Tutorials on financial options

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Tutorials on financial options

MEFF and BME Clearing Stock option The Premium Utilities What the Option Offers Guarantees and Settlement

MEFF and BME Clearing

Until September 9, 2013, MEFF Sociedad Rectora de Productos Derivados S. A. (MEFF) functioned both as an official secondary market and as a central counterparty (CCP) for the instruments included in the segment called Financial Derivatives (IBEX 35 futures and options, futures and options on shares, futures on the dividend index, futures on share dividends, and futures on the 10-year Notional Bond). Additionally, MEFF acted as a CCP for repos on Public Debt (MEFFREPO) and for electricity derivatives (MEFF Power). This activity has now been assumed by the new company, BME Clearing.

To comply with the requirements of the EMIR regulation (European Market Infrastructure Regulation, Regulation (EU) 648/2012), it was necessary to separate the market activities from those of the CCP. This separation was carried out by transferring the market activity of the former MEFF company (entity valid until September 9, 2013) to a new company. Thus, there are now two entities: one new company handling the market activities and the pre-existing one functioning solely as a CCP. The new company that has taken over the market activities is called MEFF Sociedad Rectora del Mercado de Productos Derivados (abbreviated as MEFF Exchange), while the former MEFF, which continues the CCP activity, has been renamed BME Clearing.

The division into two entities has been effective since September 10, 2013.

At MEFF Exchange, buyers and sellers meet to negotiate their orders, setting the price and quantity.

BME Clearing acts as a CLEARINGHOUSE and ensures the successful completion of transactions by acting as a counterparty in each of them. The clearinghouse is positioned at the center of every transaction, becoming the buyer to the seller and the seller to the buyer.

Financial options

An option is a contract between two parties where one of them has the right (but not the obligation) to buy or sell a financial asset at a specific price on a future date.

Therefore, it is a derivative product (or forward economic transaction) whose difference from futures lies precisely in what its name indicates: optionality. A futures contract, upon reaching the expiration date, imposes an obligation on both parties to execute the agreed-upon economic transaction. However, options involve operations with a slightly different structure, allowing for greater flexibility for one of the parties. To enable this, at the time of the agreement, the option buyer pays an amount of money to the seller. This small change means that, on the expiration date, both parties are not obligated, but the option buyer can decide whether or not they want to execute the economic transaction.

If the decision is to buy an asset, we are talking about a call option. Conversely, if the decision is to sell, we refer to a put option. In both cases, the amount paid at the time of the agreement is the price (known as the premium) that is paid for that greater flexibility or decision-making ability. The option seller receives the premium when the agreement is formalized. In return, they are subject to the buyer's decision, being obligated to sell in the case of a call and to buy in the case of a put.

In derivatives markets, two types of options are usually traded:

European: These can only be exercised on the expiration date.
American: These can be exercised at any time from the purchase of the option until the expiration date.

The price of an option depends on certain parameters such as the underlying asset price, the strike price, time to expiration, volatility, interest rates, and dividends (the composition of the premium will be addressed later). Like any other financial asset, the price of options fluctuates as these parameters change.

Call/Put

You may wonder what the content of this right is. With a Call option, you have the right to buy. With a Put option, you have the right to sell. Thus, there are two types of options: Call and Put. Call options on shares allow the holder to buy the underlying asset, while Put options allow the holder to sell the underlying asset.

Trading Unit

The trading unit is referred to as a "contract." In the case of Stock Options, each option contract traded on MEFF represents 100 shares. Exceptionally, due to corporate decisions, capital increases or reductions, stock splits, etc., some contracts may temporarily have a nominal value different from 100 shares per contract in certain expirations.

For Index Options (IBEX 35), a multiplier is used to convert index points into euros. For Futures, there are two types of futures: IBEX Futures with a multiplier of €10 and Mini IBEX Futures with a multiplier of €1. However, in Options, there are only Options with a multiplier of €1, meaning that if the index has a value of 8,500 points, the nominal value of the option is also €8,500.

Expiration Date

Options have an expiration date, meaning their right has a time limit. You can choose the expiration of your Call or Put option. At MEFF, expiration dates are the third Fridays of the expiration months. Additionally, certain options with "non-standard" expiration dates can also be registered with the clearinghouse (BME Clearing). For example, options on stocks with any expiration date and strike price, and of either American or European style.

Strike Price

In your right to buy (Call Options) or sell (Put Options), you can also choose the price at which you wish to buy or sell the shares.

