In partnership with Freedom24 – The aim of this article is to define the fundamental principles of a stock market option, to understand their operating mechanisms, and to understand their interests in order to be able to use them judiciously.
Let’s go step by step…
An option is a contract. This first part of the definition is essential. It makes it possible to understand that the option is at the center of an agreement between several parties, under conditions defined in advance. This is the very principle of the contract, like a car insurance contract, which links a driver with an insurance company, under well-defined conditions, to which both parties have expressly agreed: in this case, the insurance premium and guarantees in the event of an accident.
Definitions and concepts
In the case that interests us here, the stock market option is therefore a contract, which can be negotiated. This contract gives its buyer the right to buy or sell an asset under predetermined price and time conditions. It is essential to specify that the buyer has this right, which he can exercise or not. This is a right but not an obligation.
Is it still a bit unclear at this point? A concrete example should make this definition clear!
The story of Alice, Bob and the Delarose perfumery
Let’s imagine two participants in the market, Alice and Bob. Alice is convinced that the action of the “Delarose” perfumery will progress in the 30 days since the announcement in the local newspaper of the expansion of the store. But Alice does not have sufficient capital to be able to take full advantage of it, she wonders how she can make money from an increase in Delarose shares… Without having Delarose shares…
For his part, Bob holds Delarose shares, he even holds a significant number (1,000), which the market values at 30 euros each. But he is less optimistic than Alice about the valuation of his shares for the coming month. Bob actually thinks that, due to the road repair work in front of the store, customers will become increasingly rare.
Alice and Bob have divergent opinions on the short-term valuation of perfumery, Alice owns no shares, and Bob a respectable number. However, these two could be brought to an understanding… How? By concluding a contract!
Alice and Bob can in fact come to an agreement, by “signing” a contract whose terms are clearly defined:
a) Alice pays Bob a sum of money (they agree on 160 euros).
b) If the Delarose share gains 10% within 30 days, that is to say if it touches or exceeds 33 euros, then Bob will have to – he will have the obligation – sell them to Alice at 30 euros l ‘action.
c) For any other change in the stock price, Alice is not obligated to buy the shares from Bob.
In the case presented here, Alice is the buyer of a call option. Bob is a shareholder in Delarose, which is the underlying asset of the option. The 160 euros paid by Alice to Bob constitute the “bonus”. Finally, the price of 30 euros is what we call the exercise price of the option, or strike.
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 therefore has the obligation to sell his shares to Alice, at a price of 30 euros per unit. Alice makes a profit of 3 euros on each share (i.e. a nice capital gain of 10%), and therefore pockets 3,000 euros, since 1,000 shares are on the table. From which must be subtracted the bonus of 160 euros, paid unconditionally from the start. Alice therefore pockets 2,840 euros. Bob, for his part, is forced to sell his shares at a price of 30 euros, even though they are worth 33. But history does not tell at what price Bob had acquired, 3 years ago, the shares of the perfumery…
In the alternative scenario (scenario 2), the DelaRose share price stagnates for around two weeks, recovers slowly then drops to reach 28.50 euros at the end of the 30 days specified in the contract. Alice was therefore clearly wrong in her predictions. She will not exercise her right to purchase the shares, which are now trading at a price of less than 30 euros. Bob, for his part, keeps his shares, which are certainly worth a little less, but pockets the bonus of 160 euros, which Alice initially gave up. Premium whose amount was calculated before signing the contract based on the balance of power between supply and demand.
In the case that has concerned us so far, it was a purchase option (called a call). Note that there are, conversely, put options. These are used by the shareholder (the person owning the shares) to hedge his portfolio against an anticipated drop in the price of an underlying asset, within a given period, in exchange for the payment of a premium. He can then “sign” a contract with a non-shareholder who thinks for his part that the share price will progress.
In conclusion: the main thing to remember
Options are financial tools which allow, in the case of a call, to be able to make a profit without holding shares, or in the case of a put, to hedge your investment in shares against a supposed decline. and momentary courses within a given time frame. And this, in all cases, upon payment of a premium.
You can learn more about the fundamentals of stock investing with Freedom24, one of Europe’s leading investment platforms.
This content was produced in partnership with Freedom24. The BFM Bourse editorial staff did not participate in the production of this content.