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?
What is an option?
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:
- Underlying value
- Option types (call or put option)
- Contract size
- The exercise price
- The expiration date
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.
Option types: call or put option
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
How can you invest in options?
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:
What are the aspects which determine the value of an option?
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.
Which aspects influence the price of an option?
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
Choosing options and then selling them
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.
How much do you earn from writing options?
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.
Summary buying & writing options
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.
Selling options before the expiration date
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.
Exercising an option
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.
Option strategies: using options smartly
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.
The risks of option investment
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:
How much does investing in options cost?
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
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