The price at which the option holder has the right to buy or sell the shares is called the Strike Price.

Premium (Option Price)

In financial jargon, the price of the option is called the Premium. It is the price paid by the option buyer to the option seller to acquire the right to buy or sell a share. Remember that each stock option contract represents 100 shares, with the exceptions mentioned earlier.

Premiums are quoted in euros per share; consequently, a premium of 0.25 means that the right to buy or sell is worth €0.25/share × 100 shares/contract = €25/contract.

Buyers and Sellers

The buyer of a Call option purchases the right to buy shares, and the buyer of a Put option purchases the right to sell shares. As in any other market, when someone buys, someone else must be on the other side of the transaction, that is, someone must sell, and vice versa. This other party, the seller, is the one who sells the right to buy in the case of Call options and sells the right to sell in the case of Put options.

Once the option is purchased, the buyer becomes the holder of a right and, as mentioned, has the right but not the obligation to buy or sell the shares. The buyer, if desired, can become a seller and sell the option (that was previously bought) in the market at any time before the expiration date.

The seller of Call options is obligated to sell (or buy the shares if they are a Put seller) if required by the buyer. The seller, if desired, can become a buyer and repurchase the option (that was previously sold) in the market, thus canceling their obligation.

In any normal transaction, if someone sells something, it is because they previously bought it, and for that reason, they can sell it. Note that in the options market, options can be sold without having bought them beforehand. This is a novelty that may seem difficult to grasp at first but is very important in options trading. To sell options, collateral must be deposited.

It has been mentioned that options have an expiration date, or in colloquial terms, they have a "sell-by date," after which they cease to exist. At expiration, it may happen that the option has a positive value or no value at all. Ultimately, at expiration, the investor in options will have gains or losses.

Most of the scenarios and examples in this document assume that the investor holds the options until expiration, and then the results are explained. This is one way to invest or trade in options. A second way would be to trade options without waiting for expiration. An option is a financial asset that trades on the MEFF Exchange, and therefore its value or price can rise or fall. Consequently, you can buy or sell options without waiting for expiration, using the usual criteria of any investor: buying options when they are cheap or when you believe their value will rise, or selling options when they are expensive or when you believe their value will fall.

To trade options in general, and especially in this second way (selling), you need to have a good understanding of the factors that determine an option’s price. These factors are briefly explained in the section “The Premium (Option Price).”

More Information on Exercise

Stock options on MEFF are of both American and European types:

American options: These can be exercised at any time from the purchase date until the expiration date.
European options: These can only be exercised on the expiration date.

The reason for exercising an option before expiration is that it generates a profit for the holder.

Early Exercise

When the holder of an option exercises their right early, that is, exercises the option before the expiration date, the obligation is proportionally allocated among the sellers of options, who must fulfill their obligation.

In these cases, BME Clearing matches buyers and sellers, and the stock purchase/sale transactions must be carried out at the exercise price.

Exercise at Expiration

At the expiration of the options, unless expressly stated otherwise, all Calls and Puts that result in profits will be considered exercised.

Parameters used in option valuation

In the world of options, the price of the option is called the premium. Like any price, the premium or option price is determined by supply and demand in the market. However, the determination or estimation of the price that the option buyer or seller (option demanders and suppliers) is willing to pay or accept fundamentally depends on six factors:

The Stock Price:
There is a direct relationship between the stock price and the option price (premium). Variations in the stock’s quotation result in variations in the premium amount. In general terms, an increase in the stock price raises the price of Call options and lowers the price of Put options and a decrease in the stock price lowers the price of Call options and raises the price of Put options.

The Exercise Price
The exercise price is an important factor when calculating the option’s value (premium). For a given stock price, Call options with a higher exercise price are worth less than those with a lower exercise price (because there are fewer chances of making a profit). Conversely, Put options with a higher exercise price are worth more than those with a lower exercise price (also because there are fewer chances of making a profit).
Time to Expiration
Time is a very important variable in the value of options. Options lose value over time, meaning that if no other variable changes, the mere passage of days decreases the value of an option.

This happens because the further away the Expiration Date of an option is, the greater the uncertainty about the stock's price movements. Consequently, this greater uncertainty increases the premium value of the option, whether it’s a Call or a Put. The longer the time, the greater the chance that buying options will result in profits for the buyer, which means the seller will demand a higher price for selling. Using the same reasoning, each passing day benefits the seller, as it reduces their risk by decreasing the uncertainty about stock price fluctuations and also reduces the possibility of the buyer making a profit. Thus, all else being equal, the seller could repurchase the option at a lower premium than they originally received from the sale.

