An exchange option is a contract giving the right to buy or sell a specific asset. Options can be purchased or sold in derivatives markets. Its main difference from this kind of securities is the absence of an obligation to buy or sell an asset after the expiration of the contract. Do not confuse a stock option with a binary one. The binary option is in the nature of a bet, where the main task for the trader is to guess the direction of the market in a certain period of time.
What is an option in simple words, with which it can be compared
The easiest way is to explain what stock options are, what they are and how to make money with them, using a concrete example taken from real life. For example, someone, say, Yura sells a house (asset) for 1 million rubles, and Vasya wants to buy this house from him, but Vasya will only have the necessary amount in six months. Vasya agrees with Yura that he will wait and hold the house, and leaves a deposit of 100 thousand rubles as a deposit.
But after 4 months, it turns out that Vasya cannot pay 1 million rubles for the house or has changed his mind about buying it. At the same time, for six months, the market price of the house rose to 1.1 million rubles. And Vasya, in order not to lose the deposit, decides to give up his right to buy a house for 1 million rubles to Petya, who has the necessary amount or will be by the due date. Vasya takes 50 thousand rubles for the transfer of the house (asset) at a price lower than the market price from Petit.
As a result: Petya will buy a house at a price lower than the market, Yura will quickly sell the house and get 1 million rubles, and Vasya will regain the deposit and from above another 50 thousand rubles from the transaction. If Vasya did not resell the right to buy a house (asset) at a fixed price, then he would have lost the deposit, and so he made good money. If Vasya hadn’t agreed with Yura, then Petya could not have bought a house for 1 million rubles at the time of purchase, since his market price was 1.1 million rubles. At the same time, Yura risked no less. If the price of the house fell to 900 thousand rubles, he would not be able to help out the desired amount or could not sell it at all. At the same time, Vasya did not sell Pete a house, but the right (option) to purchase it at a bargain price.
Although the above example has nothing to do with the exchange and trading on the exchange, it does show how the buyer of the option and how he earns income. Buying or selling an asset at a pre-agreed price makes it possible to reduce the risk of loss from random market fluctuations in prices. Real estate prices, especially in Russia, do not change so quickly (and even in two directions), as in the above example. However, sharp changes, ups and downs are commonplace in financial markets. Participants in the stock or foreign exchange market never know exactly what price will be on a particular asset in a week or a month.
Types of Exchange Options
Usually they are divided into two types: an asset purchase contract (call) and an asset sale contract (put). The choice of buying a particular option depends on the situation on the market and the possible reward (loss) for the risk taken.
Call options
They are used when the investor, during trading on the stock exchange, is afraid of a sharp price increase and wants to fix profit at a certain level for a certain period of time (day, month, year). To do this, he acquires a contract that the asset will be purchased at a fixed price, and makes a deposit (premium). Even if the price jumps, the investor will not lose anything, since he will be able to buy the asset at a negotiated price, and not at a market price. If the price falls, then he may simply not implement the contract, but rather buy assets that have fallen in price, losing only the collateral or not buying them at all.
Put options
Such options are used when the investor wants to hedge against a price drop. The principle of risk insurance is the same as for call options, the only difference is that a put option is acquired in order to reduce losses in the event of a price drop.
There are also several different derivatives that are called options: binary, Asian, barrier, etc. They essentially represent a completely different type of financial instrument, which is why this article is not considered, since operations with them are gambling. Such options do not fulfill the main function for which exchange options were created - insurance.
Where do they trade
Stock trading in options is the purchase of objects with a limited period of use and their sale for a limited period of time. Therefore, they are sold and bought in derivatives markets. That is, they are traded on separate sites using software specially developed for such financial transactions.
At the point of sale, the contracts are divided into exchange and over-the-counter options, the latter can be purchased or sold on the Internet or through personal contact. For example, when transferring an asset to trust with subsequent sale or exchange for another asset. Modern means of communication allow trading on independent sites on the Internet. The OTC options market is highly developed in the USA. According to some reports, over-the-counter trade volumes there reach 60% of the total volume. The popularity of this trading method is due to the fact that there are no or very low transaction fees on over-the-counter platforms. In Russia, options can be traded on the Moscow Exchange. Exchange options are sold and bought on the Russian exchange using the specially developed FORT system.
