What is an option?

In collaboration with Freedom24 – The aim of this article is to define the basic principles of options in the stock market, understand their operating mechanisms and understand their interests so that you can use them judiciously.

Let’s go step by step…

An option is a contract. This first part of the definition is crucial. It allows you to understand that an option is at the heart of an agreement between several parties under predefined conditions. This is the very principle of a contract, such as a car insurance contract, which binds the driver to the insurance company under precisely defined conditions to which both parties have expressly agreed: in this case, premiums and guarantees in the event of an accident.

Definitions and terms

In case we are interested here, a stock option is a contract that can be negotiated. This contract gives the buyer the right to buy or sell an asset at a predetermined price and time. It is necessary to specify that the buyer has this right, which he can exercise or not. This is a right, but not an obligation.

Still a bit unclear at this stage? A concrete example should clarify this definition!

The story of Alice, Bob and Delarose perfumery

Let us imagine two market participants, Alice and Bob. Alice is confident that the “Delarose” perfumery promotion will proceed within 30 days of the announcement in the local paper of the store expansion. But Alice doesn’t have enough capital to make full use of it, she wonders how she can make money from the increase in Delarose stock… Without having Delarose stock…

Bob holds Delarose shares, even holding a significant number (1,000) which the market values ​​at €30 each. But he is less optimistic than Alice about the valuation of his shares for the coming month. Bob actually thinks the road repairs in front of the store will make customers rarer and rarer.

Alice and Bob have different views on the short-term valuation of the perfumery, Alice owning no shares and Bob a respectable number. However, these two could be brought to an understanding… How? By making a contract!

Alice and Bob can actually agree by “signing” a contract whose terms are clearly defined:

    a) Alice pays Bob a sum of money (they agree on 160 euros).

    b) If Delarose’s shares gain 10% within 30 days, that is, if they touch or exceed 33 euros, then Bob will have to – will be obligated to – sell them to Alice for 30 euros per share.

    c) In case of any other change in the share price, Alice is not obliged to buy the shares from Bob.

In this case, Alice is the buyer of the call option. Bob is a shareholder in Delarose, which is the underlying asset of the option. The 160 euros that Alice paid Bob is a “bonus”. Finally, the price of 30 euros is what we call the strike price of the option.

A study of two scenarios

Let’s imagine that Alice and Bob signed such a contract.

In scenario 1, Alice had a hollow nose and the share price was 33 euros after 13 days, well before the 30-day deadline. Bob is therefore obliged to sell his shares to Alice at a price of 30 euros per unit. Alice earns €3 on each share (ie a nice capital gain of 10%) and therefore appropriates €3,000 as there are 1,000 shares on the table. A bonus of 160 euros must be deducted from this, paid unconditionally from the beginning. So Alice pockets 2,840 euros. Bob is forced to sell his shares at a price of 30 euros, even though they are worth 33. However, history does not say at what price Bob acquired the shares of the perfumery 3 years ago…

In the alternative scenario (scenario 2), DelaRose’s share price stagnates for about two weeks, slowly recovers, and then falls to 28.50 euros at the end of the 30 days specified in the contract. Alice was therefore clearly wrong in her predictions. He will not exercise his right to buy the shares, which are now trading at a price below 30 euros. Bob keeps his shares, which are certainly worth a little less, but keeps the bonus of 160 euros that Alice initially gave up. Insurance premium, the amount of which was calculated before signing the contract based on the balance of forces between supply and demand.

In the case that concerned us so far, it was a purchase option (so-called call). Note that there are put options on the contrary. These are used by a shareholder (a person who owns shares) to hedge his portfolio against an expected decline in the price of the underlying asset over a given period in exchange for a premium payment. He can then “sign” a contract with a non-shareholder who thinks for himself that the share price will rise.

In conclusion: the main thing to remember

Options are financial instruments that allow you, in the case of a call, to make a profit without holding the stock, or in the case of a put, to hedge your stock investment against a perceived decline and current rates within a given period. Time window. And in all cases after paying the insurance premium.

You can learn more about the basics of investing in shares at Freedom24, one of Europe’s leading investment platforms.

This content was created in partnership with Freedom24. The editors of BFM Bourse were not involved in the production of this content.

Leave a Comment