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Options are conditional forward transactions. They include the right to buy or sell an underlying asset like a file at a price already fixed today (strike or exercise price) at a later date.
There are therefore call options and put options. A buyer of a call or put option on stocks can decide, depending on the price development of the underlying stock, whether to exercise his or her right to buy or sell the stock at a later date or to let the option expire. For this right he must pay the option price (premium).
The seller of a call or put option as counterparty is called the writer. He receives a premium for the sale of the option. He must also wait and see whether the buyer exercises the option or not.
Call option – Call
From the perspective of the buyer of the call option (call long):
One share is quoted at € 95 today. The buyer of a call option assumes that the share will increase in value and agrees with the seller today on a purchase price for the share of €97 in three months. For the option, he pays the seller an option price of €2 per share. Since options are written by default over 100 actions each. Altogether the option price amounts to thus 200 €.
If the share price actually rises above €97 by the agreed term end, for example to €100, the buyer will exercise the option. He can then post a profit, as he can purchase the shares at €97 per share at a lower price than he would have to pay on the market. He could then immediately sell the shares again at the market price of €100.
However, the €2 price paid for the option must be deducted from the €3 profit from the price difference. The actual profit is thus 100 € over 100 shares.
This doesn’t sound like much, but it is quite a lot, considering the €200 stake in the option. The yield is 50 %.
If, on the other hand, the buyer had originally bought the shares at €95 and later sold them at €100, he would have made a profit of €5, but the return is only 5.2%. Options therefore contain a considerable leverage.
From the perspective of the seller of the call option (call short):
In the example, the seller of the option has received the option price of 200 €. In the event that the buyer exercises the option, he must deliver the share. In this case, he receives 97 € per share. If he has bought the shares before for example to 95 € and thus already in his possession, he receives the option price of 200 € and the purchase price of 9700 € for the sale of the option, altogether thus 9900 €.
In this case he makes a profit of 4 €. Without the sale of the option, however, he could have made a profit of 5 €, because the share is worth 100 € on the market.
If the buyer does not exercise the option against it, because the price sinks, the salesman of the call option keeps the share and collects 2 € from the option price. He only bears the risk from the share. If the share has fallen to €90, for example, he can at least reduce his loss from the share over €5 by €2 from the option premium received.
Somewhat more negatively the calculation for the salesman of the option with a short sale looks, if the salesman of the call option did not have the share in its possession and must acquire these only at the market, if the buyer exercises the option.
If he has to buy the share at 100 € and only receives 9,700 € as the purchase price from the option transaction, he makes a loss of 300 €. However, the loss is reduced from 200 € to 100 € by the collected option price.
Put option – Put
From the perspective of the buyer of the put option (put long):
As in the example above, the share is quoted at € 95 today. A buyer of a put option assumes that the share will fall. He agrees with the seller of the put option on a price of, for example, €93 when the option is exercised in the future, which for 100 shares corresponds to a purchase price of €9,300. In return, he pays an option price of €2 per share, or €200 in total.
If the share price actually falls below €93, he will exercise the option. Assuming a market price of €90 at the time of exercise, he will initially make a profit of €300 from the difference in price, as he can buy the share at €9000 and sell it at €9,300.
However, the profit is reduced from €200 to €100 by the option price paid. If, on the other hand, the share price increases, the buyer will not exercise the put option, since he can sell the share on the market at a profit. The profit is only reduced by the option price paid.
However, the calculation only applies if the buyer of the put option did not previously own the stock.
For example, if the buyer of the put option had previously purchased the shares at €95 per share, he spent €9,500 for the share and €200 for the purchase of the put option, making a total of €9,700. If he exercises the option, he receives €9,300 for the shares, even though one share is now only worth €90. He thus makes a loss of €400 (€200 from the fall in share price and €200 for the option premium paid). Without the option he would have to post a loss of 500 €.
Exercising the put option is worthwhile if the share owner assumes that the price will fall even further.
From the perspective of the seller of the put option (put short):
The seller of the put option initially takes the option price of €2 per share, or €200 for 100 shares. He must then wait to see whether the buyer exercises the put option.
If the price falls to 90 € as before and the buyer exercises his put option, he must buy the shares at a price of 93 €.