In line with the above, options lose value over time.

Unless your strategy is to hold options until expiration for a very specific purpose and not trade them, it is not advisable to buy options close to their expiration date. When you sell them (if nothing changes), they will be worth much less, and you would lose money.

If your intention is to trade options, it’s recommended to sell options that you previously bought before they lose value due to the passage of time. There is no fixed rule, but in general terms, it’s advisable not to hold purchased options after two-thirds of their lifespan has elapsed. Consult your Broker.

Dividends
Dividends are paid to shareholders but not to option holders. Since the price of stocks decreases when dividends are distributed, the price of the option will also be influenced by the announcement and distribution of dividends.
Volatility

The volatility of an asset, such as a stock, is a measure of the variability in that stock’s prices. The greater the variability, the higher the volatility. A stock whose price always remains the same would have zero volatility. An asset's volatility varies over time.

Volatility is the main parameter when trading options among professionals. Most retail clients buy or sell options based on directional criteria (bullish or bearish) rather than on volatility. Trading options based on volatility is not recommended unless you are a highly experienced professional.

For a specific stock, the option premium will be higher the greater the volatility anticipated by market participants. Options on stocks with high volatility will have higher premiums than options on stocks with low volatility. This is primarily because the higher the volatility, the higher the probability of the option buyer (Call or Put) making a profit, and therefore the seller will demand a higher price.

Since high volatility makes options more expensive, it is not advisable to buy options when volatility is high—you would be buying at a "high" price. In this case, selling options is recommended because you’d be selling at a "high" price.

Conversely, if volatility is low, buying options is recommended because you would be buying at a "low" price. In this case, selling options is not advisable because you’d be selling at a "low" price.

Trading options based on volatility is one of the most complex financial operations. Professionals trading on volatility constantly hedge themselves against directional risk. Trading options based on volatility is not recommended if you don’t know how to hedge against directional risk.

Let’s now look at how to distinguish when volatility is high or low.

In the other five factors explained, there is clarity on their value at any given moment since these are known data points. However, for volatility, there isn’t a single value. What matters to an investor is knowing the correct price of the options they are going to buy or sell and also the future price of options to determine whether it’s worth buying or selling (if the price is expected to rise, buying is favorable, and vice versa). But for future price predictions, we would need to know future volatility, which is unknown. Future volatility can be estimated, but each investor might have a different estimate and therefore a different assessment of the future price of the option.

With that said, you will hear the following terms:
Historical Volatility: This is the volatility observed in the past. It may not be very useful for valuing options today since past volatility does not necessarily repeat in the future.
Implied Volatility: Generally speaking, this can be considered the "current" volatility, meaning the volatility inferred for the future based on the current price of options. Implied volatility is the percentage of volatility embedded in the price of an option, given that the other factors involved in calculating the theoretical value of the option are known.
Future Volatility: This is the figure needed to calculate the future value of options. It is not known and must be estimated; it is the critical figure for the options investor.

At any given moment, we can say that volatility is high if implied volatility exceeds historical volatility. Conversely, we say volatility is low if implied volatility is lower than historical volatility.

The value of an asset’s volatility is the most debated factor in the market and, as such, is the most important factor in valuing stock options.
Interest rates
The risk-free interest rate (e.g., the rate for Treasury Bills) affects the price of an option. Generally, the higher the interest rate, the more Call options are worth, and the less Put options are worth. However, changes in this factor have a small effect on the value of options (the premium).

Basic positions with options

A call option grants its buyer the right to acquire the underlying asset (stock or index) at a stated price (strike price) on a future date (expiration date) in exchange for the payment of a premium. The seller of this type of option will have the obligation to sell the underlying asset on the agreed date (provided that the buyer exercises his right) in exchange for the payment of the premium.

The option will be exercised whenever the price of the underlying asset is higher than the strike price. To calculate the point at which the buyer (seller) enters into profit (loss), the premium paid (paid in) must be taken into account.

In the following graph we can see what is the risk profile of a buyer of Call and a seller of Call respectively.

Risk profile of a Call buyer. Source: own elaboration.

Risk profile of a Call salesperson. Source: own elaboration

The buyer of the Call pays the premium and has the right to decide, while the seller receives the premium and does what the buyer tells him to do. As we can see, the purchase of Call has limited losses, you can never lose more than the premium paid, while the possible profit is unlimited, as much as the underlying asset rises. It is therefore a clearly bullish position.

