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?
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How can you buy options?
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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.