Derivatives De-Mystified: Basic Options

Derivatives have been blamed for much of the world’s current financial woes, but what are derivatives?

Earlier this week, Bizzia’s Lela Davidson de-mystified financial leverage, a term that has been thrown around quite a bit lately. Today, I am going to follow her lead and begin to de-mystify another term that’s getting a lot of attention: derivatives.

Photo by aturkus, courtesy of flickr

Derivatives are financial contracts. Their value is determined by the value of the underlying asset specified in the contract. Derivatives have no value on their own.

There are several forms of derivatives, but the nature of each form is the same: two parties have differing opinions about the future price movement of the same underlying asset.

So as long as people disagree, there will always be a market for derivatives!

The most common forms of derivatives are options, futures, forwards and swaps. To keep from sending you into information overload on a Friday night, I will limit this post to de-mystifying options.

There are two types of options: calls and puts. The value of each depends on the market price of the underlying asset and the exercise price specified in your contract. On stock options, each contract covers 100 shares.

Let’s assume the underlying asset is 100 shares of Time Warner’s stock (Ticker: TWX). Today, TWX closed at $7.86 per share. Let’s take a look at each type of option:

Call options - A call option gives you the right to buy 100 shares of TWX at a specified price within a specified time frame. Let’s say $10.00 is the specified price in your contract and the option expires in 3 months. (Note: The price in the contract is referred to as the option’s strike price.)

You need shares of TWX to rise above $10 before the call option becomes valuable to you. Suppose the shares rise to $15. You can exercise your option and buy the shares at a $5 discount. Most people would then sell the shares immediately to pocket the $5 gain. This gain is referred to as the call option’s payoff.

If the price of TWX stays the same or falls, you would not benefit from buying the shares. With options, you do not have to. If you don’t buy the shares, then you have decided not to exercise your option.

Put options – A put option gives you the right to sell 100 shares of TWX at a specified price within a specified time frame. Let’s assume a strike price of $5 and expiration of 3 months.

You need shares of TWX to drop below $5 before the option becomes valuable to you. Suppose the price drops to $2 per share. You can exercise your option and sell the shares at $5 each even though they are only worth $2 each. You keep the $3 payoff.

Buying options – In order to purchase options, you have to pay a premium. The premium is the fee paid to the option seller in order to purchase the options contract. Since you will have flexibility and the option’s seller must follow whatever you decide (to exercise or not), you will have to pay them for it.

Payoffs versus profits -If the payoff is greater than the premium, then you have turned a profit. With options, you can never lose more than the premium. Your downside is limited, but theoretically speaking, there is no limit to the upside potential.