My finances, my projects, my life
October 15, 2018

Investments: what is an option?

  Compiled by myLIFE team myINVEST August 30, 2018 237

You’ve almost certainly heard people talk about options in a financial context. But do you know what they are exactly? How do options work, and how you can make use of them? myLIFE is here to explain.

An option is a contract which, for the price of a premium, gives the buyer of the option the right – but not the obligation – to buy or sell a given quantity of an underlying asset (e.g. a share, index, currency or commodity) at a previously agreed price (known as the strike price) during a particular period or on a specified date.

Let’s look at a specific example that illustrates how an option works.

Imagine someone wants to buy a second-hand car that is for sale today, but they won’t have enough money for another two months. They go to the seller and negotiate a price (let’s say €5,000) and later due date for payment (in two months). They also pay a premium (let’s say €400) for right of first refusal on the car. We can now say that the buyer has taken out an option on the car, and has two possibilities:

  • either they buy the car for the agreed price of €5,000 by the end of the two-month time frame, in which case the seller is obliged to sell them the car;
  • or they decide not to buy the car, in which case they lose their €400 premium.

The principle of an option is the same. The investor takes out an option on an asset, and then decides whether to exercise this option depending on market conditions.

The advantage of an option is that it allows the investor to exercise their right to buy or sell if the market conditions are as they anticipated.

Two types of option, two different strategies

There are two types of option, each with a different approach:

  • a call option, which gives its holder the right to buy an underlying asset at a previously agreed price during a particular period or on a specified date; and
  • a put option, which gives its holder the right to sell an underlying asset at a previously agreed price during a particular period or on a specified date.

The advantage of an option is that it allows the investor to exercise their right to buy or sell if the market conditions are as they anticipated. When an investor buys a call option, they hope that the value of the underlying asset will go up, whereas when they buy a put option, they hope it will go down.

Examples:

Remember that in the previous example, the buyer had taken out a call option on the car by paying a premium of €400. If the car gains in value before the end of the agreed two-month period (e.g. it gets €1,000 worth of necessary maintenance), it will be in the buyer’s interest to exercise their option (i.e. buy the car at the agreed price of €5,000) because the car’s value has gone up.

Conversely, if the car’s value goes down (e.g. its condition worsens somehow), it will not be beneficial to the buyer to exercise their option.

Now let’s look at an example of how a put option works. Imagine that an investor owns shares in a company. They are worried that the value of these shares is going to fall, so they take out a put option enabling them to sell the shares at a strike price of €50 by a specified date (the maturity date). If the share price drops to €45 during the agreed period, it is in the investor’s interest to exercise their option to sell at the strike price. But if the share price increases to €55, they will have no reason to exercise their option because they would lose money by selling at less than market price.

A bit of jargon for you: being “in the money”

If it is in the investor’s interest to exercise their option (i.e. the price of the underlying asset is above the strike price for a call option and below it for a put option), we say the option is “in the money”. Conversely, if it is not in the investor’s interest to buy or sell the underlying asset, we say the option is “out of the money”. Lastly, if the strike price is the same or very close to the price of the underlying asset, we say the option is “at the money”

NB: options can be either American, which means they can be exercised at any time up to the maturity date, or European, which means they can only be exercised on the maturity date itself.

SUMMARY
Option-> contract
Call-> option to buy
Put-> option to sell
Underlying asset-> share, index, currency, commodity, etc.
Strike price-> price of the underlying asset (share, index, etc.) set in advance in the option contract
Maturity date-> date the option expires
Premium-> price of the option
In the money-> the investor will make a profit by exercising their option
Out of the money-> the investor will make a loss by exercising their option
At the money-> the price of the asset is equal to the strike price
American option-> the option can be exercised at any time up to the maturity date
European option-> the option can only be exercised on the maturity date

To sum up, an investor can take out a call or put option on underlying assets at a specified strike price and maturity date by paying a premium. The ultimate goal of all this is to be in the money. Still with us?

How is the price of an option determined?

The price of an option (i.e. the premium paid to acquire it) reveals the extent to which the option seller is offsetting risk. There are different risks to the option seller. With call options, they will either not sell the asset in the end, or will have to sell it for less than market price. With put options, they will either not buy the asset in the end, or will have to buy it for more than market price. In order to offset this risk, the option seller always demands a premium. The amount of this premium varies according to the type of option, the price volatility of the underlying asset, the interest rate applicable to the period in question and the following two values:

  • Intrinsic value: this is the profit that would be made if the option could be exercised at the time of purchase. In other words, it is the difference between the current price of the underlying asset and the strike price.
    Intrinsic value = price of underlying asset on day of option purchase – strike price
  • Time value: this reflects the potential for the option to gain value. The further away the maturity date, the higher the time value. The time value decreases as the maturity date approaches because there is less chance for the price to change.
    Time value = premium – intrinsic value

In short, call (or put) options are worth more: the lower (or higher) the strike price is, the further away the maturity date is, and the higher the anticipated volatility of the underlying asset is.

Do not confuse options with futures

It is important that you know the difference between options and futures. Options give the investor the right to buy or sell an underlying asset at a set price, but futures do not offer this choice. The investor who buys a future is committed to buying or selling the underlying asset at the previously agreed price, even if the market conditions are not favourable.

Finally, we should stress that the options described above are simple options. There is a wide range of more exotic options available, often with far more complex characteristics than the ones we have discussed. For experienced investors, it may make sense to combine several of these options. It’s not for myLIFE to delve into that kind of territory, so if you think this is something that might interest you, speak to an investment expert.

Finally, be aware that another product exists that works very much like an option: the warrant.