So he pays 3 € more per share than he would have to pay on the market. However, the loss of 300 € is reduced to 100 € by taking the 200 € from the option price. He thus only bears the risk from the share price development.
If, on the other hand, the share price rises or stagnates so that the buyer does not exercise his put option, the seller of the put option makes a profit in the amount of the collected option price of €200.
Advantages of options
Options have the advantage that large profits are possible with relatively little money, as they involve a leverage effect. Options can also be used to speculate on falling prices. By selling options, investors can earn the option premium that they receive from the buyers of call or put options.
Sellers only have the risk from the performance of the underlying asset. The losses, on the other hand, are very limited compared to other leveraged products. There is no obligation to make additional contributions.
Options can be concluded not only on equities, but also on a wide range of other underlying assets such as indices, interest rates, commodities, food, electricity or even the weather. It is therefore a very flexible instrument.
Exchange-traded options are also standardised. The markets are correspondingly liquid so that they can always be traded and there is practically no issuer risk.
Various types of options can be combined with each other, so that sophisticated option strategies can be developed with options, such as the delta value strategy for undervalued shares (value investing).
It is also possible to design option strategies in such a way that profits are made whether the underlying price rises or falls. For example, a buyer can purchase a call option and a put option at the same exercise price. As soon as the price change is higher or lower than the premiums paid, a profit is made.
Options can also be used to hedge stock values in the portfolio.
Advantages at a glance
- Reduced capital requirement
- Taking advantage of all market movements
- Limited risk
- Numerous underlyings tradable
- No issuer risk
- Standardized trade
- Buyers have only rights
European versus American options
Options also differ in when the holder can exercise them. European options can only be exercised at the end of the option term. American options, on the other hand, can be exercised at any time during the term of the option. The terms “European” and “American” have nothing to do with where options are traded.
There are also “exotic” options, such as Asian options, which have a special structure for calculating the payout, for example by using different cut-off dates for the exercise price.
How is the option price calculated?
The option price is composed of a time value and an intrinsic value.
The time value of an option depends on the volatility, i.e. the fluctuation margin of the prices as well as the remaining term. The time value has the property that it becomes increasingly smaller and is zero at the end of the term. A higher volatility causes a higher option price because there is a greater probability that the price will continue to move up or down, which means that the option can be more profitable.
The intrinsic value of the option is determined by the difference between the actual price and the exercise price (strike price). For put options, the difference between the strike price and the actual price is decisive. The intrinsic value can also be zero, namely if the option is worthless. The option is not worth exercising.
In practice, option prices are calculated using the standard model for option prices, the Black-Scholes model, which is admittedly somewhat complicated. Investors can, however, use an option price calculator, for example the Eurex OptionMaster.
Where to trade options?
Investors can buy standardized options on options exchanges. The largest options exchanges are Eurex, the Chicago Board Options Exchange (CBOE) or the Osaka Security Exchange. The origin of standardized options is to be found at the Amsterdam Stock Exchange, where at that time mainly futures transactions on grain were concluded. Private investors can open an account with an options broker to trade options.
Read my other articles about options:
- Bear Call Spread Options Strategy
- Bull Put Spread – Earn Money With Puts And Limit Risk
- Butterfly Spread Options Strategy
- Definition Of Option Price/Option Premium
- Earn Money With A Covered Call Options Strategy
- How to exercise Options
- How to use the Standard Deviation for Options Trading
- Iron Condor – Profit From Low Price Fluctuations
- Options Trading Tutorial for beginners
- Options vs. Futures – Two Different Types Of Futures Contracts
- Options vs. Warrants – 4 Differences
- Protective Put – Hedging Of Equity Positions
- Simple Trading Strategies for Options
- Term structure options
- What are options? – Explained Simply And Quickly
- What is a Long Call in Options Trading?
- What is a Long Put in Options Trading?
- What is a Short Call in options Trading?
- What is a Short Put in Options Trading?
- What is delta in Options Trading? – The Most Important Key Figure
- What is Historical Volatility in Options Trading?
- What is the Gamma in Options Trading?
- What is the Implied Volatility Of Options – Important Or Not?
- What is the Theta in Options Trading?
- What Is The Vega Of An Option?