Financial options, buy and sell

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Among the different derivative financial products are Financial Options. The alternatives are contracts that are negotiated between buyers and sellers. They give their holders the opportunity (but not the obligation) to buy or trade securities at a fixed price in the future. Being able to exercise this contract and right is not free, since if it were, there would only be the opportunity to win or not lose. To buy this contract, you must pay what is called a "premium" to the seller. On the contrary, if you are a seller, you become a recipient of this premium.

Ya que las alternativas financieras requieren un mayor conocimiento de la economía y las finanzas, no son un producto fácil de comprender. Por ello, este post está destinado a aclarar el mecanismo de how they work and what it means to be a buyer or seller of a call or put option. Además los diferentes riesgos involucrados y los beneficios que aporta este método de inversión. ¡Espero que les be útil!

What is a financial alternative?

A financial option is a contract that is defined between two parties (buyer and seller) that give the buyer of the contract / option the right, but not the obligation, to buy (if he has taken a Call) or to trade (if he has taken a Put) at a predetermined future price of an asset. On the other hand, the seller of a contract / option has an obligation to trade or buy at the agreed price as long as the buyer wishes.

They are widely used as hedging strategies, since they act as a kind of "insurance". If investors believe that there may be sharp movements in the market, there is an opportunity to buy a financial option. Also as a possibility to benefit from sudden movements since the losses are limited and the gains are unlimited (I will talk about this later).

To exercise this right, the buyer always pays a premium to the seller. The seller of a financial option always receives the premium that the buyer has paid. From here, in other words, the contract is defined. What does this contract entail for each party? For this, let's see what two types of financial alternatives exist, Call and Put, and what it means to be a buyer or a seller in each case.

What is a purchase alternative?

In addition you can call a call Purchase option. It is a contract that It enables you to buy an asset in the future at an already established price. These financial options can have as underlying stocks, indices, commodities, fixed income ... There is a great variety. The similarities and differences between the purchase and sale alternatives lie in the fact that the purchase alternatives become purchase rights and sales rights. There is no obligation to buy at maturity (except for the seller). But to better understand the mechanism, let's see what it means to operate with them.

Buy a call

In a call option, the buyer can choose the price at which he would like to buy in the future. Obviously, we would all like to pay the less the better. This is why there is a premium (the price the contract is worth). If the price you want to buy at is below the current listing price, the premium will be expensive. And the lower the price, the more expensive the premium will be (generally proportional). Therefore, prices are usually set (and it is most normal) that they are very close to or above the list price. The further away you are, the more difficult it will be for the quote to reach you and, therefore, the cheaper the premium will be.

• A first example in case of losing. Suppose we want to buy an option in Company X that is trading at $ 20.50. We long to buy a Call option that expires in a month and we decided to choose $ 21 and pay a premium of $ 1. Later this month the stock has dropped a lot and is at $ 15. In this circumstance we decided not to buy at $ 21 (due to we're not stupid either). The losses? The premium we pay, $ 1. (The contracts are generally for 100 shares, so the premium is $ 1 for each share in the contract. If there are 100, the loss would be $ 100)
• A second example in case of winning. We have bought our Call at $ 1 in company X. As before, it is quoted at $ 20.50 and we have bought it with the right to buy them if we wish at $ 21 (the same happens). We see that the company continues to rise in price, finally at maturity it is at $ 24.20. what do we do? The right to buy is exercised for $ 21 and since the market is at $ 24.20, we earn $ 3.20 for each share purchased. Of course, that is not the final profit, the premium that was paid was $ 1, so I would really earn $ 2.20 per share. In this circumstance earnings can be unlimited.

Market a call

Being a seller of both a call option and a sale carries a much higher risk. Here losses are not limited, but can be unlimited. Unlike the buyer, the profit is limited, because what is earned is the premium.

Being a seller means being a beneficiary of a premium, and you have the obligation to market when the buyer wishes or suits him. If a call option is sold, the ideal case would be for the asset's price to be equal to or less than the price for which the put option was sold (and keep the full premium). The worst case scenario would be for the asset to go up a lot, so the higher it goes, the more the buyer would have to pay.

What is a sales alternative?

A Put can also be called put option. It is a contract that It enables you to trade an asset in the future at a price that has already been set. These assets can be like Calls, in other words, stocks, commodities, indices ... There is the same variety.

Unlike purchase alternatives, put option contracts indicate the price at which the asset can be traded in the future. In this circumstance, the premium to be paid, the higher it will be since we opt for a higher future price. On the contrary, the premium will decrease as the price indicated in the Put is lower. In conclusion, the reverse of the purchase alternatives, you have the right to market (but not the obligation) if you are a buyer. If you are a seller of a Put contract, there is an obligation. To understand it better, let's look at the difference between being a buyer or trading a financial put option.

Buy a put

Let's imagine that we are faced with the situation in which we consider that the market can go down a lot. We decided to buy a put option on the Ibex-35. The Ibex is at 8,150 points, and today, which is Monday, we decided to buy a Put option expiring at the weekend with the right to trade at 8,100, paying a premium of € 60.

You can pass two scenarios, that at expiration the price is above 8100 or below.

• If the price is higher than 8100. We do not exercise the right of sale, since at the same time we should sell cheaper than the market is at that time. We lose the premium, the € 60 and that's it. What It is the maximum loss in which we expose ourselves.
• If the price is less than 8100. In that case, we choose to exercise the right of sale at 8100. The profit is the difference between the 8100 and the price of the Ibex. If the price is 7850, you win € 250. Clean is € 190, since the premium costs € 60. Being a buyer of a Put leads to earnings can be as unlimited as the price goes down of the underlying asset.

Market a put

Being the seller of a put option means earning the premium up front. As a seller, you have the obligation to market at the agreed price if the buyer so wishes at maturity.

If the price of the asset has risen more than what appears in the contract, no problem, no one wants to exercise the right to trade cheaper when the asset is more expensive. In spite of everything, if the price of the asset has dropped a lot, the buyer can exercise the right to trade more expensively. You just have to remember the previous case. If a Put of the Ibex-35 had been sold at 8100 and closed the week at 7850, we would have to pay € 250. The danger here is that the Ibex (or whatever) can fall much more, so the loss for a Put seller (as for a Call seller) is unlimited.

What if you want to market the financial alternatives before maturity?

If you want to trade before expiration, you will earn the premium you are trading for today the financial option contract that we had purchased. If it is sold for a higher price (premium), it will be won, and if it is lower, it will be lost.

Premiums will fluctuate until the expiration of the contract, will depend on two factors:

1. As maturity approaches, premiums will decline in value. This is because the asset is less likely to undergo sudden price changes. A 2-day expiration is not the same as a multi-month expiration.
2. As the price goes up and down, premiums will go up or down in value. This will depend on whether we are talking about a buy or a put option. In the case of purchase alternatives, as the price of the asset increases, the premium also increases. In the case of Put, as the price of the asset falls, the premium increases. And vice versa for both, the premiums will go down for Calls as the asset price goes down, or in the case of Put's, the premium will go down as the asset price goes up.

Not all brokers or entities allow you to trade financial options in the same way always. It all depends on the counterparties they have, the way they operate and the assets that the alternatives represent. Equivalently, each asset is represented in a contract differently. Not all the points of the quotes have the same value, some the point is worth a lot and others very little. Make sure you know well the amount and the conditions for which you are investing!