The integration of call options on stocks, particularly American ones, into a stock market portfolio is strategic. What is the principle and operating mechanism? And why is it relevant to use stock options for the purpose of diversification, risk management, and improvement of portfolio performance, in different market phases?
Understanding the options
It must be understood that the originality of the option consists of its nature as a contract. As in any contract, the option is at the center of an agreement between several parties, under conditions defined in advance. This contract can be negotiated under predetermined price and time conditions; it gives its purchaser the right to buy or sell an asset. Conversely, the shareholder has, for his part, the obligation to sell the share to the buyer of the option at maturity in the event of exercise of the option. And this at its original price.
Members of the family of so-called derivative products, options are financial instruments which allow, in the case of a call, to be able to generate a profit without holding shares. In the case of a put, they can hedge the investment in shares against a supposed and momentary drop in prices within a given period. And this, in all cases, upon payment of a premium. Particularly flexible, based on price development scenarios, options can, when used judiciously, provide a hedge against risk, or even improve the overall return of a portfolio. Diversification and risk management Acquiring a call option is one of the possibilities offered to ensure a certain level of diversification in your portfolio, by exposing it to new horizons (a new asset class), without investing directly, and therefore without incurring the risk associated with direct investment.
Furthermore, another strategic use of options consists of setting up a hedge, by trading put options. This category of options is used by the shareholder to hedge his portfolio against an anticipated drop in the price of an underlying asset, within a given period, also subject to the payment of a premium. The tool is particularly suitable for the holder of a share wishing to temporarily protect his investment from an unfavorable change in prices or when a share is overbought in the eyes of its holder.
Using options to enhance returns
The relevant use of options in the portfolio not only allows one to protect oneself against a risk of a fall in one’s own shares, but also to be able, subject to the realization of a scenario and upon payment of a premium, to provide of the alpha in the portfolio, by benefiting from the rise of a stock.
Here is an example: by paying a premium of 160 euros, Alice decides to negotiate a call option on a company Y, whose shares trade at a price of 30 euros. The terms of the contract are as follows: if the stock gains 10% within 90 days, Alice will receive 1,000 shares at the original price of 30 euros. In fact, the other “signatory” of the contract, opposite, will then have the obligation to sell them to him for 30 euros. Alice will therefore automatically and immediately pocket 3 euros for each share (the capital gain of 3,000 euros), from which the bonus of 160 euros will have to be subtracted (0.16 euros per share). That is a total gain of 2,840 euros, without having needed to own the Y shares upstream. In the event that the scenario does not come true (invalidation of the scenario), the investor in the option only loses the premium, known in advance, in this case 160 euros.
Take advantage of market opportunities
Stock options can be used regardless of market conditions, choppy or calm, bullish, bearish or neutral. The option investor, who has market sentiment on an asset, chooses the option that suits him best from his broker’s “catalogue”. Its strategy must be consistent with the characteristics of the option (action, starting quote, premium amount, scenario and deadline). An investor, experienced in managing a stock portfolio, and who is new to the options market, then discovers a world of opportunities, which can be exploited whatever the mood on the stock markets.
Based on market scenarios, options also constitute valuable tools for observers and analysts, in the sense that the dynamics of their negotiation allows conclusions to be drawn on the market expectations of a majority of participants, the optionally. Their role in the functioning of financial markets is important, as a barometer of prevailing market sentiment.
In a word…
Stock options, and particularly US stock options, when used strategically, can play a central role in building and managing diversified portfolios, serving as a hedge , or by improving overall performance. Thanks to optimized risk management, in particular thanks to the amount of the premium known in advance, this product is part of the active investor’s toolbox.
You should know that not all brokers offer the possibility of trading options. And among those who offer it, the “catalogues” of options are very diverse. The Freedom24 trading platform (Freedom Holding Corp group listed on Nasdaq) offers a very rich range of more than 800,000 options on more than 2,500 American assets for $0.65 per contract.
This content was produced in partnership with Freedom24. The BFM Bourse editorial staff did not participate in the production of this content.