On the other hand, the seller's profit is limited to the premium paid, in case the underlying asset falls and the buyer does not want to exercise. If the underlying asset rises, all that the buyer is gaining will be the seller's losses. The sale is therefore a moderately bearish position. I say moderately because it does not matter whether the underlying asset falls a little or a lot, the premiums are always the same.

A Put option gives its buyer the right to sell the underlying asset at a set price (strike price) at a future date (expiration date) in exchange for the payment of a premium. The seller of this type of option will have the obligation to buy the shares on the agreed date (provided that the buyer exercises his right) in exchange for the payment of the premium.

The option will be exercised whenever the price of the underlying asset is lower than the strike price. To calculate the point at which the buyer (seller) enters into profit (loss), the premium paid (paid in) must be taken into account.

In the following graphs we can see the risk profile of a Put buyer and a Put seller respectively.

Risk profile of a Put buyer. Source: own elaboration.

Risk profile of a Put seller. Source: own elaboration.

As with the Call, the Put buyer pays a premium and has the right to decide whether to sell or not, while the Put seller receives the premium and is obliged to do what the buyer tells him to do.

The Put buyer has a clearly bearish position, since, if the market goes up, he does not exercise his right and only loses the premium, while if the market goes down he earns whatever the underlying goes down.

The Put seller has a moderately bullish position, since if the market rises, the buyer will not want to exercise and will earn the premium, regardless of whether it rises a lot or a little. On the other hand, if the market falls, he loses everything that falls.

Intrinsic value and time value

Option contracts are rights that grant their holder the ability to buy (in the case of a call) or sell (in the case of a put) an underlying asset at a predetermined price (strike price) on an expiration date, in exchange for the payment of an amount called a premium.

Although they may seem like recently developed financial instruments, options have been traded for centuries. For example, there are references to Thales of Miletus profiting from options on olives by making an accurate prediction of how a particular harvest would perform. A more recent example is the active options market (called Opsies) created in Amsterdam in the 17th century.

However, the options industry took a major quantitative leap in 1973 when Fischer Black and Myron Scholes published their article “The Pricing of Options and Corporate Liabilities”, in which they found the solution to valuing financial options (previous works developed ten years earlier failed or remained incomplete, such as those by Samuelson, Sprenkle, etc.). At the same time, Robert Merton published “Theory of Rational Option Pricing.” These individuals are the founding fathers of option valuation theory, which is why Scholes and Merton received the Nobel Prize in 1997 (Black passed away in 1995; otherwise, he likely would have received the prize as well).

The famous Black-Scholes formula and its variations (Merton, Black 76, etc.) are currently used to calculate the price of options. The focus here is on the option premium, which we will attempt to explain intuitively, avoiding the associated mathematical formulation for now.

To begin, the first question we will try to answer is the following:
How much would you be willing to pay for the right to buy (call option) Repsol shares at €21 in six months when they are currently trading at €22?
Would it be €1.10? €0.25? €2.05?

Difficult, right? To answer this question, we must take the following factors into account:

Underlying asset price: The price of the asset being exchanged, which can constantly fluctuate.
Strike price: The agreed price at which the asset can be bought or sold, depending on whether it is a call or a put.
Time to expiration: The remaining time until the contract expires.
Future volatility: The estimated fluctuation of the underlying asset until the expiration date.
Risk-free interest rate: The rate applied up until the expiration date.
Dividends: The returns generated by the underlying asset between the time of purchase or sale and the expiration date.

Taking these parameters into account, when setting the premium for a call option on Repsol with a strike price of €21 and an expiration in six months, we can infer the following aspects:

The price of the underlying asset is a key factor: if Repsol trades at €20, it must rise above €21 for the call option to generate any profit at expiration. However, if Repsol trades at €22, the option holder might already be interested in exercising it.
Another crucial factor is the time remaining until expiration. If we are talking about a six-month period, almost anything can happen to the price of the underlying asset. However, if only one day remains, barring an extraordinary event, the underlying asset's price will likely be close to its current value—slightly above or below, but not far from it.

The aspects mentioned above can be summarized in the composition of the option premium as the sum of two components: intrinsic value and time (extrinsic) value.

Premium = Intrinsic Value + Time Value

The intrinsic value is the benefit that an option would provide if it were exercised at the same time it is being valued. Therefore, this component will always be equal to or greater than zero (see graphs 1 and 2). Although we are getting a little ahead of ourselves, it is necessary to comment that this early exercise of options is almost never optimal, except in very specific cases, precisely because only the intrinsic value would be earned, whereas if the option were sold on the market, the intrinsic value plus the time value would be obtained.

