Options, Caps, Floors and Collars.
What Is an Option? T he term option refers to a financial instrument that is based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures , the holder is not required to buy or sell the asset if they decide against it. Each contract will have a specific expiration date by which the holder must exercise their option..
Understanding Options Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract. Call options allow the holder to buy the asset at a stated price within a specific timeframe. Put options, on the other hand, allow the holder to sell the asset at a stated price within a specific timeframe. Each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller..
What Are the Main Advantages of Options? Options can be very useful as a source of leverage and risk hedging. For example, a bullish investor who wishes to invest $1,000 in a company could potentially earn a far greater return by purchasing $1,000 worth of call options on that firm, as compared to buying $1,000 of that company’s shares. In this sense, the call options provide the investor with a way to leverage their position by increasing their buying power..
What Is a Cap? A cap is an interest rate limit on a variable rate credit product. It is the highest possible rate a borrower may have to pay and also the highest rate a creditor can earn. Interest rate cap terms will be outlined in a lending contract or investment prospectus. Common types of capped interest rate products include adjustable-rate mortgages (ARMs) and floating-rate bonds..
Example of Interest Rate Cap An adjustable-rate mortgage (or ARM) is one of the best examples of an interest rate cap in a lending setting. In an adjustable-rate mortgage, borrowers pay a fixed rate of interest in the first few years of the loan and then a variable rate after that. This variable rate is determined by an underlying benchmark rate; when the benchmark rate increases or decreases, the interest rate on the loan can adjust accordingly..
Floors Buying a floor means buying a put option on interest rates. If interest rates fall below the floor rate, the seller of the floor compensates the buyer in return for an up-front premium. As with caps, floor agreements can have one or many exercise dates ..
What Is a Collar? A collar, also known as a hedge wrapper or risk-reversal, is an options strategy implemented to protect against large losses, but it also limits large gains ..
Understanding the Collar An investor should consider executing a collar if they are currently long a stock that has substantial unrealized gains. Additionally, the investor might also consider it if they are bullish on the stock over the long term, but are unsure of shorter-term prospects. To protect gains against a downside move in the stock, they can implement the collar option strategy. An investor's best-case scenario is when the underlying stock price is equal to the strike price of the written call option at expiry..
The call and put should be the same expiry month and the same number of contracts. The purchased put should have a strike price below the current market price of the stock. The written call should have a strike price above the current market price of the stock. The trade should be set up for little or zero out-of-pocket cost if the investor selects the respective strike prices that are equidistant from the current price of the owned stock ..