How financial options work

At present, investors have a wide variety of derivative products, which allow investments to adapt to the needs of buyers and sellers. With the derivative products we have the possibility of negotiating on a product, but without negotiating the product directly. For example, it allows us to buy one share in a year, at a previously determined price. One of the main derivatives are the options, so in this article of .com we will explain how the financial options work.

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What is a financial option

An option is a type of contract between two parties, which awards the buyer the right, but not the obligation, to buy or sell a certain financial asset (which is called an underlying asset ) at a previously agreed price, within a certain period of time. . It is important to highlight that whoever owns the option acquires the possibility of exercising their right to purchase or sale in the future, but does not have to exercise it if it does not suit them.

Let's take a simple numerical example to help us:

An action currently has a price of € 10 in the market, but we do not know what price it will have within a year. We have the opportunity to acquire an option that allows us to buy such stock within a year at € 11. This option has a price that we have to pay, called premium, which in this case is € 1.

A year later the stock has risen, costing € 14 in the market. However, we acquired an option that cost € 1, and allows us to buy the same action at € 11 now. So we decided to use the right granted by the option. This means that, with a total investment of € 12, we are buying an action worth € 14, with the consequent benefit.

If the stock instead of going up, had fallen in price, we simply would not have used the right option and we would have lost the € 1 we paid for the premium.

Parts of a financial option

There are some parts of the financial options that should be clarified when talking about them, since they have unconventional names and can be a bit messy:

- Premium: it is the price that we pay to acquire the option.

- Underlying asset: it is the asset that is subject to purchase and sale, and on which the option is negotiated:

  • Call option : option that allows you to buy an underlying asset in the future.
  • Put option : option that allows you to sell underlying assets in the future.

Characteristics of financial options

The options have very unique characteristics, which we can not find in a market other than financial derivatives:

  • They allow us to assume safe positions, which protect us from the uncertainty that characterizes the financial markets.
  • They give us the possibility of obtaining unlimited benefits, if the price of the underlying asset rises a lot of price and we have a purchase option, or a lot of price goes down and we have a put option.
  • In case the evolution of the price of the underlying asset is not what we expect, our losses will be limited, from just the premium paid for the option.
  • If we invest correctly, we can obtain benefits regardless of the evolution of the market, whether it goes up or down.