The Options – Calls & Puts – allow you to know the risk of your investments and execute strategies in the different phases of the Markets.
Even if you are not interested in trading in the options market, you need to observe it to know what level of risk traders are waiting for about the financial asset you decide to invest in.
In this article we will look at the key ideas to understand them.
What are Options – Calls & Puts?
When we venture into learning finance, we quickly and often face new, difficult-to-understand concepts usually accompanied by complex mathematical formulas.
One of the biggest challenges is just unraveling financial options.
But it is an arduous path that in the end brings us a reward.
If we can fully understand the options, we will have managed to uncover the most important secrets of financial knowledge.
In the options are present the keys to learn and understand Finance:
Risk, time and interest rates.
The options are, briefly, contracts that have the following elements:
An exercise price
An expiration period
A premium, or price paid by the buyer of the option
Let’s see, for example, what happens when we trade on the QQQ options market, the ETF developed by Invesco to emulate the Nasdaq 100 index:
When we purchase a call, we are entitled to purchase 100 QQQ, at the agreed exercise price, and up to the respective maturity period.
When we buy a put, we have the right to sell 100 QQQ, at the agreed exercise price, and up to the respective maturity period.
Whenever we buy, whether it’s a put or a call, we have a right for a limited time.
In general, if the market goes up we will win with the call and lose with the put, and conversely in case of corrections.
Our maximum risk is losing the premium we’ve paid.
The seller’s position is more complex.
It charges a price for granting the option, but is subject to the buyer’s decision.
And the buyer will act according to what happens in the market during the term of the option, as we will already expand.
How is the Options price set?
This is the most interesting part.
Buyers and Sellers have to agree on a price.
What does that price depend on?
On the one hand, data that is known to both parties:
The market price of QQQ
The exercise price of the option
The expiration period of the option
The interest rate in force during that period
Dividends to be paid by QQQ during that period
But there is a value, decisive for worth the options, that no one knows, and both sides must estimate.
This is the volatility that can be expected in QQQ during the term of the option.
You may be interested: Volatility – VIX – VXN
When the parties agree on a price, they are giving us very important information: what is the expected market risk for QQQ within that timeframe.
That’s why we highlighted at the beginning that we had to look at the options market even if we didn’t want to buy or sell Calls & Puts.
We need to know the expected level of risk for any asset we decide to invest in.
And that risk is called Implied Volatility, and can be calculated using the agreed prices in the options market.