Graph 1: Intrinsic value of Call. Source: Own elaboration

Graph 2: Intrinsic value of Put. Source: Own elaboration

For example, if the underlying asset (AS) is quoted at €21, the intrinsic value (IV) of the following options will be calculated from their corresponding strike price (SP) by applying the formula:

Table 1: Intrinsic value. Source: Own preparation

VI Call = Max(PS – PE,0)	VI Put = Max(PE – PS,0)
Call PE 20, VI = 1€	Put PE 20, VI = 0€
Call PE 22, VI = 0€	Put PE 22, VI = 1€

Avoiding complex mathematical calculations, for the time being, we will define the time value of an option as the amount by which the total premium exceeds the intrinsic value. This is the additional amount that the investor is willing to pay to benefit from a favorable price evolution by limiting his loss to the premium paid in the event of an unfavorable evolution. Therefore, based on the time to maturity and taking into account the expected volatility of the underlying asset, it is estimated at what levels (maximum and minimum) the underlying asset could be at the date on which the option expires. In other words, we will be willing to pay a premium depending on the probability of making money with that option, so the more uncertainty there is, the more time value we will be willing to pay (see graph 3).

Graph 3: Call and Put time value. Source: Own elaboration: Own elaboration

The time value is maximum for those options whose strike price is close to the level of the underlying asset, since they incorporate the greatest uncertainty as to their probability of exercise. Those options whose strike price is farther away from the underlying asset involve less uncertainty and, therefore, their time value is smaller.

Consequently, the intrinsic value is calculated directly from the price of the underlying asset and the strike price. However, the calculation of time value will be influenced by other factors discussed above, especially time to maturity and volatility. These two components are basic to the valuation of options and are closely interrelated: for volatility to translate into price variability there must be time to maturity and vice versa. For this reason, the time value of options erodes until it is zero at expiration (see Figure 4).

Graph 4: Evolution of time value. Source: Own elaboration

ATM/OTM/ITM classification

The choice of the strike price of an option determines the premium to be paid for it. For example, having the right to buy an asset at a strike price lower than the current level of the underlying asset will be significantly more expensive than acquiring that right at a higher level. In the first case, the option includes both intrinsic value (profit if exercised at the time of valuation) and time value, whereas in the second case, the entire premium consists of time value only.

Below, we explain the possible classification of options as “In the Money (ITM), At the Money (ATM), and Out of the Money (OTM)” based on the relationship between the strike price (S.P.) and the current price of the underlying asset (U.A.P.) (see Table 2):

In the Money (ITM):
- A call option is ITM when the price of the underlying asset is above the strike price.
- A put option is ITM when the price of the underlying asset is below the strike price.
At the Money (ATM):
- In both call and put options, the option is ATM when the price of the underlying asset matches the strike price.
Out of the Money (OTM):
- A call option is OTM when the price of the underlying asset is below the strike price.
- A put option is OTM when the price of the underlying asset is above the strike price.

Classification of options into ITM, ATM, and OTM. Source: Own elaboration.

	P. E < P. A. S	P. E = P. A. S	P. E > P. A. S
CALL	ITM	ATM	OTM
PUT	OTM	ATM	ITM

From the table, it follows that when a given call is in-the-money, the put of the same strike price is out-of-the-money and vice versa.

With respect to the composition of the premium, ITM options are characterized by having both intrinsic value and time value, while OTM options only have time value. On the other hand, applying the strict definition, an option only acquires ATM status when the price of the underlying asset coincides with the strike price. However, since this situation occurs sporadically, a more flexible interpretation considers as ATM options those whose strike price is closer to the price of the underlying asset. Therefore, these options may or may not have intrinsic value (in either case it will be very small) while their time value is maximum.

Call Put Parity

Replica concept

Previously, we reviewed the parameters that influence the valuation of options and the impact each of them has. The variation that call and put options with the same strike price experience when any of these parameters change must maintain a specific arbitrage relationship, known as the put-call parity theory.

This theory establishes a relationship between the price of a call option, a put option (both with the same strike price), and the price of the underlying asset, determining how two of these three components can replicate the behavior of the third.

Let's illustrate this with a simple portfolio example:

Buy a call with a strike price of 100.
Sell a put with a strike price of 100.

