Options Basics – What You Should Know About Options

Are you familiar with options? How do options work? Do you already trade derivatives and use options to optimize your investment returns or for hedging? On this page you will find useful information and tips about options.

 

What are options?

• Options are a financial product that belongs to the derivatives category (futures transactions).
• When you buy an option, you acquire the right to buy or sell a commodity or asset such as a stock (underlying asset) up to a specific point in the future at a pre-agreed base price (strike).
• By purchasing the option, you only acquire the right to exercise this call or put option. However, you are not obligated to actually execute your option.
• When you buy an option, you enter into a contract with the option seller (writer), known as an options contract.
• The option seller must guarantee that you can exercise your option. In return, they receive a small amount as compensation, the option premium. You must pay them this premium immediately upon entering into the contract and you will not get it back, regardless of whether you exercise your option or not.

 

The most important characteristics and parameters of options

• Options are traded in a standardized manner on exchanges and are more heavily regulated than other speculative financial products.
• When buying options, unlike futures, you must pay a premium upfront.

There are different types of options with various underlying values (also called underlyings). Here are some examples:

• Options on a market index/stock index (Eurostoxx 50, S&P 500, Nasdaq 100, ...)
• Options on a stock (Microsoft, Amazon, SAP, ...)
• Options on currencies/forex pairs (EUR/USD, ...)
• Options on a commodity (oil, gold, silver, copper, ...)
• Options on a bond (e.g. German government bond, corporate bond, ...)

 

Call and put options

Call options

• When you buy a call option, you acquire the right to buy an underlying asset such as a stock at a pre-determined price up to a specific point in the future.
• If you expect, for example, that the price of a stock will rise sharply, you could buy a call option with the strike price of the current stock price and a term of one month. This would give you the right for one month to buy the stock at that price, regardless of how the stock price develops. If the stock price actually rises very sharply, you will be glad to be able to buy the stock at the agreed, lower price. You would exercise the option and your incurred costs for the option premium at purchase would quickly be forgotten. However, if the stock price falls, it makes no sense for you to exercise the option, so it expires at the end of the term and the purchase premium you paid represents a small loss for you.

Put options

• When you buy a put option, you acquire the right to sell an underlying asset such as a stock at a pre-determined price up to a specific point in the future.
• If you expect, for example, that the price of a stock in your portfolio will fall sharply, you could buy a put option with the strike price of the current stock price and a term of one month. This would give you the right for one month to sell the stock at that price, regardless of how the stock price develops. If the stock price actually falls as assumed, you would still be able to sell the stock at the agreed, higher price by exercising the option.

 

European options and American options

There are two variants of exercise. Even though the names might suggest it, the two types have nothing to do with Europe or America as regions, but define when an option may be exercised by the buyer (there are also European options in America and American options in Europe).

1. European options

With an option using the European form of exercise, you can only exercise the option on the expiration date, meaning only at the end of the term, not in between. This exercise style is frequently offered for options on stock indices, e.g. for options on the DAX index or EuroSTOXX index.

2. American options

With an option using the American form of exercise, you can exercise the option at any time between its purchase and its expiration, you do not need to wait until the end of the term. This exercise style is frequently offered for options on stocks and ETFs. You can use this advantageously, for example, to have a dividend stock booked into your account before the ex-date, so that you receive the dividend of the underlying asset credited to you.

By the way: In practice, American options are also almost always held until the end of the term. This is because the time factor is generally factored into the option valuation, and the time value of an option is higher the longer the term. 

 

 

Use cases and strategy examples for options

• You can use options to hedge against market fluctuations and price crashes and thus minimize risk factors.
• You can also use options for speculation with high returns.

 

Advantages of options

• Low capital investment required, but high returns possible.
• Large selection of underlying assets.
• Standardized trading on exchanges.
• Simple way to bet on falling prices (going short).
• Possibility of hedging against financial crises or sharply falling prices.

 

Disadvantages of options

• Very high losses possible.
• Unlike holding stocks, you do not receive dividends for purchased options.
• Trading options is a fairly complex subject area and requires fundamental prior knowledge. For private individuals, a certified eligibility for futures trading is also essential.

 

 

Sources and interesting links

1. finanzfluss.de - What are options? – Options explained simply
2. gevestor.de - European option – Basic knowledge
3. deltavalue.de - European options – Definition & example
4. banxbroker.de - Options trading knowledge: American vs. European option
5. finanzderivate.net - American options and the difference from European options
6. lynxbroker.de - Early exercise of options – How to react correctly and stay relaxed

 

Do you have any further tips and suggestions for trading options? What are your experiences with these derivatives? When and how do you use them in your investments? Feel free to leave a comment.

Comments 0