I know, it’s a bit awkward that I am writing a post on option trading, while on the other side my website is aobut long-term financial development. Nevertheless, I remember being very active in options trading as a student, just like most of my fellow-students, and actually it did earn me some money. In addition, options can be a great strategy to use as an insurance, in combination with shares. In this post, I am mainly referring to European options. Also, please keep in mind that not in every country option tranding is possible for individuals.

Options are much like insurances: they give the buyer the right to buy a specific item, during a certain period, for a certain price. Options exist for many items, perhaps one of the most well-known is real estate. Consider the following example:

Your are considering buying a nice holiday home in France. You see a nice real estate you like, but you are not quite sure about the purchase. In addition you need to clarify some formalities with your bank, such as whether or not you will be granted a mortgage. Knowing that this process might take 2 months, there is a risk that someone else buys the real estate and takes away this opportunity from you, and there is a risk of rising real estate prices; In 2 months time the real estate might be worth 330.000 Euros. By buying an option, you will obtain the right to buy that house (also called the underlying value) during a certain period, for a pre-set price of, let’s say, 300,000 Euros. As such, even if the real estate price has increased to 330.000 Euros, you will still be able to buy the object for 300,000.

As with real estate, you could buy options on stocks. Stock options come in two forms: call options give the right to buy specific stock for a certain price (strike price) before a pre-defined date (expiration date), and put options give the right to sell specific stocks for a strike price before the expiration date. Now, being able to exercize that right does not mean you have to. With a changing price of the underlying value, the option price will change too, and you can simply trade in options, aiming at making profits from it. There are actually three things you can do with an option:

1. You can buy an option and sell it at a profit later.
2. You can buy an option and at a later point exercize your right to buy the underlying value.
3. You can buy an option and let the option expire at the expiration date: the option will end worthless and will be taken from the market.

How options are listed

Options are listed in a specific way. Look at the following examples:

ING C 0912 9.00 lists a call option (note the C) on the stock ING, expiring on december 2009* with a strike price of 9.00 Euros.

ING P 1003 11.00 lists a put option (note the P) on the stock ING, expiring on march 2010* with a strike price of 11.00 Euros.

*Note: the expiration date in any given month is usually the third friday of that month.

This is how options work

How options work exactly can best be explained by the following example:

Let’s take the ING call option example from above. The strike price of the option is 9.00 Euro, and the stock itself closed at a price of 9.53 Euro today (19 november 2009). This means, that if I would would have the ING C 0912 9.00 option, I could buy the ING stock at a price of 9.00 Euros, although the real price of the stock today is 9.53. As a result, the stock price must at least cost 0.53 Euro; if the option would cost less, I could make an immediate profit by buying the option and immediately exercizing my right. This difference is called the intrinsic value. In addition, there are also option series with an intrinsic value of exactly 0, and there are option series with a negative intrinsic value.

Suppose the stock price would tomorrow increase from 9.53 to 9.69 Euros, which is an increase of 1.65%, the option price must increase to at least 0.69 Euros (else someone would be able to make immediate profits). But look at what happens: from 0.53 to 0.69, that’s an increase of 23.1%.

Put options work exactly the other way around; they are rights to sell stocks, and thus if the stock price decreases, the value of the option would increase. This is one feature what makes options so interesting; it allows for making profits in both increasing and decreasing markets.

Note: options are bought per contract, 1 contract includes the option to buy 100 shares. So, if an option is priced at 0.53 and you would buy one contract, you would actually invest 53.00 Euros.

This example shows the leverage effect of options, that everyone is talking about. But be cautious: whereas there is a leverage effect on profits, the same leverage effect applies on losses!

The options’ price structure

As we saw in the above example, the intrinsic value of the above option is one element of the options’ pricing. However, if we look at the real value of the INC C 0912 9.00 series, we see saw that this option is currently being traded for 0.83 Euros.

There two important elements, which influence the pricing of an option. This is one of the reasons why options are so risky:

• Time value: the more time is left until the expiration date, the higher the time value of an option. The reason is that more time equals a higher chance that the stock will move in a certain direction. If I look at the price of the same option, but with an expiration date in january 2010, the price is 1.10 Euros.
• Expectation value: if a stock is very volatile, or if there is a high expectation that it will develop in a specific direction, this might add up to the expectation value of the stock price.

Considering the pricing of an option, the worst thing that can happen is to own an option on a stock, which is stable; a stock’s stability is the stock trader’s enemy, since expectations and the time value will become less and less. This is what makes options risky: although you would not have gained or lost anything on the stock, the option is becoming worth less, and you are losing money over time.

Get professional advice

This article explains some of the basic principles of options. There are so many different types of options and option strategies, that I would highly advise to read in-depth material and consulting a specialist before attempting to trade in options yourself. Option trading bears a very high risk.

This post is in no way a subsitution to professional advice and should not be seen as such. Moneywise24 can not be held responsible for any personal decisions. Please also refer to our disclaimer at the bottom of this page.

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