At expiration, two mutually exclusive scenarios can occur:

If the underlying asset is above 100:
- We exercise the call, allowing us to buy the asset at 100.
- The put option is not exercised by the counterparty.
- As a result, we acquire the underlying asset at 100.
If the underlying asset is below 100:
- We do not exercise the call since buying at 100 would be unprofitable.
- The put option is exercised against us, forcing us to buy the underlying asset at 100.

From this analysis, we can conclude that in both cases, the final outcome is the same: the portfolio results in the purchase of the underlying asset at 100 on the expiration date. Therefore, the risk-reward profile is equivalent to owning the underlying asset at 100, even though this transformation only occurs at expiration (see Graph 1).

Graph 1: Purchase of synthetic underlying asset by buying Call and selling Put. Source: Own elaboration.

As we have seen in the previous example, from call and put we have replicated the behavior of the underlying asset. In the same way, with call and underlying asset we can replicate the behavior of a put and with underlying asset and put we will replicate a call.

Call-Put Parity

Therefore, we can establish a relationship between call and put of the same strike price and underlying asset that in a first approximation we define as:
S₀ = C - P + K

Taking into account that the payout/receipt of the premiums and the underlying asset is made on today's date and that the resulting position is obtained on the expiration date, as well as the possibility that the underlying asset will generate some dividend in this period of time, the so-called call-put parity is defined as follows:

European stock options: Ke^-rt + C = P + S₀ - D
European options on futures: K + C = P + F₀ + (C-P)e^rt - (C-P)

Due to the early exercise conditions of American options, call-put parity is only strictly true for European options, and it is possible to establish the following relationship for the former: S₀ - D - K ≤ C - P ≤ S₀ - Ke^-rt

Where:
S0= Underlying asset
K= Strike price
Ke-rt= Banking
C= Call
P= Put
D= Dividends discounted
(C-P)ert -(C-P)=Cost of premium financing.

^{1) You could also place the underlying asset right at the strike price resulting in what is called “Pin Risk”. If this happens, having bought a call and sold a put, you need to convert one of the two into the underlying asset on the expiration date, but you can only decide on the call. If the call is exercised and the put is also exercised, the underlying asset will be doubled. If the call is not exercised and the put is not exercised either, you will not have the required underlying asset on the expiration date.}

Options Strategies

There are fundamentally three types of strategies:

Trend Strategies: Expect the underlying asset to move in a specific direction.
Volatility Strategies: Anticipate either high movement (high volatility) or low movement (low volatility) in the underlying asset, without a clear directional trend.
Mixed Strategies (Ratios): A combination of the two previous categories.

Trend Strategies

These strategies are based on the expectation that the underlying asset will move in a specific direction:

Bullish strategies: Expect the asset price to rise.
Bearish strategies: Expect the asset price to fall.

These strategies typically have low Vega and Theta parameters, meaning they are less affected by time decay. To achieve this, they often involve the simultaneous buying and selling of options—calls, puts, or a combination of both.

The most notable trend strategies include:

Vertical Spreads
Tunnels

Volatility Strategies

These strategies focus on fluctuations in volatility, which can be understood in two ways:

Realized volatility of the underlying asset.
Implied volatility at which options are priced.

Typically, realized volatility influences implied volatility, but they don’t always move in the same direction. Let's consider two examples:

Case 1: A company releases unexpected news, causing the stock price to fluctuate sharply, which increases implied volatility.
Case 2: There is high uncertainty about upcoming news, leading to low price movement in the stock. However, option prices rise because the market anticipates strong future fluctuations.

For both cases, specific volatility strategies exist. The most important ones are:

Straddles
Strangles
Butterfly Spreads
Calendar Spreads

Mixed Strategies (Ratios)

As the name suggests, these strategies combine both trend and volatility elements. Unlike the previous strategies, which involve buying and selling equal amounts of different options, ratio strategies create an imbalance between the two sides.

Because they involve a greater number of one type of option than another, ratio strategies can be particularly useful as adjustment or repair strategies.

The most notable ones include:

Strip/Strap
Ratio Call/Put Vertical Spread
Ratio Call/Put Back Spread

Summary of Strategies

Now that we have categorized the different types of strategies, we will analyze each one in detail, covering their construction, applications, and potential modifications. But before diving into specifics, let's first review a summary of the most important strategies.