How can I get the benefit
The benefits of financial transactions with stock options can be obtained by selling them at competitive prices in the derivatives market. The speculator should take into account that the option is a perishable product, if it does not sell it on time, it will lose all invested funds, and if the market situation unfolds unfavorably and the price starts to fall, but if the trader manages to sell the contract, he will be able to return only part of the funds.
Investors use the option as insurance, and speculators as the object for subsequent resale. The option is also quoted on the stock exchange and has its price, which changes under the influence of supply and demand. Due to these market fluctuations, the speculator can make a profit.
Who is the main buyer of options
Options are used by investors, companies engaged in international trade (when buying / selling foreign currency), speculators. Investors and companies are the main buyers of options. They buy them in order to minimize losses from accidental fluctuations on assets acquired or sold. For example, an Italian company supplies furniture to the United States. To protect herself from accidental currency fluctuations, she buys a contract to sell $ 1 million per euro four months later at a certain rate, for example, on the date the contract is drawn up. If she does not, then she risks losing part of her cash proceeds in euros if the price of the euro rises during this time.
Key Options Trading Strategies
Various options are used to trade options. Usually, the ready-made one, developed by other people, is taken as the basis and, after some changes, is used. The following are a few stock options trading strategies.
The strategies are taken from the training book “Options Trading” by M. Tommerset. Novice investors and traders can take advantage of them, but they must remember that the above examples may not suit them due to individual characteristics, such as risk appetite, temperament, level of intelligence, etc.
- Vertical spread. The bottom line is to use harmonic fluctuations in changes in the prices of the underlying asset. The price, one way or another, constantly moves around a certain value and periodically returns to its previous level. The main thing when applying such a strategy is to correctly calculate the time range.
- Bull Spread. This is a fairly simple strategy. An investor buys a call option on a growing asset and sells it after a certain period. Profit is formed due to the difference between the purchase price of an asset and its sale.
- Bear spread. An investor buys a put option in a falling market. The lower the stock price falls, the higher the price of the stock option.
- Box Spread The bottom line is buying call and put options on the same asset. Such a strategy is considered to be a win-win, since no matter what direction the price of the underlying asset goes, the profit from the sale of a winning option will more than cover the loss from a win-win.
- Calendar (temporary) spread. An investor buys options with different validity periods for the same asset. If the first contract by the current moment turns out to be win-win, then perhaps the next one will turn out to be winning, as sooner or later the price will turn in the other direction.
As can be seen from the above strategies, in their work, traders take into account factors such as time (period), price of the underlying asset, the purchase price of the option and their changes.
How to determine the benefits
The benefit from the exercise of exchange options is determined by two parameters - the ratio of the purchase price to the sale price, or by what benefit (savings) the purchase or sale of an asset brings under the contract, and not at the market price. In the first case, the trader benefits from the sale of the option at a price higher than the purchase price, the second benefit can be obtained by taking profit (loss) at a certain level or by buying an asset at a price below the market or selling at a price above the market.
Example
The investor acquired 1000 shares of PJSC "..." at a price of 120 rubles apiece, and a month later the shares were quoted at 140 rubles apiece. He wanted just in case to be safe and take profit. For this, he acquired a contract for 12 thousand rubles, according to which he will be able to sell shares at this price in 2 years. If the price drops, he will not lose his 20 rubles profit, since he has a contract. If the price rises, he will be able to sell the shares at a better price, since he is not obliged to fulfill the terms of the contract. In this case, he will lose only the contract fee - 12 thousand rubles.
Consequences of Contract Failure
Exchange options is an effective financial instrument that helps to save profits from sharp fluctuations in the market. If the investor does not use this tool, then he risks losing his pants if the market changes direction. Moreover, if he, using the exchange option, does not apply it, that is, does not acquire the underlying asset in accordance with the contract, he risks losing only the pledge left and no more.
The advantages of an option as a financial instrument
The main advantage of using stock options is minimization of risk. In fact, trading with an option creates a condition for virtually risk-free exchange trading, since losses are strictly fixed. However, traders who do not know how to make money on stock options by making speculative operations can lose money on them. An incorrect assessment of the direction of the market and the frequent loss of collateral (premium) can, in the end, ruin the investor. This means that he should not hope that the option will replace market analysis.
In order to trade options successfully and make profit from such trading, the trader will have to monitor two markets at once: the change in the price of the underlying asset and the change in the price of the option in order to sell it in time, thereby minimizing the possible loss on the transaction. And if for an investor an option is an effective way to reduce risk, for an exchange speculator it is a very complex financial instrument with a high percentage of profitability.