Investing in options: the complete guide
Do you want to obtain a higher return on your investment and are you willing to take higher risks to achieve this objective? If this is the case, option investment might be a very interesting opportunity! Investing in options starts from a few hundreds of euros and it allows you to earn quite some money with it. But how do you invest in options and what’s the process behind? This guide tells you all you need to know about investing in options!
Investing in option guide
- What is an option and what does it consist of?
- How can you invest in options?
- What determines the value of an option?
- Which aspects influence the price of an option?
- How can you read options?
- Which options are the best to invest in?
- How do you write options?
- Excercising and selling options
- What are the best option strategies?
- What are the risks associated with options?
- How much does investing in options cost?
An option gives you the rights to buy or sell a financial security at a specific price. Financial security examples are among others a share or a bond. To obtain these rights a premium needs to be paid to the other party. The option exchange is the next phase in the process and allow you to actually execute the option. An option has the following characteristics:
The underlying value refers to the financial asset to which the option is linked. This could be the Heineken share for example. Options can also be linked to indices like the Dow Jones or to currencies like the Dollar.
When investing in options, one can choose between call and put options. It’s of crucial importance to understand these two option types:
- Call option: gives you the right to buy a financial security at a certain price.
- Put option: gives you the right to sell a financial security at a certain price.
Call options allow you to speculate on price increases while put options allow you to speculate on price decreases.
One option contract always equals 100 shares. Is your option traded for $2? In that case, you will pay $200 for the contract as a whole.
The exercise price is the value at which the underlying value can be bought or sold. To give you an example: when an option has an exercise price of $20, the share can be bought (call option) or sold (put option) at the aforementioned price.
With regard to call options, the options having a lower exercise price are more expensive. This makes sense of course because you will be able to buy a share at a guaranteed lower price. The risk of an option turning worthless, is therefore much smaller.
With regard to put options, the other way around is applicable. Options with a high exercise price are more expensive because there is a higher chance of selling a share at a high price.
The expiration date indicates the validity of an option. Some options have a one-week validity while other options can be valid for years. Options with a long-term expiration date have a higher price since there is an increased chance that these options will become profitable. The following 3 stock exchange terms indicate whether an option is currently profitable:
- In the money option: at this specific moment the option is profitable.
- At the money option: at this specific moment the option has a break-even price
- Out of the money option: at this specific moment the option is worthless
Logically, in the money options have a higher price than out of the money options. A call option with an exercise price of $20 at an exchange price of $25 is immediately worth quite some money. A put option with an exercise price of $20 and an exchange price of $25 is what we call ‘out of the money’ and has no direct value at that specific moment.
Illustration of in & out of the money at a $5 call option
Previously one had to travel to an option exchange and scream loud to place his or her order. Luckily, these are things of the past. Buying and selling options is currently accessible to each one of us. When you would like to invest in options, you will need an account at a broker. A broker is a 3rd party which arranges the buying and selling of financial securities on your behalf.
Would you like to know which broker is the most beneficial when talking about options? We have made a list of the best brokers on the market. Use the below button to instantly compare the best brokers:
The value of an option consists of the intrinsic value and the expected value.
The intrinsic value is the value an option has when executing it. Let’s say for example you have a call option with an exercise price of $10 and the exchange price equals $5. At that moment, the intrinsic value of the option equals $5. When the exercise price equals the exchange price, the intrinsic value is $0. The same $0 intrinsic value applies when the option is out of the money and can therefore not be executed.
- Option in the money? The option has an intrinsic value.
- Option out of the money? The intrinsic value is $0.
The expected value is determined by the expectations of the market. An out of the money or at the money option does have value because there is always a future chance the option will turn into an in the money option. The expected value is higher when:
- The expiration date is further into the future.
- The underlying security is a volatile one.
When an option has an expiration date in a not too distant future, there is a bigger chance of the option becoming valuable. A volatile security also increases the chance the exchange price will reach certain levels at which executing the option becomes interesting. Buying an in the money option isn’t automatically the most attractive choice: after all, you will pay considerably more for options which offer more security.
The price of an option is mainly influenced by the price of the underlying asset and by the volatility of the underlying asset.
Price of the underlying asset
The price of the underlying asset strongly influences the value of an option. The value of a call option:
- Increases when the price of the underlying asset increases.
- Decreases when the price of the underlying asset decreases.
It’s the other way around when referring to the value of a put option. The value of a put option:
- Increases when the price of the underlying asset decreases.
- Decreases when the price of the underlying asset increases.
The volatility of the underlying asset
The volatility of the underlying value has a strong influence on the price of an option. The following applies:
- Is the underlying asset fluctuating a lot? The price of the option increases.
- Is the underlying asset barely fluctuating? The price of the option decreases.
Volatility increases the probability that an option will become valuable (in the money). Therefore, options with a volatile underlying value have a higher price. If you are aiming to make money by trading options, you should consider the volatility of the underlying market. Major economic events can cause a big market fuss and can lead to considerably higher option prices.
Options are not completely written. It would also become a bit of a mess when you would have to enter full sentences in your broker account. But how can you read an option before buying it? This is how an option looks like:
Name option C/P date exercise price buy price
So, it looks like the below example:
Philips C 8/6 $10 $1
This is a call option on the Philips share with an exercise price of $10 and an expiration date of 8/6. The option in this example can be bought for $1. Because stock options represent 100 shares of the underlying stock, you will have to pay $100 for one Philips option contract.
Examples of options
Before you can buy an option, you will have to decide which option you want to go for. If you want to achieve the maximum return on investment with your options, don’t let fear determine your investments. A decent first step would be to choose the underlying asset you want to trade on. This can be the Heineken share for example. Next, it is important to take the following items into account:
- Do you expect a price decrease or an increase?
- Do you think the price will be very volatile or just a little volatile?
- Do you think the volatility will last for quite some time or do you rather believe it will be a short-term action?
When you expect a price increase, you have to buy a call option. If on the other hand you expect a share price decrease, buying a put option is the preferred choice to make. A call option is bought when speculating a price increase and a put option is bought when speculating a price decrease.
Do you expect the price to hardly move? Buy an in the money option. Do you expect a strong price increase or decrease? Buy an out of the money option. Keep in mind you will pay more money for an increased level of safety. So, if you do expect a strong increase or decrease, it’s smarter to buy an out of the money option. Your return will be a lot higher.
Next, you will have to determine whether it will be a sudden increase or decrease or if it will be a long-term one. When expecting an explosive increase or decrease, the best choice is to go for a short-term option. Do you believe it will take quite some time? In that case, you should buy a long-term option. The more security, the more you will pay. If you expect a short and strong price movement, it’s best to buy a short-term option.
Buying an option is a piece of cake. You just select the option with the right exercise price and expiration date. Next, you enter how many call or put options you want to purchase. Keep in mind one option contract equals 100 shares. Choose the option which suits your prediction the best and maximize your potential revenue!
You can also gain some extra money by writing options. When you write an option, you are the counterparty of the person buying an option. When you write an option you have an obligation to deliver. If the counterparty executes the options, you will have to deliver the underlying asset. This can be a stock like Heineken or Apple.
