Options – CII CF2, R02, J10, AF4 Exams
Sometimes it doesn’t matter how often a subject comes up in the exam manuals it still doesn’t always help us really understand a topic. It seems that derivatives are one of those subjects, so this article has been written to try and simplify things – starting with options.
Options are generally thought of as complex and risky and most individual investors would avoid them like the plague. The truth of it is that options can be highly speculative or actually quite conservative – it depends on what they’re being used for. Options are used to not only hedge other investments; they’re also used as insurance to offset losses.
Options are contracts which give you the right to buy or sell shares (or something else…) by a specified date for a specified price. You don’t own the shares – just the right to buy or sell them. The point of the option is that the price is fixed so no matter how much movement in the share price occurs, you have fixed that price.
- The call option gives you the right to buy shares.
- The put option gives you the right to sell shares.
For both options you have to pay a price (the premium) and this will depend on how attractive the offer is. If the fixed share price offer is good, then the price to enter into the contract will be higher.
If you buy a call option (the right to buy at a fixed price) and that share price goes up, then the option becomes more valuable (the value of the option has a direct relationship to the value of the share). You can then sell the option for more money than the original purchase price. Alternatively you can exercise the option and buy the shares at below market value.
If you buy a put option you are hoping that the share price will fall, because if that happens, the option becomes more valuable. You could then sell the put and take the profit or exercise the option and sell the shares at the fixed price which is higher than the current market value.
All decisions have to be made by the time the option expires.
Calls and puts are basically opposites, because an investor in each of them has the opposite belief in the future share price movement.
Fund managers will often buy put options on a stockmarket index to hedge their portfolio. If the stockmarket falls then the profit on the put will offset the losses on the shares.
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