader who knows well and who owns this derivative is able to work wonders in the market under any circumstances. Understanding this tool can help not only professional trades or investors, but also other people to apply its principles in personal financial matters.