When you write an option It doesn’t matter how much money you lose: you will always have to deliver. Writing options is therefore a risky endeavour. In exchange for the risk associated with writing an option, you do receive a premium.
You have two possibilities for writing options:
- You write a call option when you expect a price decrease.
- You write a put option when you expect a price increase.
Writing a call option
When you write a call option, you make a promise you will sell an underlying asset at a certain price. This can for example be a share. Price increases are in this case clearly disadvantageous because you will have to sell your shares at a much lower price than their true value.
On the other hand, when the price decreases, you make a nice profit with a call option. You receive a premium, and you do not lose money by exercising the option.
Writing a put option
A put option works the other way around. When writing a put option, you make a promise to buy the underlying asset at a certain price. A share is once again a possible example. Price decreases are in this case clearly disadvantageous because you have made a promise to buy the shares at a certain price, and you lose money buying them.
On the other hand, when the price increases, you make a nice profit with a put option. You receive a premium, and you do not lose money by exercising the option.
You earn money from writing option because you receive a premium. The premium rate increases when the risk increases. You receive a higher premium when:
- The option period of the option is longer.
- The exercise price is closer to the current price.
Requirements linked to writing options
A broker’s main objective is to limit the risks associated with writing options as much as possible. Collateral will be held to make sure you can cover your position. This can be as well covered as uncovered.
When writing a covered call, you do own the shares when a call option is exercised. You can make a nice additional profit on your equity portfolio. If things go wrong though, you run the risk of having to sell your shares at a less favourable price. Put options can be covered by purchasing more favourable put options.
You can also make a money deposit to serve as collateral. This money is deposited on a margin account. Only upon closing the position, the money will be refunded. The higher the position risk, the higher the margin a broker can demand. Do you no longer comply with the margin requirements? In that case, the broker has the right to close your complete position and you lose your complete investment.
Before we proceed, we will summarize once more in short what the differences are between buying and writing options:
- A call option gives you the right to buy. You pay a premium.
- A put option gives you the right to sell. You pay a premium.
- Writing a call option, obliges you to sell. You receive a premium.
- Writing a put option, obliges you to buy. You receive a premium.
Many investors choose to sell their options before the expiration date. A written option can also be closed before the expiration date. In that case, you receive the current value of the contract on your bank account. Similar to stock exchange prices, option prices are continuously moving. A nice profit can be made by selling or buying options at the right moment.
You can also choose to exercise an option. In case of a call option, you receive the shares at a more favourable price. Nevertheless, in most cases, this isn’t the smartest move to make. Many brokers charge extra costs for exercising options. Moreover, it costs extra money to sell the shares.
Exercising options can be an interesting option, when you were already looking forward buying the shares. It can also be an interesting option when dividends are paid quickly because option owners do not receive a dividend. Shareholders on the other hand do receive a dividend.
Have you just written options? In that case, you can be forced to fulfil your obligation when reaching the expiration date. The obligation can be: selling shares when talking about a written call option or buying shares when talking about a written put option.
Naturally, options have an important role to play on the exchange. By using them smartly, you can achieve a higher return on investment on the exchange.
More return on investment with a leverage
Options are so-called leverage products. You buy an option for a smaller amount of money and theoretically this will allow you to achieve a much higher return on investment. After all, you can choose to invest $1000 to buy a specific share, but you can also choose to buy a call option at the same price. Although in both cases the investment is the same, favourable price movement will allow you to achieve a much higher return on investment using a call option. If it goes wrong, the downside is that you will lose your whole investment.
Aiming for the highest return on investment? In that case, you have to buy an out of the money option. As a result, do take into account the risk of losing your whole investment is the highest.
Anticipating a price decrease
Put options allow you to anticipate and invest in a price decrease. Are you anticipating a move down? Put options give you the chance to turn this move down into a nice profit. You can give your potential return on investment a considerable boost by buying an option with a low exercise price. These options are very cheap. Nevertheless, take into account that when the underlying company is doing well, you lose your whole investment.
Put options as insurance
Put options can also be used as insurance. When you expect (serious) price falls, it can become very interesting to buy a put option. After all, put options will make you gain money when prices are falling. Buying a put option on the AEX is way cheaper than selling and buying again all of your shares. After all each transaction goes hand in hand with transaction costs.
Don’t use the put option as insurance too frequently because insurances are costly! You pay a premium for this added security and investors are paid for taking risks not for increasing their security. Therefore, it is advisable to only buy put options, when you want to cover a serious risk.
Receiving more money when selling your share
You can write a call option if you want to receive more money when selling your share. If at the moment, a share has a value of $10, and you want to sell it when the share price reaches $12, you can write a call option. You receive the premium anyway. When the price subsequently rises to $12, you sell the shares at the price you already wanted to receive. You have nevertheless received an extra premium and therefore also an extra return on investment!
Does the price keep on rising? That doesn’t really matter anymore! You were planning to sell your share at $12, and you have earned some extra money. Only when the prices are falling instead of rising, you are in trouble. You are losing money. Do you expect a serious price fall? Don’t write call options but sell your shares.
Buying a share cheaper with a put option
Put options can be smartly used to receive a reduction on your shares. Do you consider a share to be too expensive at the moment? And would you like to buy the share when there is for example a $2 price decrease? You can write a put option for the lower price. You receive the premium anyway. When there is a $2 price decrease, you buy the shares at the price you already aimed for.
When the price keeps on falling, you probably lose money. Nevertheless, if you had bought the shares at the current price, you would have lost even more money. A strong price increase? Even then, you have not really lost. After all you have received your premium, and you weren’t planning on buying the shares at the current price.
Take advantage of volatility with a strangle
Certain events can cause a serious effect on the price movement at stock exchanges. Let’s take the results of the Brexit referendum for example. It’s not always that easy to predict the effects though. If you expect the stock to make a serious move, but you are not sure about the direction yet, you can buy both a call and a put option.
In this case, you do choose an exercise price which strongly deviates from the current price of the underlying asset. So, it means you will make money both when the price exceeds a certain value and when it goes below that same value.
Take advantage of a stable stock exchange
You could also take advantage of stability. Do you barely expect movements on the stock exchange? Then you can write a put option as well as a call option which sufficiently deviates from the current exchange price of the underlying asset. Both options guarantee a premium. This position may nevertheless cause you a huge loss, when the price suddenly decides to go up and/or down.
Investing and risks go hand in hand. Options are no exception to this rule. Before investing in options, it is of crucial importance to understand the ins and out of options. Upon reading our guide, you get a good understanding of the basic aspects of option trade. It’s nevertheless very important not to immediately invest all your money in options. After all, there is always a risk of losing your whole investment when making the wrong decision.
The better approach is to try the different possibilities first. It could for example be an approach to invest in fictitious options and to keep an eye on the exchange trend. In a next phase you evaluate what went wrong and what went well to further optimize your strategy. Some brokers offer a free demo so you can give investing a try. Would you like to know which brokers offer a free investment demo? Use the below button to get an overview:
Normally, you are paying a fixed amount per contract when investing in options. In this case, it doesn’t matter what value the contract has. With each transaction, it’s therefore of vital importance to first calculate if the revenue is still profitable after deducting the transaction costs. It’s important to choose a cheap broker to avoid spoiling money by paying unnecessarily high costs. On our page about cheap investing you can immediately see where you can invest the cheapest in, among others, options.
