Options

Options - Investors Academy

 

What is an option?

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.

An investment product with many possibilities and pitfalls

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.

What you need to know about options

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.

  1. The Leverage Effect

    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.

  2. Call options and put options

    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.

    Options

    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.

  3. Important concepts

    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.

  4. The premium of an option

    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:

    • Then the premium of a call option on that underlying asset will usually also rise; and
    • Then the premium of a put option on that underlying asset will usually fall.

    If the price of the underlying asset decreases:

    • Then the premium of a call option on that underlying asset will usually also fall; and
    • Then the premium of a put option on that underlying asset will usually rise.
  5. Writing options

    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.

  6. Covered and uncovered writing

    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.

  7. How do options end?

    Options can end in different ways.

    If you have bought an option
    If you have bought an option, your option may end because:

    • you exercise your option; 
    • you close your option (closing sale); or 
    • your option expires on the expiration date without value.

    If you have written an option
    If you have written an option, your option may end because:

    • your option is assigned. A buyer then exercises his right and you as a seller (writer) must then fulfil your obligation. This can happen not only on the expiration date, but also earlier in the exercise period; 
    • you close your option (closing buy); or 
    • your option expires on the expiration date without value.

    ‘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.

  8. Indicating the value of an option

    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.

  9. Your maximum profit and loss when buying or writing options

    Profit and loss depend on a number of factors:

    If you buy an option, your maximum profit is:

    • The positive difference between the price of the underlying asset and the exercise price;
    • Minus the premium you pay; and
    • Minus the costs you pay.

    If you buy an option, your maximum loss is:

    • The premium you paid; 
    • Plus the costs you paid.

    If you write (sell) an option, your maximum profit is:

    • The premium you received;
    • Minus the costs you paid.

    If you write (sell) an option, your maximum loss is:

    • The negative difference between the price of the underlying asset and the exercise price. With a call option, this difference is theoretically infinite; 
    • Plus the costs you paid; 
    • Minus the premium you received.
 

The advantages of options

  • Options offer you opportunities to respond to the rising, the falling and the remaining constant of the underlying asset. This way you can also achieve returns in a falling or constant market.
  • Due to the leverage effect, an option allows you to benefit more from a share price movement than from an investment in shares alone. 

The disadvantages of options

  • Options are complex investment products. You must understand them well before you can trade them responsibly.
  • You can lose more than your investment due to the leverage effect. And sometimes even have a debt.
 

This is how you trade options

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.