Protective Put

Before executing a hedge, we must clearly define our expectations. To do this, we should ask ourselves a few questions:

Regarding the underlying asset: Will it decline or not? Will it drop significantly or is it just a correction? For how long? Is the asset in an uptrend, downtrend, or moving sideways? Are there any support or resistance levels nearby that could guide my decision? Is it worth hedging, or should I close my position and look for other investments? How much am I willing to lose? How much do I want to gain and in what timeframe?
Regarding volatility: Is it expensive or cheap? Historically, are we at low or high levels? How does implied volatility compare to realized volatility? How did implied volatility compare to realized volatility a month ago? How does the asset’s volatility compare to that of its sector? And to the overall market?

Once we have answered these and many other questions—or even if we are unable to answer all of them—we can determine whether it is appropriate to hedge by buying a put, selling a call, buying a put spread, or using a bearish tunnel. We will also know which strike price and expiration best suit our objectives. First, we will analyze hedging with a put purchase, while other strategies will be examined later.

Let’s consider a simple example: We start with a portfolio consisting of 1,000 shares of Telefónica. We purchased these shares with our savings, intending to invest for three or four months to earn additional returns. We fully understand the risk of buying stocks, which is the potential decline in their price, and we are willing to accept it. However, we do not want to lose too much money because we will need it in the future. At the same time, we would like to benefit from a possible price increase.

Now, suppose we are offered the following option: "Your investment is currently worth €17,000 (with TEF trading at 17.00). If you pay €590, you ensure that until June, you cannot lose more than €590, while still being able to profit from any increase in Telefónica’s price." Given our circumstances, we would likely say yes, as this alternative aligns with our needs.

What is being offered is essentially insurance for our investment. This strategy is as simple as buying a put option. As shown in Table 1, the June 17.00 put is priced at 0.59 per share. If we hold an equal number of shares and puts, our resulting synthetic position is equivalent to a long call.

Static coverage with C/PUT-STAF. Source: Own Elaboration

According to the Call-Put parity, without considering interest rates:

K + C = S + P → 17.00 + C = 17.00 + 0.59 → C = 0.59

The resulting synthetic call has a price of 0.59, so we can deduce that this strategy at the March expiration has the following characteristics:

Maximum loss = €590
Maximum profit = Unlimited, as the underlying asset can rise indefinitely.
Break-even point = 17.59 = 17 + 0.59 (Strike price + synthetic call or underlying asset + put, which in this case result in the same values as the strike price and the underlying price match).

This strategy allows us to benefit from increases in the underlying asset while also providing the possibility of exercising the put in case of an unfavorable price movement (a drop in the stock price). Therefore, this technique is applied when we expect high volatility in two ways:

Underlying asset volatility: We expect the underlying asset to trade significantly above or below its current level by the expiration date.
Implied volatility: We anticipate that the implied volatility of the options will increase, raising the value of our options.

Depending on the expected volatility in both the underlying asset and options, the investor can choose shorter or longer-term options and decide between ITM, ATM, or OTM options. In this regard, it is not possible to determine the "best" type of put hedge, as the choice depends entirely on each investor’s expectations.

Covered Call / Buywrite

This time we will analyze the combination of a share purchase with a call sale, which, as we already know, is synthetically equivalent to a put sale.

We might think that converting a position with unlimited profit and loss into a position with limited profit and unlimited loss is not a hedging operation. However, we will now discuss the situations in which this strategy may be interesting and its characteristics.

Let’s use the same example as in the previous section, where we explained hedging with a put purchase, so we can compare the two alternatives.

Let’s assume that we have bought 1,000 shares of Telefónica thinking that the stock price will rise in the coming months. However, time passes, and the shares do not take off. On the other hand, there has not been a price drop either, the stock is simply moving sideways within a narrow range, leaving us very little margin and not providing the expected return. We were wrong.

In this situation, we can do two things: the first is to sell the shares and reconsider our investment, and the second is to try to generate a return by taking advantage of the stock’s sideways movement. This second alternative involves selling a call option, earning a premium, although there are some additional details to consider.

Therefore, we sell 10 June 17.00 calls at 0.55, meaning we collect €550 while holding a €17,000 share position. This income provides a return of 3.23% between the moment we implement the strategy and the third Friday of June (63 days). Annualized, this return becomes 18.74%.

According to Call-Put parity, without considering interest rates:
K + C = S + P → 17.00 + 0.55 = 17.00 + P → P = 0.55

At expiration, if Telefónica’s price is above €17.00, the call will be exercised, and we will be obligated to sell the shares at that price, regardless of how much the stock has risen. In this case, our maximum profit is €550, which equals 3.23% (18.74% annualized).

However, if Telefónica’s price falls below €17.00, the call will not be exercised, but we will start incurring losses on our stock position, net of the €16.45 break-even point, which provides some protection.