Ready to invest in options?
Upon reading this guide, you have all info at your fingertips, and you know everything you need to know to buy and sell your first options! Do you still have questions about trading options? Don’t hesitate to leave your comment below. We will try to help you as soon as possible. Good luck!
Brief course in options trading
- What are options? - What does an option consist of?
- How does trading in options work? - buying options and the value of options
- Earn money with options - turn a profit with options and issuing options
Strategy and options
- Use a put option to catch a downtrend - secure your profits at a correction
Try trading risk free?
Calculate the return on your investments
With this handy tool, you can calculate how your return on investment would develop. You can enter the amount you initially invest and the expected return. Then you enter the expected percentage of return, and the tool calculates how your wealth will develop over a longer period.
Return on investment calculator
The investment will be worth!
Growth of the investment over time:
Investing balance in year
If you would start one year later with investing you would have less than if you would start today.
As you can see, your return increases over a longer period. This is due to compound interest. You receive interest on your interest, provided you choose to reinvest this interest. If you continue doing this for a long time, you can even build up a large fortune with a small amount.
Do you want to see how your return develops when you also deposit money in between? Then use this tool.
Using the tool
To use the tool, you only need to enter the following numbers:
- Initial investment: the amount you want to invest on day 1
- Expected return: the percentage of return you expect
- Number of years: until when would you like to withdraw the amount?
You will then see your initial investment in blue and the return you earn on your investment and reinvestment of your investment in green.
If your wealth remains invested for long enough, your return increases. You can see in the chart which percentage is your initial investment and which percentage is your return.
We also show how much you would own if you started one year later. You would then have one year less to earn a return on your investment, which causes you to miss out on money.
In the table, you can see exactly how this works: you see how the return keeps increasing, causing your equity to grow exponentially.
Why does your return keep increasing?
This is because you also earn a return on your return. If you invest $ 100 in a share, and you receive a return of 10%, this amounts to $ 10.
If you receive another return of 10% the following year, you receive this on $ 110 instead of on $ 100. This means your return that year is $ 11 instead of $ 10.
This effect is exponential, which causes your return to keep increasing over a longer period.
Start investing yourself?
Do you also want to start building a fortune? Compare the best brokers directly and get started. As you can see in the tool, waiting can cost you money:
What is a short squeeze? Profit from shorters!
In 2021, Gamestop was without a doubt the most well-known short squeeze. In this article, we discuss what a short squeeze is and how it takes place. After reading this article, you will know what a short squeeze means and how to profit from it.
Do you want to profit from a short squeeze yourself?
1 – Open an account with a broker that allows shorting: You can then speculate on falling prices.
2 – Deposit money: Deposit money into your account using creditcard or bank transfer.
3 – Short a stock: Buy a stock with a high chance of a short squeeze.
What is shorting?
A short squeeze can only occur when many people short a stock. You go short on a stock when you speculate on a decreasing price. You then sell shares that you do not own, hoping to buy them back at a lower price later on.
If you want to read more details about shorting, you can read this article:
What is a short squeeze?
When you open a short position, you borrow shares from another party. At some point, you will have to buy back these shares. Shorters hope to buy these shares at a lower price.
However, this does not always work out; the price can also rise. When many people own short positions, this can lead to a domino effect. A positive news article can give a boost to the stock price, after which shorters begin to close their positions. A short position is closed by buying the shares, which further increases demand for the stock.
With a short squeeze, the shorters are squeezed like a lemon: the stock price can suddenly rise sharply.
The 6 steps of a short squeeze
- A company does not perform well, which leads to many people shorting it.
- The company reports better-than-expected results, causing the price to rise.
- Some shorters panic and close their positions, forcing them to buy the stock.
- This creates a chain reaction causing more investors to close their short positions.
- Due to the large increase in demand for the stock, the price rises explosively.
- The short squeeze is a fact, the rocket goes up, but often crashes back down quickly.
Gamestop: A well-known example of a short squeeze
Perhaps the most well-known example of a short squeeze occurred in 2021. The Gamestop stock rose from a few dollars to over 300 dollars.
Gamestop is a simple physical gaming store, not the type of modern company that attracts substantial stock price increases. However, at one point, there were more short positions than Gamestop shares, which makes the likelihood of a short squeeze very high.
A large group of retail investors on Reddit noticed this and decided to buy the stock massively. As a result, the stock price skyrocketed to enormous heights within a week, and a group of “ordinary people” defeated several large hedge funds.
How to benefit from a short squeeze?
As an investor, you can benefit from a short squeeze. It is essential to find shares with a high chance of a short squeeze:
- Stocks with a low market capitalization (i.e., a low total value) have a greater chance of a short squeeze (<$1 billion)
- Stocks with a good news expectation. The good news then gives the initial boost to the stock price.
- Stocks with relatively high short positions compared to the number of available shares have a greater chance of a short squeeze.
For the last point, look at the short interest ratio. This ratio indicates how many shares are shorted percentage-wise. When there are 100 shares, and 10 shares are shorted, this percentage is 10%. It doesn’t matter how many absolute short positions there are; it’s entirely about the number of relative short positions.
When positive news is released, the chances of a short squeeze occurring are higher. However, keep in mind that the stock market is difficult to predict: there is certainly no guarantee of a short squeeze.
What is the biggest short squeeze?
The biggest short squeeze ever occurred on Volkswagen/Porsche shares in 2008. This story demonstrates the power of a short squeeze, as the company was temporarily the largest in the world.
In 2018, the company’s stock initially dropped significantly, almost 50%. This attracted many shorters, as you can make money with a short position when the stock price falls. However, Porsche announced that they bought a large part of the company, causing shorters to close their positions. In an acquisition, you often see a significant increase in stock price, since a premium above the asking price is paid.
This led to a massive chain reaction, causing the stock price to increase fivefold within a few days!
What are the risks of a short squeeze?
Short squeezes are not entirely without risk. Short squeezes don’t always occur; if the stock price continues to drop, you can lose money on your investment position.
Even investors who enter at the right time frequently still lose money in a short squeeze. They are greedy and do not exit in time. A short squeeze is always temporary by definition: it typically only lasts a few days. This was also the case with Gamestop: after the peak of $300 was reached, the stock price fell back to $40.
How can you protect yourself against a short squeeze?
When you open a short position yourself, you can encounter a short squeeze. Your loss can then be enormous: when the stock price increases several times, you can lose the entire amount in your investment account.
It is therefore advisable to always use a stop loss. With a stop loss, you set an amount at which you automatically take your loss. However, a stop loss cannot always be executed in fast-moving markets. With some brokers, you can use a guaranteed stop loss, which is attractive when you expect a lot of volatility.
What is a gamma squeeze?
Options played an important role in the strong price development of Gamestop. When you buy options, the counterparty is at risk when they do so without owning the collateral. A naked call can become costly, especially when the price rises sharply.
