Financial Derivatives: Equity Call Options

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Once you have gotten to grips with the basics of building an expat portfolio and have a bit of experience and comfort in trading various asset classes such as ETFs, Equities, etc, you might want to broaden your investment horizons and look at other financial products that are available.

The most common next step for retail investors is typically in trading equity options.
Equity options fall under the umbrella of what we call “Financial Derivatives” or “Derivatives Contracts” or often just “Derivatives” for short.

As their name would imply, derivatives are financial products that derive their value from an underlying asset.

The most common types of financial derivatives are what we call “Futures Options” and “Futures Contracts” both of which operate in a very similar, but very distinct way.

Futures Options

The use of Futures Options allows investors to make outsized bets on the future value of an asset with limited downside.

In this article we will cover the Future Option to BUY an asset at a future date for a fixed price.

These types of Futures Options contracts are know as “Call Options”.
The option to SELL an asset at a future date for a fixed price, are known as “Put Options” and are covered in their own article.

Call Options

Let’s say we have an individual equity – lets call it ‘ABC’ – which is currently trading at $10 a share.
We think that by this time next year, ‘ABC’ will be trading at $20 a share.
We have $1,000 to invest.

The classic approach here to capture this upside would be to buy the stock and hold it for a year.

Buy 100 x ABC @ $10 = -$1,000
Sell 100 x ABC @ $20 = $2,000

The main downside here is the fact that all of your capital is tied up in the investment and the potential gain is limited by the volume of shares you are able to buy outright today for cash.

However, utilizing equity Future Options we can avoid both of those downsides by either spending a much reduced initial outlay of capital, achieving a multiple of our successful outcome, or a mixture of both of these.

First, let’s understand what Futures Options are.

Futures options are a contract that gives the owner the option, but not obligation, to buy or sell an asset at a fixed future date for a fixed price.

It’s important to note at this point that Equities Options Contracts are sold in lots of 100 shares, which means any contract must be a multiple of 100 shares.
A single contract is for 100 shares.
5 contracts are for 500 shares.
10 contracts are for 1000 shares.

For example, in the scenario above we could buy a contract that gives us the option to buy 100 shares of ABC for $10 in one years time.
In return, we pay a premium to the counterparty of this deal for this option.
The key items here to take into account are:

Expiration Date – When they contract is valid until?
Strike Price – What price you have the option to buy at?
Premium – How much you will pay for this option contract?

With that in mind, we can also use futures options pricing as an indicator of where the market thinks a stock price will be at a point in the future.

In the above example, let’s imagine that the options market looks like the following:

Equity Futures Option Contract – ABC (Currently trading at $10)
Strike date: 1 year from today
Premium: $1
Number of Contracts: 1

If we were to buy this contract we would pay $100 in premium ($1 premium * 100 shares in 1 contract) and get the option to buy 100 shares for $1,000 1 year from now.

By looking at the premium, we can see that the market predicts that 1 year from now a share of ABC will be trading at $11.
We can see this by taking the current price of a share and adding the current Futures Option premium.

Price today: $10
Option premium: $1
Implied future price: $11

So let’s run this thought our scenario in which the future price of ABC rises to $20.

Premium Paid: -$100
Buy 100 shares of ABC @ $10 = -$1,000
Sell 100 shares of ABC @ $20 = $2,000

For a realized profit of $900

In this situation we realized a slightly lower profit, but we benefited in two other ways:

Firstly, our maximum loss from this deal was limited to $100.
We kept $900 of our $1,000 capital free for the entire duration of the year.

Let’s run both of these in an alternate scenario to better explain this.

Let’s now imagine that ABC has a terrible year and rather than hitting $20 it instead falls to $5.

Buy buying the shares directly we would now look like this:

Buy 100 shares @ $10 = -$1,000
Sell 100 shares @ $5 = $500

For a realized loss of -$500.

However, if we had bought the futures options instead of the shares directly:

Premium Paid: -$100
Decline the option to buy 100 shares of ABC @ $10 = $1,000

For a realized loss of -$100 only (the premium paid).

As we can see, the use of Equities Futures Options locks in the maximum potential loss for a trade whilst keeping the potential profit open, in return for giving up some of the upside via the premium paid.
However, buying the Futures Option does mean that there is a total loss if the price of the equity falls below the strike price, compared to the value you would maintain in the equity if you held the shares directly.

To better illustrate this, let’s run a more aggressive Futures Option purchase through the same scenarios, with us spending the entire $1,000 on Futures Options premiums:

ABC rises to $20

Premium Paid: -$1,000
Buy 1,000 shares of ABC @ $10 = -$10,000*
Sell 1,000 shares of ABC @ $20 = $20,000

For a realized profit of $9,000

ABC falls to $5

Premium Paid: -$1,000
Decline the option to buy 100 shares of ABC @ $10 = $10,000

For a realized loss of -$1,000 (the premium paid).

If we visualize this in a table, we can see the following:

ABC @ $20 ABC @ $5
Buy Equity Directly $1,000 -$500
Buy 1 Futures Option $900 -$100
Buy 10 Futures Options $9,000 -$1,000

So, there we go.

Equities Futures Options can be used as a financial tool to limit potential downside on an investment – at the expense of a share of the potential upside, or to multiply the potential upside – at the expense of increased risk of loss, both without having to use leverage.

*Note: If you’re on the ball here you might worry how you could afford the $10,000 to execute the Futures Option contract in order to buy the share to then sell them and realize the profit.

In this case, if you did not have the $10,000 to facilitate the execution of the Futures Option contact, you could simply sell the contract on again to someone that presumably does have the capital.

The Premium you could command for selling the contract on would be close to the total profit you would gain by executing it yourself, minus a small discount.

This is because in the scenario above, this contract is now effectively a licence to print $9,000 and so its market value would reflect that.
In fact, executing the option is a bit of a hassle, particularly if it is a large option or the underlying stock price is high.
In many cases, it’s easier and more convenient to sell the contract on.

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