Options as protection against investment risk

Options are a type of investment contract. Thanks to them, you can spend the entire transaction even if your investment is not possible. At the same time, hedge against the risk.

An option is a contract – a financial derivative in which two parties agree that one of them has the first, but not the obligation, to buy (or sell) an asset from the other party, and the other party has an obligation to sell (or sell) the asset. to buy it) in the agreed moment for the price, which is agreed upon when concluding the contract. This definition corresponds to the so-called European option, the American is more complicated that the purchase (or sale) can be exchanged by the rightful party at any time during the agreed period. According to the term option, I will understand the European option.

The party that bought the option enters the so-called long position. The party that sold the option to someone (just by issuing it), on the other hand, enters the so-called short position. If an option of its holder corrects itself with the purchase of an asset, then it is called a call, if it is corrected for a sale, then it is called a put. Depending on whether it is a call option or a put option, and depending on whether we hold the option or listed it, we can have three types of positions: long call, long put, short call and short put.
The price at which the issuer sells the option is called the premium again.

The price at which the holder of an option first has to buy (or sell) an asset is called the strike price. This asset is called the underlying asset. I can use practically anything from stocks, mn, commodities and other options. The point at which an option is exercised is called the expiration date.

The first option option is only suitable for its holder

In that case, the option is “in the money”. For a call option, this is the case if the current price of the underlying asset is the strike price on the expiration date. This can be shown on a simple example. Imagine that you bought an option for the first premium of 2 USD / barrel, which in the first place you buy one barrel of oil for 40 USD. If the oil price is $ 41 on the maturity date, then you will want to exercise this option. You can earn $ 1 by buying oil for an option for $ 40, but sell it for $ 41.

The total loss from this operation would be $ 1, because you had to go pay by changing the premium again. However, pay this in any case, and therefore if the price of the underlying asset is not the realized price, it is appropriate for you to insist on the exercise of the option.

The price, from which there would be a profit for the entire transaction, is also the realized price plus the direct premium. In our case, the price of oil would have to be not $ 42 per barrel. This point is to breakeven point. Note that if you hold a call option, it speculates on the rise in the price of the underlying asset. Your maximum loss is limited, but again in the right. In the worst case, let the option just fail.

If, on the other hand, you were the issuer of a call option, then it would be limited in your maximum profit, but your maximum loss would be unlimited. What the owner of the option, on the other hand, lost the writer and turned. As the issuer of the call option, you therefore speculate that the price of the underlying asset will be low at the maturity of the option.

For put options, unlike call options, their holder speculates that the prices of the underlying asset will be low at the time of expiration. If the price of the underlying asset was not the strike price, then the holder would not want to pay it in full and the option would be so-called “out of the money”. In the other case, of course, he would like to fill it, as we can see in the treasure. Let’s say you bought a put option that corrects you to sell one barrel of oil for $ 40, for another $ 2. If the price of oil at maturity is $ 39 per barrel, then you will insist on the full exercise of the option, because you can earn $ 1 by buying oil for $ 39 on the bargain market and selling it for $ 40 per barrel to the option issuer.

The total loss from this operation would be 1 USD, because you had to pay another premium to go. However, pay this in any case, and therefore if the price of the underlying asset is not the realized price, it is appropriate for all to insist on the exercise of the option. The price from which the entire transaction would be profitable is also the realized price minus the direct premium. In our case, the price of oil would have to be less than 38 USD per barrel. As with a long call position, your maximum loss is limited in the premium. As it would be if your position was a short put, be sure to complete it yourself.

And so far we have assumed that the option will be drained and expires. But of course it doesn’t have to be. Today, options are still traded on stock exchanges, e.g. on tv Chicago. The options are standardized there and very liquid. Therefore, you can issue not only due to changes in the price of the underlying asset in the positive direction, but also due to changes in the price of the option itself, which you can sell later. And from what does the price of the option or the premium come from? The level of option prices is a relatively complex issue on the border of mathematics and economics, but there are certainly easily explained contexts.

For example, the price of a call option is the same, the lower the realized price, because logically the profit from the exercise of the option is logically possible. For put opc salary, of course, the opposite. Also bad for fluctuations in the exchange rate of the underlying asset. The salary is yours, so is the money that the option gets into the state of money, and that is you and its price. A similar salary relationship for the period until the option expires.

An example of how to use options to mitigate risks

Imagine that the company receives a payment for a finished order of more than 1 million EUR for a full year and the current exchange rate is 26 EUR / CZK. In this case, the company will receive 26 million CZK after the exchange of euros into Czech crowns. In that full year, however, the crown sent me and the company would sell. To hedge against the risk of falling with this case simply. Buy a put option for EUR 1 million e.g. for a rebate of EUR 60,000 with an realized price of EUR 26 / CZK payable for half a year.

If after half a year the exchange rate will be less than 26 EUR / CZK, then exercise the option and sell the euro for 26 EUR / CZK. You have avoided the loss courses, of course for the price of the premium again. If, on the other hand, the exchange rate is not 26 EUR / CZK, then let the option expire and exchange the euro on the foreign exchange market. You can even spend the entire transaction, not just hedge against the risk. And this is one of the benefits of opc, as opposed to futures or forwards. You can thus hedge against exchange rate risk, but you cannot afford to spend it on a favorable exchange rate movement. This strategy is called a protective put and is, of course, applicable to other underlying assets, not me.

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