#51 What are options and how do they work?

Options are like vouchers. They give the owner the right to buy or sell an underlying asset – typically a stock – at a set price within a certain period of time. However, this is not an obligation. You can simply let the option expire, i.e., not exercise it. And every option has an expiration date.

There are two types of options:

• Call options: These give the buyer the right to buy a share.
• Put options: These are vouchers to sell a share.

How call options work

If you expect the price of a share to rise, you can purchase a call option for 5 francs. The price of the option is also known as the premium. Each option has an exercise price, which is referred to as the strike price. If it is 100 francs, the share can be purchased at this price. If the share price reaches 120, you make a profit of 20 francs, minus the premium of 5 francs already paid. If the price falls below 100 francs, the option expires and you only lose the premium of 5 francs already paid.

How put options work

Investors who want to protect their investments against losses can buy puts. A put option gives you the right to sell a share at a predetermined price, regardless of how far the share price falls.

Let's look at this using falling prices as an example: You own a share in a Swiss company. The current price is 200 francs.

To protect yourself against potential losses, you purchase a put option with an exercise price of 150 francs for 3 francs. If the price falls to 100, you can sell your share at the predetermined price of 150 francs. This limits your maximum loss to 50 francs – plus the 3 francs for the option. Without the insurance cover, you would have incurred a loss of 100 francs.

Who are options suitable for?

Options are primarily used by professionals, often institutional investors. Private investors also have the opportunity to trade options. However, they need to know what they are doing, as options are highly speculative. They are subject to greater fluctuations than the underlying asset, i.e. the share.

Do you need options in your portfolio?

Options can be used selectively for short-term speculation. The advantage is that even a small capital investment can have a big impact. For this reason, options are referred to as leveraged products. However, it is very difficult to find the right time to buy and sell. The art of market timing is so challenging that even seasoned experts regularly get it wrong.

In summary, a long-term investor does not need options. At True Wealth, we do not use any leveraged products. We do not believe in market timing, but instead use diversified investment strategies for long-term success.

Do you already have experience with options? How exactly did you use them? Send me an email with your feedback.