How does investing in options work?

What used to be a dream for the private investor has become reality: everyone can now invest in options. Options carry more risk, but offer a higher potential return and the opportunity to strategically protect your portfolio. Let us take a look at how you can invest in options.

Where can you invest in options?

You can invest in options with a professional broker:

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What is an option?

Before we discuss how to invest in options, you must understand what options are. Options are financial derivatives that can be traded on the stock exchange. With an option, you buy the possibility, but not the obligation, to buy a security. An option can relate to a stock or an index.

With a call option, you buy the possibility to buy an underlying security at a fixed price and with a put option, you buy the possibility to sell an underlying security at a fixed price.

With a call option on the AEX, you can  buy a contract on this index within a certain period. The option becomes more valuable when the AEX price falls: your relative profit then increases.

Would you like to read in more detail what options are? First read the article what is an option. Here you can read the different concepts that are important when investing in options.

How do options work?

The exercise price of the option indicates at which price you can buy or sell the underlying share. With a call option with an exercise price of $10, you can buy 100 stocks at $10, whereas with a put option with an exercise price of $10, you can sell 100 stocks.

This cannot be done indefinitely: options have an expiry date. On this date, the option expires and can become completely worthless. If you have a call option for $10 and the price of the underlying share drops to $5, the option is worthless. You can then buy the share directly on the stock exchange for cheaper than with the option.

The premium also differs from option to option. When a premium is more attractive, the premium is higher. This is the case when the option is already in the money, for example. This means that when you execute the option, you will immediately make a profit.

How do you buy an option?

When you buy a stock, the price is always fixed. However, on the same share you can buy several options at different prices. This is because the strike price, expiration time and premium to be paid differ. So, at any given moment, there are different options, some examples:

Philips’ stock with current value of $18.00

• Call option with strike price of $20.00 and expiry period of three months
• Put option with strike price of $30.00 and expiry time of two years
• Call option with strike price of $16.00 and expiry time of two weeks

The price of an option is determined by its attractiveness to the buyer. A call option with a strike price below the current price yields an immediate profit and is therefore valuable. A comparable option will therefore be traded at a higher price. There are three possibilities when you invest in a call option:

• In the money: the exercise price is below the current stock market price: the option is worth something immediately
• At the money: the strike price is equal to the current stock market price: the option does not yield anything right now
• Out of the money: The strike price is higher than the current stock market price: the option is still worthless

For a put option, the opposite situation applies. With a put option, you can sell the underlying share at a fixed price. A put option is in the money when the share price is lower than the strike price of the option.

How do you read an option?

C AEX 512 JAN 2019

Above is an example of an option contract. The C or P indicates whether it is a call option or a put option. The underlying security is then indicated. In this example, it is an option contract relating to the AEX. If a stock has a long name, it is usually abbreviated. The number after it indicates the strike price.

Then you will see when the option expires. For example, this option would expire in January 2019. For options that expire on a monthly basis, this happens on the third Friday of the month. There are also option contracts that cover a week or a day.

How does the value of an option come about?

The value of an option is determined by the intrinsic value plus the expected value. The intrinsic value is the current value of an option. If a call option gives you the right to buy a share that now costs $30.00 for $25.00, you immediately make a profit of $5.00 per share. The intrinsic value is then $5.00. The entire option therefore has a value of $5, since an option contract usually relates to 100 underlying stocks.

However, there is also an expectation value. If an option is out of the money but valid for a long period, the expectation that a higher price will be reached will increase. In the end, it all comes down to whether or not one believes that the option will be worth something in the future. If the option is valid for a longer period, the expectation value will be higher.

In addition, options written on volatile shares will be worth more. When shares move strongly, the probability that the price will go higher for a call option or lower for a put option increases. As a result, the price of an option on the same stock may change depending on its volatility.

Actively invest in the value of an option

It is possible to actively invest in the value of options. It is possible to buy and sell options in the meantime before its expiration date. Many people actively trade options without ever exercising them. But how can you successfully invest in the value of an option?

