Options are financial derivatives, that give the holders the right, but not the obligation to buy or sell the underlying asset at an agreed-upon price, known as strike price, at a specified expiration date. They play a pivotal role in financial markets, offering investors various strategies for managing risk, generating income, and speculating on asset price movements.
Two types of options can be distinguished, for which there is a buyer and a seller position:
· Long (buy) call: the holder has the right, but not the obligation, to buy a specific underlying at an agreed-upon price and date.
· Short (write) call: the holder has the obligation to sell or deliver the underlying asset.
· Long (buy) put: the holder has the right, but not the obligation, to sell a specific underlying at an agreed-upon price and date.
· Short (write) put: the holder has the obligation to buy the underlying asset.
At the same time, there are three concepts to determine the value of an option:
· In the money (ITM): An option is ITM if it possesses intrinsic value, that means, there is an opportunity to profit due to the relationship between strike price and market price. For example, a call option is ITM if the strike price (the agreed price) of the underlying is below the market price, since the holder can buy the asset for less money than its current value. A put option is ITM if the strike price is above the current market price since the holder can sell the underlying asset for a higher price.
· Out of the money (OTM): As opposed to ITM, an option is OTM if it does not possess intrinsic value. For call options, it would be a case where the agreed price of the underlying is above its market price. Under this scenario, it is less likely the option will be exercised. A put option is OTM if the strike price of the asset is below its market value.
· At the money (ATM): A call or put option is said to be ATM when the strike price of the underlying asset is equal to its market price, so the holder is indifferent whether to exercise the option or not.
Normally in the financial markets, three types of options are available, depending on their exercise restrictions. Firstly, there are American options, the most widely known and used. These options allow the holder to exercise the call or put before the option’s expiration date. Secondly, there are European options, which can be exercised only on the expiration date. Finally, there are Bermudan options, where the holder can exercise the option at specific dates before expiration, so these options can be seen as something in the middle between American and European options.
The risk of options can be assessed through “The Greeks”, because individual risks have been assigned Greek letter names. The most common Greeks include:
· Delta: Sensitivity in option’s price to changes in the underlying’s price.
· Gamma: Sensitivity in option’s delta to changes in underlying’s price.
· Theta: Sensitivity in option’s price to the passage of time.
· Vega: Sensitivity in option’s price to changes in volatility.
· Rho: Sensitivity in option’s price to changes in interest rates.
The main uses of options are for hedging (for example, a protection against a decline in the underlying’s price), for income (the premiums received in a seller position), and for speculation (whether an increase or decrease in the underlying’s value can be expected). Also, different strategies can be constructed using calls, puts, or both, with ‘covered call’ and ‘protective put’ among the most known strategies.
- Covered Call: In a covered call strategy, investors holding underlying assets sell call options against their positions. By doing so, they collect premiums from the option buyers while retaining ownership of the underlying assets. If the option is exercised, investors sell the underlying assets at the predetermined strike price, realizing additional profits beyond the premiums received. Covered call strategies are favored by investors seeking to enhance income from existing stock holdings while mitigating downside risk.
- Protective Put: The protective put strategy involves purchasing put options to hedge against potential losses in a stock position. Investors holding underlying assets buy put options with strike prices below the current market price, thereby limiting their downside risk. In the event of a market downturn, the value of the put options increases, offsetting losses incurred on the underlying assets. Protective put strategies offer downside protection without sacrificing the potential for gains, making them popular among risk-averse investors and those seeking to safeguard their portfolios against adverse market conditions.
In essence, options provide a diverse range of opportunities for investors to manage risk, generate income, and speculate on market movements. By incorporating options into their investment strategies, investors can tailor their approaches to suit their risk tolerance, financial objectives, and market outlook, ultimately optimizing portfolio performance and achieving their investment goals