The counterparty can also be moved to buy more shares when many call options are taken. This can increase the chance of a significant increase in stock price for investors who buy options, which is also called a gamma squeeze.
How to short sell with DEGIRO? – a user-friendly guide
You can short sell with DEGIRO, which means you speculate on a decreasing share price. In this short guide, we’ll discuss how to short sell with DEGIRO.
You need to have an account with DEGIRO to follow this tutorial. If you don’t have an account yet, use the button below to open one:
In brief: what is short selling?
When you short sell, you speculate on a declining stock price. For instance, you can short sell a stock. If the stock’s price then drops, you’ll earn a profit. However, if the price goes up, you’ll lose money.
Would you like to learn more about how short selling works? Then read the extensive short selling guide:
How to short sell with DEGIRO?
Before you can open a short position with DEGIRO, you need to enable this option first. To achieve this, navigate to the settings within your account.
Then, scroll down and enable debit securities.
Before you can enable debit securities (short selling), you need to take a short knowledge test. DEGIRO tests whether you have sufficient knowledge to open short positions. If you pass the test, you can enable the option.
When you open a short position, you sell a security that you don’t already own. It is not possible to short a security that you already own; you would have to sell the securities you already own first.
Opening a short position works the same as opening a normal stock position. Simply enter the number of shares you want to short, and then click place order to submit the order.
It is recommended to use a limit order, as it allows you to set a price that you are willing to pay. With a market order, you may receive a less favourable price, especially in times of high volatility.
What to watch out for with short positions?
Short positions are risky investments. Your potential loss is unlimited: a stock cannot infinitely decrease, but it can infinitely increase.
As stock prices rise, your losses may increase. When the risk increases, DEGIRO may ask you to deposit more money, which is also known as a margin call. If you do not deposit more money, your positions can be closed automatically at a loss.
In rare cases, the counterparty may claim the stocks. DEGIRO can then close the position immediately or within a certain deadline, which can result in losses for you.
How much does short selling cost at DEGIRO?
Short positions are riskier, even for the broker. Therefore, DEGIRO charges extra fees for opening a short position.
The amount of these fees depend on the risk category of the stock. Currently, the fees are:
- Category A: 1%
- Category B: 1.5%
- Category C: 2%
- Category D: not possible
In addition, you also pay financing costs, known as debit interest. The debit interest on euro, dollar, and pound accounts is 3%, and on all other currencies, it is 4%.
What is a put option?
Investing in options can earn you a lot of money, but you need to know a few things about them before you can make a profit. Buying or selling a put option are some of the possibilities if you want to start trading in options. You can read what a put option is and how you can start trading put options in this article.
Before we explain what a put option is, we should perhaps first explain briefly what an option is. When you start investing, you may be familiar with what a stock is, but it becomes more difficult to explain what an option is.
When you buy a share, you actually buy a piece of a company. You get a share with which you can prove that you are a co-owner.
When you buy an option, you do not buy a piece of a company. An option is a derivative that relates to an underlying security. This is often a share, but it can also be a derivative of an index, currency or commodity such as gold.
What makes an option different from a stock?
If you buy a Royal Dutch Shell stock, the price of that share can rise and fall, making your share more or less valuable. An option is called a derivative, because an option is based on the value of that underlying security.
To explain this, we return to the example of Shell. A Shell option is based on the value of the underlying Shell share. The price of the option is largely derived from the underlying product, but is also determined by the maturity and volatility of the price.
Types of options: what is a put option, and what is the difference with a call option?
An option gives you the right to buy or sell a predetermined quantity of shares at a specified price, also known as the strike price. Options also have an expiry date. This means that on the expiry date, you have to choose whether you want to exercise your right to buy or sell stocks.
You can buy an option with a duration of, for example, a week or a month. After you have bought an option, the expiry date and the exercise price cannot be changed. You buy an option to respond to an expected price increase or decrease. For this purpose, you can buy a call option or a put option.
What is a call option?
With a call option, you buy the right to buy shares. Let us use the example of Royal Dutch Shell again. Suppose you buy a call option Shell for $50. You then have the right to buy 100 shares of Shell within a period of one month for $10. If the price of a Shell share rises within that month from $10 to $12, you can therefore buy 100 shares at a profit of $2 per stock. After deducting the costs for buying the option, you will be left with a total profit of $150.
What is a put option?
With a put option, you buy the right to sell, which is actually the opposite of a call option. Let us return to the example of Royal Dutch Shell. Suppose you buy a put option Shell for $50. You then have the right to sell 100 shares of Shell within a month for $10.
You buy a put option because you think that the price of Shell shares will fall. If the price of a Shell share does indeed fall to $8, you can still sell your Shell shares for $10. In this example too, you have made a profit of $150 after deducting the costs you made to buy the option.
What is the difference between a European put option and a US put option?
Different rules apply to US options and European options. With American put options, you can exercise your right to sell during the entire term. But with European options, you can only exercise this right on the expiry date. You can remember this with a memory aid: The A of American stands for Always, and the E of European stands for End of Maturity.
However, although with an American put option, you have the right to sell earlier, in practice it does not happen very often that people exercise their right to buy or sell before the end of the term.
Just like a share, you can buy and sell a put option at a certain price. You can make a profit by trading in put options when the price of a share drops, because the value of your put option then rises. The difference between the price you paid when you bought the options and the price you sold them for is your profit.
A good party where you can buy and sell options is DEGIRO. DEGIRO is a reliable broker where you can get started against low fees. Use the button below to open an account at DEGIRO:
How can you make money buying put options?
With a put option, you buy the right to sell shares. You can do so for a fixed exercise price and before a certain expiry date. When the option period expires, you determine whether you want to exercise the right to sell. If the share price is lower than the exercise price, you would be wise to exercise your right to sell. You can then sell your shares at a higher price than the current trading value and make a profit.
How can you make money writing put options?
Two parties are involved in concluding a contract for an option: the buyer and the seller or writer. Instead of buying a put option, you can also write a put option.
In the case of a call option, the option gives you the right to buy, and you pay a premium for doing so. The writer, on the other hand, has the obligation under the contract to sell the option, but receives the premium for doing so.
With a put option, it works differently. If you have bought a put option, you have the right to sell, and you pay a premium for this. The writer then has the obligation to buy the shares but receives the premium.
The risks of writing put options
By writing put options yourself, you can make money on the premiums. But you can also lose large amounts of money if you do not handle it well. For example, it is wise when you write options to actually buy the share so that the options are covered.
If you do not do so, there is a chance that you will have to buy the shares at a higher price later on and that you will suffer great losses. This is called uncovered option writing. Because of the high risks involved, it is better to wait until you have more experience in buying options.
What is a margin requirement for writing options?
By writing an option, you create a short position. If you enter the position, you will receive money. But if the price is not moving in the right direction, it costs more money to close the position.
This is what the margin requirement is for. The margin requirement acts as a buffer by requiring you to have the same amount of money in your account as the option you want to write. If you do not have enough money in your account, your bank or broker can ask you by telephone or e-mail to deposit money to meet your margin requirement. This is called a margin call.