For this, you have to take the expected value and the movement of shares into account. A call option should be bought if you expect the price of the underlying stock to rise. This is the case when positive news is expected. A put option must be bought if you expect the stock to perform worse in the future.

You can also decide to buy an option if you expect more movement in the future. If the underlying share becomes more volatile, the chance that the price will rise above the strike price is higher.

Investing in options example

Below are two examples of how investments in call & put options work out.

Call option investment example

Suppose you buy a call option on a stock for $1. The strike price of the share is $10. For the option contract you pay in this case 100 times $1, so the premium is $100:

The maximum loss when investing in a call option is therefore the premium paid, in this case $100.

Investment in put option example

In this example we buy a put option on a share for $1. The underlying stock has again an exercise price of $10:

The maximum loss with a put option is therefore the premium paid, in this case $100. Your potential profit is the result you obtain if the value of the share is $ 0. In this case, the profit would be $900.

Writing options

You can also choose to write options. When you write an option, you will receive a premium. When you write an option, you usually hope that the option will not be exercised. If this is the case, you do not lose any money, and you can keep the premium in your pocket. Writing options can be a lot riskier.

Writing a call option example

In this example we write a call option on a stock. We receive a premium of $1 and since option contracts go for 100, we receive $100. Depending on the stock price, we get the following result:

When you write a call option, your potential loss is unlimited. However, you can cover the position by buying the shares. That way, you can at least deliver the stocks and you do not have the risk of suddenly having to buy them for a much higher amount.

Writing a put option example

In this example we write a put option on a stock. We receive a premium of $1 and since option contracts go for 100, we receive $100. Depending on the share price, we get the following result:

When you write a put option, your potential loss is equal to the amount you lose when the stock is worth $0. As you can see, your losses when writing options can increase considerably. This is especially the case when you write them uncovered.

Investing in options & leverage

Investing in options can be very attractive because of the leverage. It is possible to achieve a better result with a much smaller amount. With the call option on the $10 stock, to take an option on 100 shares, you only pay $100. Normally, you could only have bought 10 shares for this amount.

If the price then rises to $12, you make a profit of $100. On an investment of $100, this is a 100% return.

If you had bought the stocks physically, you would only have achieved a 20% return. For $100 you could only buy 10 shares that individually increased in value by $2.

Leverage therefore enables you to achieve much greater results with a smaller amount of money. However, this does come with a risk, as you can also lose the entire amount when investing in options.

What are the advantages of options trading?

By buying options you can protect yourself against price decreases. With a put option, you can sell the underlying security at a fixed price. If the share price falls, then you can still sell the stock you own at a high price. It is therefore use put options as an insurance in uncertain times.

You can also use options to obtain an extra return on the shares you already own. You do this by writing out call options. This is especially interesting when you wanted to sell the stocks anyway. You receive an extra return on your shares and when the price rises anyway, you receive the premium as well as the selling price.

The presence of a leverage effect can make investing in options extra attractive. It allows you to achieve a higher potential return with a smaller amount of money. However, it is important to be careful: if you use the leverage incorrectly, you could also lose a lot of money.

What are the disadvantages of investing in options?

A big risk of investing in options, is that you can lose your entire deposit. 75% of the options never get in the money and are therefore never executed. Because if an option expires worthless, you lose your entire premium, you can quickly lose 100% of your deposit.

When you write call and put options, your losses are (almost) unlimited. If the stock price suddenly rises or falls sharply, you can lose many times your initial investment. Options are therefore not suitable for novice investors, but rather for investors who already have some experience with stock market trading.

Note the difference in options

There are both American and European options. American options can be executed at any time during the term while European options can only be executed at the end. As options are traded on the stock exchange, you can always sell them in between.

Good luck with options

There are several successful option strategies that you can use when you start investing in options. In the article how to make money with options, we look at how you can use options to achieve better investment results. Do you have any questions? Then place a comment below this article!

Auteur

Over Alex Mostert

When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.