Options

An option allows the holder to buy (call option) or sell (put option) a product at a fixed price. For example, an option may allow the holder to buy 100 shares of ABC Co. at a price of $20 each. The product being bought or sold can be a security (such as shares in a company), a commodity (such as oil), a currency, an index (such as a stock market index), etc. The product is called the “underlying interest.”

The option is valid for a specified period. For example, the purchase of 100 shares of ABC Co. at $20 must be completed before December 17. After the expiration date, the option’s value is nil.

The holder of the option can decide whether or not to exercise their option to buy (call option) or sell the product (put option).

For example, Mary pays $5 for a call option for 100 shares of ABC Co. at a price of $20 before December 17.

  1. On December 7, the share price is $21. Mary decides to “exercise her option” (she exercises her right to buy the shares at $20). With her option, she buys 100 shares at $20, which she resells for $21. Her profit is $95 (100 shares x $1, minus $5 for purchasing the option).
  2. However, if the price does not go above $20 before December 17, Mary would not exercise her option (she would not buy any shares). Her loss is therefore $5 (the price she paid for the option).

Expected return

The return consists of capital gains (or losses).

If the option is exercised, the return will depend on the profit generated.

The option can sometimes be sold before expiration. Its value will depend on a number of factors, including the price of the underlying interest and the time remaining before expiration. The market value of an option tends to decrease the closer it is to expiration. In the above example, if the price of ABC Co.’s shares was $18 on December 14, it would be increasingly unlikely that the value of the share would exceed $20 before the December 17 expiration. This will decrease the value of Mary’s call option, simply because there would be less time for the value of the underlying interestAn underlying interest is the asset upon which a derivative (call or put option, futures, etc.) or other investment (such as exchange-traded funds) is based and that influences its value. The underlying interest may be a stock, an index, a currency or a commodity. to increase (in the case of a call option) or to decrease (in the case of a put option).

If the option is not exercised before expiration, its value is nil.

Liquidity

Options are usually traded on an exchange. As a rule, they can easily be resold. If the option is not traded on an exchange, there may not be a market for its resale.

Risk

The risk depends on the underlying interest and how the option is use

  • If it is used as a hedgingHedging consists of making an investment to offset possible losses on another investment.

    For example, an investor who owns shares could buy a put option on the shares they hold. This way, if the shares decline in value, the investor can exercise the option to offset the decrease in the value of the shares.
    instrument, the risk is reduced.
  • If it is used for speculation purposes, the risk is high.

An investment in options is more suitable for sophisticated investors.

Futures and forward contracts

With these contracts, the parties involved agree to buy (or sell) a specific quantity of a commodity (grain, meat, etc.) or financial product (stock market indexes, bonds, common shares, etc.) at a predetermined price and date.

The commodity or financial product is called the “underlying interest.”

  • Futures contracts: Generally traded on an exchange. The value of the contract is usually the only element that fluctuates throughout the term.
  • Forward contracts: The characteristics of forward contracts are negotiated by the parties; contracts are not traded on an exchange and are seldom transferable.

Unlike options, these contracts require each party to carry out the transaction or pay an equivalent cash amount. For example, if Mary has a forward contract to buy 100 shares of XYZ Co. at a price of $20 each by December 17, she is required to buy these shares at this price on the expiration date, even if the real value of the share is lower and the transaction generates a loss for her. She could instead decide to pay an equivalent cash amount. However, if she had a call option, she would not be required to exercise her option.

Transactions are finalized when the financial product or commodity is delivered to the other party involved in the transaction, or an equivalent cash amount is transferred.

Expected return

The return, in the form of capital gains (or losses), depends mainly on changes in the value of the underlying interest.

Liquidity

Futures contracts are generally traded on exchanges, which makes it easier to buy and resell them.

Forward contracts may be difficult to sell.

Risk

  • If the contract is used as a hedging instrument, the risk is reduced.
  • If it is used for speculation purposes, the risk is high.

In addition, with forward contracts, there is a risk that the counterparty may not be able to honour its commitments.

Futures and forward contracts may only be suitable for sophisticated investors.