An option

is a contract traded on the market (exchange) where one party (the buyer) acquires the right while the other party (the seller) undertakes the liability to sell or buy a certain asset (equities, goods etc.) in the future at a previously fixed price. For the right thus acquired the buyer pays the seller a "premium" consisting of a part of the asset value.

Options in NORVIK BANKA

NORVIK BANKA gives clients the opportunity to operate with the full range of options on US exchanges as well as with options on currency rates, interest rates, and stock market indices. An option is a derivative, that is, its value is proportional to the value of another financial asset on which this option is based: equity, currency, exchange index etc.

Key characteristics of options:

  • Underlying asset
  • Option type (call/put)
  • Strike price
  • Maturity date
  • Premium (price)
  • Number of shares in a contract

There are two main types of options:

Call Options

A call option gives its buyer the right to buy one or another asset at a previously fixed price in the future. Call options are an attractive alternative to the purchase of equities thanks to a number of features. A call option allows the investor:

  • complete participating in profit of growth of the active´s price lying in its basis, for example shares, but not to bear losses in the event of its falling. So the possible profit of the investor is not limited, and the risk of losses is limited by cost of the option, which consists of a few percent of the active´s cost;
  • take a full part in the profit from a growing price for the underlying asset, e.g. equity, but be saved from losses in case of a price drop. Thus the investor´s potential gain is not limited while the risk of losses is restricted by the option´s own value that only consists of a few percent of the asset value;
  • a call option is an economical way of increasing the profitability of investment capital many times over. The value of the option, and therefore also the amount deposited by the investor, is so small compared to the potential gain that the profitability rate may reach several hundred percent;
  • since the investor’s risk is limited by a small and previously known amount, the call option allows participation in a game with more risky and therefore also more profitable assets (currencies, market indices etc.)

Operations with options for index equities allows investment in world markets and economic sectors, limiting the risk of loss to few percent of the investment portfolio.

Call options give the buyer the right, but do not impose the duty, to buy an asset (for example, equities) underlying the option at previously fixed price within a specified period of time in the future. That is why the price of the call option increases in direct proportion to the price of the underlying asset.

Example: Instead of buying 100 shares of company Х with the current market price 50 dollars per share and thus having paid for them, accordingly, 5 000 dollars, the investor acquires the call option on Х shares (one option usually applies to 100 shares) with one year time to expiration and the exercise price of, say, the same 50 dollars. Upon acquisition of the option now the investor only pays 200 dollars (2 dollars per share). The acquired option gives the investor the right at any time within the next year to acquire 100 shares Х at 50 dollars per share regardless of their market price. Indeed, if until the expiration of the option the market price of Х shares will not change or will decrease, the option will cost nothing (why buy shares for 50 dollars when they are cheaper on the market) and the investor’s loss will amount to 200 dollars, no matter how low the price of the shares would drop. However, if the share price rises, then the option value will be the whole difference between the market price of the shares and the price of execution of the option, and this will be the investor’s profit. If the price of Х shares grows, say, up to 60 dollars per share, then the option will cost about 1 000 dollars (10 dollars per share), which means that the profit will be fivefold. It is clear that if the investor acquired the shares and not the options, his profit would only be 20% if the price of X shares grew from 50 to 60 dollars.

Put Options

A put option gives its buyer the right to sell one or another asset at a previously fixed price in the future. Put options enable speculating for a fall in the market or in particular equities as well as securing (hedging) own investments against drop in market prices. A put option gives the owner the right, but does not impose the duty, to sell an asset (for example, a equity) underlying the option at a previously fixed price in the future. The operation technique when speculating with put options is the same as in a call option wager, but here it is aimed at a decline in the equity price.

Example: An investor acquires 100 shares of company Х at 100 dollars per share, thus having paid for them, accordingly, 10 000 dollars. In addition, the investor acquires a put option on Х shares (one option usually applies to 100 shares) with half a year to expiration and the same 100 dollars exercise price. The investor pays 200 dollars for the option (2 dollars per share). The acquired option gives the investor the right at any time within the next half year to sell 100 Х-shares at 100 dollars per share independently of their market price. If until expiration of the option the share price will decrease, say, tо 80 dollars, the put option will cost about 2 000 dollars (20 dollars per share), which compensates the investor for his loss on the shares being also the same 2 000 dollars and thus he will lose nothing. As evident from this example, having paid 2% from the total investment amount the investor excluded the risk of loss, that is, secured himself absolutely. If the share price grows, say, up to 120 dollars per share, the profit from the shares will be USD 2 000 while the option itself will cost nothing. Remember that earlier the investor paid 200 dollars for the option and therefore the total profit from his strategy (shares + option) will amount to 1 800 dollars or 18%. The investor paid 2% for protection against losses.

Hedging

It is especially interestingly when a put option is acquired for protection (hedging) of portfolios in case the shares therein will fall in price. In this case investors can operate following a practically failsafe strategy: create an investment portfolio with unlimited income in the event of growing shares in the portfolio and not participate in potential losses in the event of declining shares, since they will be compensated in full by the profit from increasing prices of the put options. In fact, using the protection by means of the put option the investor takes a full part in the gains while his maximum losses are restricted to a few percent (the value of the option).

More in Details on Hedging

In view of the certain similarity of investment features you may be also interested in opportunities to deal with future contracts or CFD.