Sell put options with price gain
Another way to make money with put options is to sell the option with a price profit. If the price of the underlying security falls, the put option will only become more valuable. Instead of exercising your right and selling the shares, you can also choose to sell the options.
The advantage of selling your option with a price profit is that it is a lot easier than selling an option on a share. An additional advantage is that most brokers charge less transaction costs.
If you want to trade in options, you can use different strategies. We list the best-known put option strategies:
With the married put strategy, you buy a put option on shares you already own. In this way, you create an insurance against price falls, as it were, because with a put option you have the right to sell shares at the exercise price. With this strategy, you can therefore limit the risk of your shares.
Put credit spread
This strategy is called the put credit spread or the bull credit spread. You use this strategy if you expect the price of the underlying asset to rise. In this case you write an out-of-the-money put option (an option with a strike price above the current market price) and, at the same time, you buy a put option that is even more out-of-the-money.
You want the premium received for the written put option to be higher than the premium you pay for the option you buy, so you receive money at the start of this strategy.
You make a profit if the price rises, stays the same or does not fall further than the strike price of the written put.
The straddle is a strategy that you use if you suspect that something is going to increase the volatility of the underlying asset, but you do not yet know in which direction the price will move. This can be the case when a company is about to announce its results. In this strategy, you buy a call option and a put option with the same strike price and the same expiry date.
The exercise price of these options is as close as possible to the current market price (at-the-money). Because you buy both options and also have to pay an option premium for both, the price fall or rise must be greater than what you have paid in option premiums.
What does long and short mean when trading put options?
You have probably come across the terms long and short in relation to options trading. Let us first look at what these terms mean before we discuss how it works in relation to options trading.
In stock trading, a long position means that an investor owns the shares and responds to a price increase. Short selling means that the investor sells shares he does not own, with the aim of buying them back at a later date at a lower price.
You basically borrow the shares to sell them, and therefore hope to buy them back at a lower price, because then you make a profit. The profit that the investor makes is the difference between the selling price and the lower purchase price of the share. With a long position, you make a profit if the share rises, and with a short position, you make a profit if the share falls.
Long put option and short put option
When writing options, going long and short have an extra dimension. With a long call, you buy the call option and profit from an increase in the price of the underlying asset. With a long put, you buy a put option and you make a profit if the price of the underlying asset falls.
A short call is exactly the opposite of a long call. With a short call, you sell the option and make a profit when the value of the call or the underlying asset decreases. With a short put, you sell the option and make a profit if the underlying asset is higher than the strike price of the option.
What is the difference between options and CFDs?
With an option, you as a buyer have the right but not the obligation to buy or sell a share at a predetermined price within a certain period. If the share price at the end of the period on the expiry date does not meet the Exercise Price, the option no longer has any value.
A Contract for Difference or CFD is broadly similar to a traditional option, but there are some important differences. When trading CFDs you can speculate on the future price or strike price of, for example, a share, index or commodity, without having to buy the underlying asset. After the expiry date the difference between the opening and closing price is immediately settled with your balance, whereas with traditional options, you do not have the obligation but the right to buy or sell.
Trading options with a broker
Options trading is quite complex, and requires you to be involved in investing at least on a daily basis to be able to predict the prices as accurately as possible. You can also call in the help of an investment specialist or a broker such as DEGIRO. The big advantage of this broker is that it is a reliable party where you can trade in options against low fees. Click here to go to DEGIRO:
If you want to trade options successfully, you must learn to analyse the market and try to predict what the price of a stock will do in the short term. This sounds easier than it is. Prices can be very volatile, which can make it difficult to make a prediction.
Analysing the market for trading put options
If you want to trade put options, and you want to predict what the price of a stock is going to do, you can use two techniques: A Fundamental Analysis (FA) and Technical Analysis (TA). Both techniques complement each other and are therefore often applied together.
Fundamental Analysis (FA)
With fundamental analysis (FA), you determine the value of a stock by using economic and financial factors. By applying an FA, you can discover whether the current valuation of that share is overvalued or undervalued. For this purpose, you analyse the value of a company on the basis of turnover, profit, debts that you obtain from annual accounts and quarterly figures.
Technical analysis (or TA)
With technical analysis (TA), you try to predict the future price movements of a share on the basis of its past prices. You can look for patterns in trend lines, candlesticks and graphs.
The advantage of buying options compared to buying shares, is that options are much cheaper. When you buy an option, you do not buy a share in the company, but a derived product. That makes options more attractive for small investors.
Another big advantage is that trading options allows you to achieve high returns within a short period of time. More experienced investors can also use a leverage effect with options. This allows you to invest large amounts with a relatively small investment, because the person who sells you the options with leverage actually lends you the money.
Another advantage is that you can protect your shares from falling in value by buying a put option on the shares. If the shares fall in value, you can still sell your shares at a reasonable price.
Trading options is more complex than making a long-term investment. This means that you need to gain some experience before you can make high returns. It also takes a lot of time to keep track of the market and execute analysis.
The biggest disadvantage is that you can lose your entire investment with options. If you do not manage to sell your option at a profit before the expiry date, it will not be worth anything after that date.
If you are going to write put options, there is a chance that when the price falls, you will be asked to buy while you expected the price to remain the same or even rise. When the exercise price is higher than the share price, you will have to pay more, which means you will lose money.
Where can you trade put options?
You can trade put options by placing an order with a broker. A broker provides you access to the financial markets. As a private individual, you can buy and sell put options at a broker such as DEGIRO.
Click here to go to DEGIRO & open an option investing account directly:
Plus500 is a good broker for trading CFD options. If you are just starting out, you can get unlimited practice with a risk-free demo, and has the big advantage that the website and the help desk are in English. At Plus500, you can only trade CFDs, not traditional options.
Click here to go to Plus500:
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 choose to actively speculate on price fluctuations of options. Like shares, option prices fluctuate regularly. At Plus500, using CFDs allows you to directly speculate on fluctuating option prices. Plus500 offers commission-free trading and you can also try the features for free with a demo. Use the button below to open an account at Plus500:
Would you rather buy options for the longer term? You can do this at the Dutch DEGIRO. You only pay €0.85 per call option on the AEX. Use the button below to open an account at DEGIRO:
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:
|Share||Premium paid||Value at expiry date||Total result|
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:
|Share||Premium paid||Value at expiry date||Total result|
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.
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:
|Share||Premium received||Total 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:
|Share||Premium received||Total 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!
What are financial options?
An option gives you the right to buy or sell a certain security within a certain period of time at a fixed price. You must pay a premium for this right. Options are riskier and somewhat more complicated than shares, but by using options in a smart way you can greatly increase the return on your investments.
What are options and how do they work?
With an option, you can buy or sell shares at a fixed price. Each option consists of a number of fixed elements.
What is the underlying asset of an option?
The underlying asset of an option indicates the financial effect to which the option relates. The underlying asset can be a share, index, currency pair or commodity.
How does the contract size work with an option?
When you invest in options, you buy a contract. A contract always applies to 100 underlying assets, it is not possible to trade with smaller quantities. When the price of an option is $2, you pay a total of $200.
