Introduction to Options
Part 1
Options are financial derivatives that give the investor right but not the obligation to buy the stock or any other instrument at a given strike price. The option is priced based on Binomial, Black Scholes or Monte Carlo simulation methods. However, the price might differ from the market due to volatility and liquidity. The most traded types of options are European and American. European options can not be exercised early if the stock price is above the strike in terms of a call option. However, American options can be exercised early if it is in the money. The exercise of in-the-money options is done only if investors seek to benefit from dividend payout otherwise without a dividend-paying stock early exercise and premium for European and American options should be the same. Derivatives products are mainly used for two reasons either Hedging or speculating on price movement. However, the return will be higher than buying the instrument such as the stock itself due to the leverage.
The two basic types of options are
Call option:
A right to buy stock or any other financial instrument at a given strike. The cost of the option will depend on Volatility, Time and closeness to the current stock price. If the stock price is above the strike price the investor will make money and theoretically unlimited amount.
Eg: Mr A. have $1000 and wishes to invest in the stock market with his research suggesting an uptrend in the stock of Apple “AAPL”. The stock is currently trading at 125 and based on Mr A research the stock will go up nearly 10%. He can either invest in stock by buying 8 stocks and make $100 in profit if the stock goes according to his prediction of 10%. However, the option price of AAPL at 125 strikes expiring in September is $5. if he buys 100 contracts (10*100)=$1000, he can buy 100 shares worth of call options or 1 contract (each contract represents 100 shares). If Mr A buys 1 contract and if the stock goes up by ((125*1.1*100)–(1000+125000))=$250 The Investor will make $250 in profit vs $100 if invested in options because of leverage. On the downsize if Apple’s stock goes to $0 the Stock owner will lose the $1000 invested whereas the option investor would have lost only the premium paid.
Put option:
A put option gives the right but not the obligation to buy a stock if the stock is below the strike price. The profit will be limited and is max when the stock hit $0. This strategy is used mostly for hedging and speculating. Especially buying a put option would save you from a massive loss from a short squeeze. However, stock shorting is cheaper and does not expire like an option. let's use the example of Apple (AAPL). Now the investor is looking at a fall in the stock price. He buys at the money option at $10 per one option the contract cost $1000 for the strike price at $125. The stock price is trading at 125 which makes the breakeven at (125–10=115) so the stock needs to close at 115 for an investor to break even and fall further to make money. The graph will show the pay off like this at expiry and the max return would be $11,499.90 at expiry if Apple goes to 0.
