Options are securities bought and sold on the trading floor that make various investment strategies possible. They include terms that bind the buyers to the vendors.
Options are always transacted based on an underlying element. This underlying element can be shares, market indexes, bonds or other products negotiated on the markets. The company connected to the underlying element is not involved in negotiating the various option series; the stock markets assume this role. Generally, an option represents 100 units of the underlying element.
More specifically, an option has the following characteristics:
The stock market puts a series of options on company ABC into circulation. The call on ABC, which expires in December and has an exercise price of $10, is defined by the term "callabcdec10".
This option can by bought or sold in exchange for a cash amount. This is the premium.
The buyer of "callabcdec10" pays the premium to the vendor and hopes that the premium will have appreciated by the option maturity date (or before).
The vendor of "callabcdec10" receives the premium and hopes that it will lose value by the option maturity date (or before).
Description of the transaction:
The buyer purchased an initial call option (the term "opening position" is also often used).
The vendor has sold an initial put option (the expression "writing a call" is also used).
An initial call sale can be:
At any time, the buyer has the right to exercise the option and to buy the shares at $10 (in our example, the exercise price is $10) and then resell them at a higher price (there is no interest in exercising this option if the shares are not higher than $10). The option vendor has no other choice but to comply with the terms of the contract and sell the shares at $10. If he or she does not hold them (uncovered selling position), he or she must buy them on the market at a higher price and take a loss. If the option vendor holds the shares (covered selling position), he or she needs only to deliver them in exchange for the stipulated price of $10 per share.
The buyer can sell his or her option before the maturity date to close his or her position. This is what is called a call liquidation sale (closure). If the share price has increased, the option price will increase as well, providing the possibility of profit.
The vendor can buy back the call before the end of the term to close his or her position. This is what is called a call closure purchase. If the share price drops, the option price does as well, providing the possibility of profit.
The buyer and/or vendor can allow the option to expire. At that time, the buyer loses the amount corresponding the premium initially paid, while for the vendor this amount is transformed into a profit.
The level of risk attached to the options varies depending on the strategy used. There is a significant lever effect present in the negotiation of options.
The option is only valid for a limited time, and the value of the option can therefore drop very quickly.
The losses for the buyer are limited to the premium paid. On the other end, the vendor of an uncovered call exposes himself or herself to an unlimited theoretical loss.
On the other hand, profits can be modest or multiplied based on the strategy used.
Options are both complex and risky for the novice investor. They are for investors with very good knowledge of the markets. There is a very real risk of losing the entire investment and even more using this strategy. Used wisely, options can contribute to reducing certain risks and protecting a portfolio against market variables, or they can be used to speculate on price fluctuations. They can also allow investors to participate in the stock market for a relatively low cost and make considerable potential gains.
Options can be traded in a combined manner, in what is called a spread. A representative is needed to carry out this type of transaction.
A full report on the risks associated with options is available in the "Disclosure Document for Recognized Market Options". A copy of this document is included in our Welcome Kit that is sent out to all investors who open a LBDB options account. It is also available on our website.
More information on options is also available on the website of the Montreal Exchange.