Types of options
There are two types of options: call options and put options. In this part of the article we describe the difference between these types of options.
What is a call option?
A call option gives the buyer the right to buy a share at a fixed price.
What is a put option?
A put option gives the buyer the right to sell a share at a fixed price.
What is the exercise price or strike price of an option?
The exercise price or strike price is the price at which the underlying security can be bought or sold.
The more favourable the situation for the buyer of the option, the higher the premium to be paid. In the case of a call option, the price of the option will increase as the share price rises. In the case of a put option, the price of the option will increase when the share price falls.
What is the expiry date of an option?
The expiry date is when the option expires. The premium to be paid increases if the option’s term is long. There is then a greater chance that the price moves in the right direction and you can exercise the option profitably.
When the option has reached its expiry date and does not generate any money, it has become worthless. When you start investing in options you may lose your entire investment.
How can you actively speculate in options?
Plus500 allows you to actively speculate on the price developments of options by using CFDs. You can even apply additional leverage which can quickly increase both your potential profit and potential loss. Use the button below to instantly open a free demo on Plus500:
How to buy options?
Would you like to buy options yourself and add them to your stock exchange portfolio? You can do this at DEGIRO where you pay relatively low transaction fees for investing in options. Use the button below to directly open an account with DEGIRO:
Option examples: how do options work?
Call option example: you can buy a call option on the Shell share. You can then buy a Shell share at the price set within the option (point A). If the share price is then higher at the time you exercise the option, you make a profit. You can then calculate your profit by deducting the premium from the sale price.
On the y-as you can see the development of your profit or loss and on the x-as you see the development of the price of a share. A is the moment where the price of the share is higher than the strike price of the call option.
Put option example: you can also buy a put option on Shell. You can then sell Shell at the price set within the option. If the price is then lower at the time you exercise the option, you make a profit. You can then sell the share at a higher price.
On the y-as you can see the development of your profit or loss and on the x-as you see the development of the price of a share. A is the moment where the price of the share is lower than the strike price of the put option.
Buying and writing options
You can choose to buy an option. You then own the option, and you have the possibility, but not the obligation, to use it. To buy an option, you will have to pay a premium.
You can also choose to write an option. You will receive a premium for this. When you write an option, you have the obligation to buy the underlying security in the case of a put option at the strike price or to sell it in the case of a call option at the strike price.
|Buying||Option to buy||Option to sell|
|Writing||Obligation to sell||Obligation to buy|
You have to be cautious when writing options: you can lose a lot more money than the amount you put in. This is especially the case if you write the option uncovered and do not yet own the underlying security.
How often are options issued?
Options have different durations. For liquid shares you can find options that expire in 1,2,3,6 and 12 months. You can also trade short-term options that are sometimes only valid for one day. For investors with a long-term view you can also find options with a term of five years.
What can you use options for?
Firstly, you can use options to speculate. The prices of options fluctuate constantly. The price of an option depends on the price of the underlying security. For example, a call option on a share increases in value when the underlying share rises. By analysing the underlying security, you can benefit in the short term from price fluctuations on the option.
It is also possible to use an option as protection against a possible fall in the share price. With a put option, you buy the right to sell a certain share at a predetermined price. If the price suddenly drops sharply, you can still sell the share at the original price.
You can also receive additional returns on your shares by writing call options. You will receive a premium for writing options. If the price rises above the exercise price of the share within the period, you must actually deliver the shares. If this does not happen, you will receive an extra return on the share. This can be attractive if you intend to sell a share anyway.
Finally, you can improve your results. With options, you make use of leverage: this way a small movement has a bigger effect on the result. The advantage of options is that you can create this lever with a relatively small amount of money. When you make good use of this, you can achieve a higher profit. Of course the risks are also higher when you apply leverage.
What are the risks of options?
Options offer higher returns. But as always with investing, higher returns also entail higher risks. With options, you run the risk of losing your entire investment. When you buy an option, it can become worthless. This happens in the case of a call option when, on the expiry date, the price of a share is lower than the exercise price. When you write options, you can even lose more than the amount you receive in premium.
When you write call options you lose money when the share price rises. You then have to deliver the underlying asset of the share at the strike price. If you do not actually own the share, you have to buy it at the current price. Your loss then comes down to the amount you received in premiums minus the purchase costs of the shares. Your loss can then increase considerably!
With writing put options you can also get in trouble easily. When the price falls, you can be forced to buy the underlying asset at the strike price. If this price is higher than the share price, you will make a loss. This loss consists of the difference between the strike price and the share price minus the premiums received.
You can write covered options when you already own the underlying security. By writing your options covered, you decrease the risk of your investment.
How can you make money with options?
There are two methods to make money by investing in options. The first way is to buy an option. When the option increases in value, you will make a profit.
It is also possible to write an option yourself. When you write an option, you will receive a premium. When the option expires you can keep the premium as a profit. In the article on how does investing in options work, we will go into more detail about investing in options.
How does leverage work?
When you invest in options, you use leverage. This is because you need to invest less money than if you were to buy the underlying asset directly. As a result, the potential profit with an option is higher than when you buy a share directly. At the same time, your potential loss is also much higher: with an unexpected stock market movement, you can quickly lose your entire investment!
When do options expire?
Most options expire on the third Friday of the month. Of course, this does not apply to day options or week options. You should therefore pay close attention to the expiry date when you start investing in options.
How does the value of an option come about?
The price or value of an option consists of its intrinsic value and its time value.
What is its intrinsic value?
The intrinsic value is the amount that the option is worth at that time. If you can buy a share with a call option for $20 that is currently worth $25, the net asset value is $5 per share. You can then immediately buy the share for $20 and sell it for $25, giving you a profit of $5 per share. If the exercise price is higher than the current price then the option is in the money. If the exercise price is lower than the current price, a call option is out of the money.
What is the time value?
If the intrinsic value were to determine the full price of an option, the intrinsic value would always be equal to the price of the option. Due to the time value or expected value, this is not the case.
An option has a certain duration and if investors expect the net asset value of the option to increase in the future, the price of an option will be higher. The time value is higher if the expiry date is far in the future or if the underlying security has a high volatility. When the option is about to expire, the time value is close to 0.
What are the advantages of options?
People would not invest in options when this was not advantageous for them. You can use options to protect your equity portfolio against price falls. With a put option, you get a positive result when the price falls: that way you can take out insurance on your investment portfolio.
You can also increase the return on your shares. By writing call options, you will receive a premium. If you already own the shares, you can always sell them. If the options expire, you can put the premium in your pocket as an extra return.
Because options have a leverage effect, you can also benefit from small price movements. Both your potential profit and potential loss increase sharply when you make use of financial options.
For whom are options suitable?
Investing in options is not suitable for everyone. You need to understand the underlying asset well. For example, do you know how volatile the underlying asset can be? It is also important that you have sufficient knowledge of financial options. In addition, make sure that you have sufficient time to do research into the market and stock market prices. Options are only suitable for investors who have a high-risk appetite.
How much return can you achieve with options?