Static hedge with V/ ATM Call. Source: Own elaboration.

This strategy provides a fixed return, which is quite attractive if the underlying asset rises. However, in the event of a drop in the stock price, we are only protected up to a certain point (break-even), below which we will incur unlimited losses. Therefore, this technique is used when we expect low volatility in two aspects:

Volatility of the underlying asset: We expect that by the expiration date, the stock price will not have moved significantly, either up or down.
Implied volatility: We expect the implied volatility of options to decrease, as that benefits our short position.

The difference between this strategy and hedging with a put purchase lies precisely in volatility expectations and the existence of unlimited losses. Therefore, it is considered a riskier strategy.

Once we have clear expectations regarding the underlying asset and volatility, the next step is to select the expiration date and the strike price of the call option.

Stock options allow for a wide range of combinations that perfectly adapt to hedging, investment, and speculation needs.

Here is a summary of the most important uses:

To reduce investment costs by taking advantage of leverage. Stock options can generate considerable returns with small amounts of capital, and naturally, due to the leverage effect, they can also result in the loss of the premium paid in the case of buying options, or a loss equivalent to the movement of the stock price in the case of selling options (see Call purchase).
To secure a price for a future transaction. By buying stock options, investors can lock in a purchase or sale price for a stock in exchange for a premium (see Call purchase, Put purchase).
To improve the profitability of already owned stocks. By selling Call options, the investor receives a premium, which provides an immediate additional return.
As insurance against a drop in stock prices. By purchasing Put options, these products allow investors to eliminate risk (see Put purchase).
To buy stocks at a discount.
Simply as a means of speculation, whether betting on price increases or declines.

The purchase or sale of a futures contract, meaning the execution of a financial transaction for a future date within the framework of an organized market, involves the presence of a clearinghouse that ensures the successful completion of all operations. If any participant in the market fails to meet their obligation to deliver the asset or the agreed-upon price, the clearinghouse steps in to fulfill the obligation on their behalf. To manage this credit risk, the clearinghouse implements a series of procedures, including the following:

Daily Settlement of Profits and Losses:
At the end of each trading session, the clearinghouse credits or debits the profits or losses incurred during the day. This way, all positions are marked to market value at the end of each session.

Let's assume that a buyer and a seller agree to exchange an asset in two days at a price of 100. Based on the market price of the asset at the end of each trading session, the clearinghouse applies the following credits/debits to the respective accounts:

		DAILY SETTLEMENT
DAY	ASSET PRICE	BUYER	SELLER
0	97	-3	3
1	103	6	-6
2	105	2	-2
TOTAL SETTLEMENT:		5	-5

On the day the agreement is made, by the end of the trading session, the market price of the asset is 97. This results in the buyer experiencing an implicit loss (as they will have to purchase at a higher price than the market in two days) and the seller experiencing an implicit gain (as they will sell at a price higher than the market in two days).

Given this, the clearinghouse adjusts for this implicit loss/gain by making the necessary debits and credits to the buyer’s and seller’s accounts. After this settlement, the obligation to buy/sell at 100 is now effectively an obligation at 97.

This process repeats daily, ensuring that by the contract's expiration date, the buyer receives a net credit of 5 and the seller incurs a net debit of 5. Given that the final market price of the asset is 105, the final daily settlement reflects:

The buyer’s profit, as they are obligated to buy at 100 when the asset's price is 105.
The seller’s loss, as they are obligated to sell at 100 when the asset's price is 105.

Thus, daily settlement ensures that investors realize their profits or losses on a daily basis. This mechanism significantly reduces the clearinghouse’s credit risk, as it does not have to wait until expiration to determine whether a participant will fulfill their obligation. Instead, the process occurs daily. However, since the clearinghouse still bears credit risk for 24 hours (the time between two daily settlements), an additional risk management process is required.

Deposit of Margins:
Market participants assuming obligations must deposit certain amounts of money or financial assets to ensure compliance. Since these participants already settle their daily profits or losses through the previous process, the margin to be deposited is an estimate of the maximum loss that could occur within 24 hours and the subsequent closing of the position in the following trading sessions.

Once a futures contract position is taken, the investor has several alternatives:

Maintain the position open (long or short) until the contract's expiration.
Close the position before expiration by executing the opposite transaction (selling if they initially bought, and vice versa) for the same type and number of contracts. This way, the investor eliminates their contractual obligations, realizing a net result based on the difference between the sale price and the purchase price of the future.