An option is a derivative financial product. The value of an option depends on the price development of the underlying asset: the product to which it is linked. The underlying asset can be a share, bond or index, for instance. With the term ‘option’ you soon think of a temporary right to buy something, for example a house. The provider of this right therefore has an obligation to sell it to you. In investing it works the same way. Options are standard contracts that allow you to buy a right or an obligation to buy or sell something at a set price.
Options allow you to respond to rising, constant and falling share prices. Therefore, it can be a useful investment product within your investment strategy. With options you can get a lot of return on a small investment, but the risk of a significant loss is also high.
Options are complex investment products. At ABN AMRO, you can only trade in these if you have successfully completed a knowledge and experience test. You must also first sign a separate agreement.
Options operate with a leverage. Due to the leverage effect, the profit you can make with an option is greater than if you invest directly in the underlying asset (calculated in percentages). This is because you have to invest a smaller amount with an option than with a direct investment in the underlying asset. But the chances of profit are equal. Depending on the movement you want to respond to, in the event of a ‘wrong’ movement you lose fast with options, and often a lot of money. Faster and more than with a direct investment in the underlying asset. For example, if the price of the underlying asset remains about the same, the option will lose its value increasingly quickly and will expire without value on the option’s expiration date. With a direct investment in the underlying asset, your investment would simply remain approximately the same value.
There are two types of options: call options and put options. If you buy these, you are buying a right. You can read more about entering into an obligation (writing options) under ‘5. Writing options’.
Buying a call option
If you buy a call option, you pay a premium. This gives you a right to buy a certain amount of an underlying asset at a predetermined price in a certain period of time.
Buying a put option
If you buy a put option, you pay a premium. This gives you a right to sell a certain amount of an underlying asset at a predetermined price in a certain period of time.
You decide whether you use your right. If you use this, we call this exercising.
Exercise price
We refer to the predetermined price as the exercise price.
Expiration date
The day the option expires is the expiration date. This is always predetermined.
Expiration time
The time when the option expires is called the expiration time.
Exercise period
The period up to the expiration time of the option is called the exercise period. Options have different exercise periods. The most common are monthly options, where the expiration date is the third Friday of the month. But there are also weekly options and even daily options.
Premium
We call the price of an option the premium.
Contract size
The size of the underlying asset of the option is always predetermined. With a share option, the contract size is usually 100: you can buy or sell 100 shares with 1 option. With an index option, the contract size is always 100: if the index changes by 1 point, you will receive or pay €200.
The price of an option is called a premium and consists of two parts:
The time and expectation value
This section indicates what the market expects from the price of the underlying asset. The market takes into account the time that remains until the expiry date of the option, the expiration date. At time of expiration, the time and expectation value is close to zero.
The intrinsic value
This part is the difference between the exercise price and the price of the underlying asset. There is intrinsic value if the price of the underlying asset is higher than the exercise price of a call option. Or if the price of the underlying asset is lower than the exercise price of a put option. The intrinsic value can never fall below zero.
If the price of the underlying asset increases:
If the price of the underlying asset decreases:
A special feature of options is that you can also sell an option without having a position in it. You will then receive a negative position. This selling is called writing and we call such a negative position a short position. If you write an option, you will not be given a right but an obligation:
If you write a call option
You will receive the premium. This means that you have the obligation to deliver a certain amount of an underlying asset at the exercise price during the exercise period.
If you write a put option
You will receive the premium. This means that you have the obligation to purchase a certain amount of an underlying asset at the exercise price during the exercise period.
Covered writing
With covered writing, you have the underlying asset in your investment portfolio and you write on the basis of that cover. Example: You have 200 Philips shares and write 2 call options on Philips. If you have to fulfil your obligation at some time and deliver the shares, then you can simply deliver those 200 shares. This happens automatically, you do not have to give an order yourself.
Uncovered writing
With uncovered writing, you do not have the underlying asset in your investment portfolio. We take the same example: If you have to fulfil your obligation at some time and deliver the 200 Philips shares, you cannot do this. You must first buy the shares on the stock exchange and immediately deliver them, this also happens automatically.
If you write put options, it is always uncovered. With a written put option you have to purchase the underlying asset. Say you wrote 2 Philips put options and you have to fulfil your obligation at some point. Then you buy 200 Philips shares at the exercise price, this again happens automatically.
Margin
To make sure that you can fulfil your obligation of your uncovered written option, you must keep a certain amount in your account. We call this amount the margin. The margin is not a fixed amount, but can change every day, depending on the premium, among other things. If your margin is too low, your orders cannot be executed.
Options can end in different ways.
If you have bought an option
If you have bought an option, your option may end because:
If you have written an option
If you have written an option, your option may end because:
‘American’ or ‘European’ style
American style options can be exercised during the entire term of the option. These are usually share options. European style options can only be exercised on the expiry date. These are usually index options. In addition, with the American style options, settlement takes place physically, in the underlying asset itself. While with the European style options this happens in money.
We indicate whether an option has value with the terms: In the money, Out of the money and At the money.
In the money
This means that the price of the underlying asset is higher than the exercise price of a call option. Or that the price of the underlying asset is lower than the exercise price of a put option. At that time, the option has a positive value for the investor. The premium then consists mainly of intrinsic value and less time and expectation value.
Out of the money
This means that the price of the underlying asset is lower than the exercise price of a call option. Or that the price of the underlying asset is higher than the exercise price of a put option. At that time, the option has a negative value for the investor. The premium then only consists of time and expectation value.
At the money
This means that the price of the underlying asset is approximately equal to the exercise price of the option. The premium then only consists of time and expectation value, in the beginning it may be slightly higher than the time and expectation value of an option that is out of the money.
Profit and loss depend on a number of factors:
If you buy an option, your maximum profit is:
If you buy an option, your maximum loss is:
If you write (sell) an option, your maximum profit is:
If you write (sell) an option, your maximum loss is:
At ABN AMRO, you can trade options with the investment method Self Directed Investing Plus. Options are complex investment products with greater financial risks than shares. Before you can trade options at ABN AMRO, we first ask you to take a knowledge exam about these. If you pass the test, you have sufficient knowledge to be able to invest in options.