If you take a smart approach, you can achieve high returns with options. An option can sometimes increase in value by as much as tens of a percent. Of course, you can also make substantial losses: if the option becomes worthless, you lose the full amount of your deposit. It is also important to remember that you do not receive a dividend payment when trading options.
Option meaning: the Greek symbols
If you want to better understand the meaning of options, you can use the risk measures of these financial instruments. In this part of the article, we will go deeper into the mathematics behind the option. This will give you a better understanding of the definition of options.
The Delta indicates the extent to which the price of an option changes when the price of the underlying security rises or falls by $1. With Delta, you can therefore determine how price sensitive an option is. The call option always has a Delta between 0 and 1 and a put option has a Delta between 0 and -1. When the delta is 0,7 the value of the call option increases by 70 cents when the price of the underlying security rises by $1.
If you want to hedge your share position, you can also use the Delta to calculate how many shares to buy. The aim of a hedge is usually to achieve a delta-neutral position. In that case, it does not matter whether the prices rise or fall for the result of your investments. If the delta is 0,5 then in the case of a put option you would have to buy 50 shares for a full hedge.
You can also determine from the Delta what the chance is that the option ends up in the money. With a Delta of 0,5, the chance of this is 50%.
Theta indicates how much the price of an option decreases when time passes. When time passes, the chance that an option becomes more valuable decreases. If the Theta of an option is -0,25 then the value of the option drops 25 cents per day if all other factors would remain the same.
Gamma shows how the Delta of the option changes when the underlying security rises or falls in value. This is also called the second order or derivative of price sensitivity. For a Gamma of 0,1 delta increases or decreases by 0,1 when the price of the underlying security increases or decreases by $1.
Gamma allows you to determine how stable the delta of an option is: when gamma has a high value, the option can change significantly in value when the price of the underlying security changes. Gamma is highest when the option is at the money (the strike price and the price of the underlying security are almost equal). The range values decrease when the option is stronger in or out of the money. As the expiry date approaches, price changes have a strong influence on gamma.
Vega shows how much the value of an option depends on the volatility of the underlying security. When Vega is 0,2 the value of the option changes by 20 cents when volatility changes by 1%. Higher volatility increases the likelihood of extreme values and therefore profitable results: when volatility increases, the value of an option generally increases.
Rho indicates how the option changes when the interest rate rises or falls by 1%. This allows you to determine how sensitive the option is to changes in the interest rate. When the rho is 0,1 for a call option, the price of the option would rise 10 cents when the interest rate rises by one percent.
American and European options
There are two types of options: American and European options. The American options are the most common and can be executed at any time (until expiration). European options can only be executed on the expiry date.
How can you protect your stock portfolio with put options?
In the long term, the best results are achieved with shares. On average, however, share prices are anything but stable. Certainly, in times of crisis, things can go very wrong. By buying put options, you can absorb the falls without having to reduce your entire portfolio.
Advantages of options
If you do not use options, and you expect a significant fall in the stock market, you will need to sell stocks in your portfolio. As soon as the stock market recovers, you will have to buy all the securities again, which only makes the broker happy. By using put options to protect your portfolio in case of an (expected) drop, you save a lot of money on transaction costs!
Before you can use this strategy, you should know what an option is. An option gives you the right, but not the obligation, to buy or sell a share at a fixed price. With a call option, you can buy a share at a fixed price and with a put option, you can sell a share at a fixed price.
Buying put options
Suppose the AEX is at 700 points, and you expect a drop to 670 points. Annoying, since all your Dutch securities will drop in value considerably. However, this is not a problem with put options. With a put option, you profit from price decreases whereby every decrease is a profit for you.
Buy a put option with a low strike price around the expected turning point (in this case 670 points). When the prices actually drop, you will obtain a good return, because you will be able to keep the price low. After this turning point, the prices will probably rise again: in this way you will come through the fall unscathed.
Of course, it is also possible that you were wrong; the prices will then rise. In that case, you pay a premium for the option and this equals your loss; the option is no longer usable. No problem, you expected a fall, and you have insured yourself against this risk by means of an option. Because the prices rise anyway, your return increases, and you earn money after all.
Be economical with put options
Do not try to protect your entire portfolio all the time. Put options are expensive! It is wiser to protect your portfolio when there is a specific reason for doing so. Think for instance of the issuance of new quarterly figures. Then consider, on the basis of historical figures, how far the price can fall. Options with a more favourable strike price are more expensive. By thinking strategically, you will achieve better results with put options.
Using an index option
It can also be attractive to use an index option to hedge your risk. This is especially a good option if you are trying to protect your portfolio against a general risk factor. After all, the risk of the collapse of a specific share due to disappointing results is hardly counteracted in this way!
If you want to protect your entire portfolio, it is more profitable to use a put option on an index than to take put options or each individual share. This is because you pay transaction costs for each share transaction.
Do you want to learn more strategies to make money with options? Read the article about making money with options!
Earn money with options: 4 strategies
Options are interesting securities with which you can make good money. Before you can really invest in options, it is important to know how to select options and how profits and losses are determined. We also discuss some strategies that you can apply to make money with options.
Options are financial derivatives that give you the option, but not the obligation, to buy or sell an underlying security at a specified price. An option may relate to a share, for example.
- A call option allows you to buy the underlying share at a set price.
- A put option allows you to sell the underlying stock at a set price.
Options always have an expiry date. The option expires after that date: if the option is worthless at that moment, you lose the entire deposit.
If you use the options wisely, you can earn a lot of money with them. However, it is important to mention that options are riskier than the average investment: you can easily lose your entire deposit when you invest in options. For this reason, you should first practise investing in options first.
There are two ways in which you can invest in options: you can buy options or you can actively trade the price movement of an option.
At DEGIRO, you can buy options at low fees. Buying options is attractive when you want to exercise them for instance. Use the button below to open a free account at DEGIRO:
You may also choose to actively trade the price movement of options. At Plus500 you can speculate on both the rise and fall of option prices. When the prospects of an option deteriorate, the price may fall. Use the button below to try trading CFD Options for free with a demo at Plus500:
Trading in options is mainly strategic in nature. You should try to predict how the price of the underlying asset will develop and in what timeframe this development will take place. By predicting this, you can pick an option that suits your prediction.
Before selecting an option, it is important to determine whether you expect the price to rise or fall further. Also take a look at the volatility of the underlying asset: with a high volatility, there is a bigger chance that a high or a low value will be reached before the expiry date. Finally, don’t forget to look at the expiry date and assess whether the option will be of value before this time.
When you are more certain about a rising or declining trend on an option, you can choose an option with an expiry date which is less far in the future and which is further out of the money. This way you can optimize the amount you earn by trading options.
Some examples of option trading
If, for example, you think that the Philips share that is quoted today at $18 will be quoted at $20 within three weeks, you take a call option with an exercise price of £ 20and an expiry period of one month.
However, if you think that the stock is going to fall to $16 within four months, you take a put option on the stock with strike price $16 and an expiration time of four months.
You should select options based on your predictions. Bear in mind that the party writing the options apparently thinks that exactly the opposite will happen. In the end, of course, only one party can be right: investing in options is a zero-sum game.
Before you can make money with options, you need to understand how profits and losses in options work. Options expire on the third Friday of every month. An option is in the money when executing the option earns you a profit. This is the case for a call option at an execution price of $20 and with a premium of $1 when the price rises above $21. After paying the premium, you make a profit by immediately selling the share at a higher price.
Selling an option before the expiry date
When you are in the money with your option at the end of the period, you can exchange it for stocks. You then buy the stocks against a lower price than the current price. However, it is easier and cheaper (you pay less transaction costs) to sell the option before the expiry date.
Depending on the intrinsic value and the expected value, you will be able to receive a certain amount for your option. The actual profit you make can always be calculated by subtracting the premium paid from the profit received.
If you have paid $1 premium for your option, and you can now sell it for $2, your profit will be $1 per option. Your return is then 100%.
You can also lose
If an option is out of the money at the expiry date, it is worthless. You can then let the option expire and no further action is required. The loss consists of the premium you paid.
See in more detail how profits and losses are structured in the article on investing in options.
How can you write options?
Besides buying an option, it is also possible to write an option. When you buy an option, you receive a right, but when you write an option, you enter into an obligation. You have to sell the security (call option) or buy it (put option) at a certain value. In exchange for this obligation, you receive a certain premium from the buyer of the contract; this premium is your profit.
If you write out an option, you will earn money when you don’t have to execute the contract. Therefore, write out an option with characteristics of which you think they will not come true. The more favourable the conditions for the buyer of the option, the higher the premium you will eventually receive. So be on the edge of your prediction, that way you will earn more.
Once you have written an option, you can close it early by trading it on the stock exchange. Writing a position requires a certain margin with your broker, so you can deliver the securities at the promised price. After the expiry date, the buyer of the option can oblige you to deliver the securities.
In the last part of the article we will look at which strategies you can use to make the most money with options. This way you will know how to achieve a good result responsibly.
Strategy 1: Use options to increase returns on existing shares
It may be wise to combine options investments with the underlying asset. By buying shares, you ensure that you cover the risks. It is then possible to use options to achieve a better return on your portfolio.
To achieve this, you can write a call option on stocks you already own. Suppose you have 100 stocks with a value of $10, and you do not expect a rise in the future. You can then use options to still achieve a return on your shares. By writing a call option, you receive a premium on your stocks.
In this example, you write an option with a premium of $70, committing yourself to deliver 100 shares at a price of $11 with an expiry date of the third Friday of the following month. Because you own the stocks, delivering the shares will never be a problem.
An advantage of this construction is that you obtain a guaranteed return of $70 whereas otherwise you might not obtain any return at all. However, if the share price rises above $11, the buyer of the option will probably exercise it. Therefore, you cannot profit from sharp price increases during this period.
Roll over: Continue with this tactic
It could be that the stock has risen slightly to $10.50. This also gives you a positive return on your shares. At the same time, the buyer of the option will not exercise it as there would be a negative return. So, in this scenario, you profit twice! Next, there are several ways to make more money with the options.
The first option is to sell your shares. You will then have a price gain of $0.50 per stock and on top of that, you will have received the extra premium of $70. In this way you have increased your return thanks to the options.
It is also possible to roll over the position. You then write out an option again for which you will receive a premium. Of course, you then always run the risk that the price of the share drops considerably, causing you to experience price losses, or that the price actually rises and you have to deliver the stocks. Regardless of what happens, you are guaranteed to receive the premium.
Finally, you can also hold on to the stocks and not issue options. This is the best decision if you expect the shares to rise further.
Strategy 2: Buy shares at a lower price
You can write a put option to buy stocks at a lower price. Let’s assume you are interested in a share trading at $10. You write a put option at the price of $11 and receive $70 in premiums. You now have the obligation to buy 100 stocks at the price of $11 at the end of the expiry date. The premiums that you receive can be used as a discount so that you can buy the shares cheaper later on.
If the price rises dramatically within the period, and you buy the shares too late, you will miss out on this huge increase in price. However, the put option is not executed, so you do have the premium as profit. If the price falls sharply, you will have to deliver the shares. By doing so, you make a loss. However, if you had bought the shares immediately, you would also have suffered this loss. Thanks to the premium, your loss is now lower.
Strategy 3: Protecting your portfolio
You can also use options to further protect your share portfolio. You can use put options to ensure that you can sell the shares that you own at a certain price, guaranteed. In this way, you actually protect your shares against a sharp fall. Of course, you do pay a premium for this, which can reduce your return. You can read more about options as insurance in this article.
Strategy 4: Make money with active trading
You can also use options to actively trade the underlying asset. For this, you need to make predictions about the future price development of the underlying share. However, there are other factors that influence the value of an option. Think for example of the volatility of the market and the time that remains until the expiry date. Therefore, make sure you read up on all these factors before you start actively trading options!
How can you earn more money (in theory) with options?
If you use options wisely, you can make more money than when you buy shares. This is the case because you can use leverage with options. This means that you can open a larger investment position with a smaller amount of money. As a result, your potential profit (but also your potential loss) is higher.
You only pay a premium for an option. That premium can be $1 and that option can relate to a share of $20. If you were to buy the share with $100, you can only buy 5 of them. However, you can buy multiple call options at the price of $1.
Of course, with an option, there is a chance that you will lose the entire deposit. If the option does not generate a profit, the option remains out of the money. When the call option in the example is at $22, the share price has to rise to a value above $23 to have a favourable result.
Speculating in options can therefore be very attractive, but you have to know what you are doing.
Buy or write options?
For most investors, it is smarter to buy options. When you buy an option, your risk is limited to the premium you pay. At the same time, your positive result is theoretically unlimited.
However, when you write options, your profit is limited: you never receive more than the premium you pay. At the same time, your loss is theoretically unlimited. Nevertheless, many people write out options: according to research, more than 75% of the option contracts end up being worthless. When you really know what you are doing, you can earn a lot of money with writing options.
Writing options is risky: at most brokers, you can only write covered options. This means that you write options on shares that you already own.
When do you make money with a call option?
You make money with a call option if the underlying security increases in value. How much money you make depends on the difference between the premium you pay and the profit you make.
When do you make money with a put option?
You make money with a put option if the underlying security falls in value. How much money you lose depends on the difference between the premium you pay and the profit you make.
Before you start investing in options, it is important to determine your risk tolerance. Options are high-risk investment products. If you prefer lower risk, you are better off investing in individual stocks.
Investing in call options is slightly less risky than investing in put options. This is because shares tend to rise over the long term. This is logical when you consider that the general production within an economy is only increasing. Buying a put option can be a less risky alternative to a short position, as you have no obligation when you buy options.
When you want to write options, put options are the least risky. The biggest risk you run is that you pay too much for a share when it crashes. When you write a call option, your theoretical loss is unlimited when you do this uncovered. We also call this writing an option naked. Therefore, this is not advisable for most private investors.
You can further limit your risks by setting up option spreads. You then combine different types of options.
Also read this
- What is an option – here you can read in detail how options work.
- How options investing works – find out how to invest in call options and put options.
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.