Stock options for dummies

Golden rules for option investors

The investing in stock options from listed companies is very popular, mostly in Western Europe and the US. Many historians state that the invention of options was done in Amsterdam (the Netherlands). Stories go that the options were invented early 1800 when the Western-European companies went to the East (VOC-time).

But other sources state that options were invented earlier on other places. In 1973 the first options exchange was founded, the CBOE, Chicago Board Options Exchange. Anyway, in Amsterdam many foundations were made for the current option markets. On April 4th in 1978 the European Options Exchange was started in Amsterdam in the Beurs van Berlage. Investors living in the Netherlands can visit the Dutch website Analist.nl with option data. In 1997 that option exchange merged with the Amsterdam Exchanges. A year later they moved to the large trading floor at Beursplein 5, which came free shortly after the transition to fully automatic trading.

At the end of 2002 the 'old' floor trading (open outcry) stopped and from then all the option trading was done only by screens. Famous option traders are Edward Thorp, Andy Krieger and Sem van Berkel. In this article we give a short introduction about stock options.

Options only on the larger stocks

The option world is one of a kind and is known about a lot of complex jargon, strange symbols (like the Greeks), rituals and other remarking things. In this article we try to avoid this by keeping it as simple as possible. Despite options are very well known by far not all stocks have options outstanding.

Normally it are only the largest stocks (read: companies) from the major indices like the Dow Jones Industrial Average, AEX and the OMX Copenhagen that have options outstanding. And mostly a part of the midcap stocks have options outstanding. But the smaller companies, like the micro- and small caps almost never have options outstanding. The reason for this is because of the lower liquidity of the smaller companies. Market makers need to have a minimum liquidity to be able to provide bid and ask prices for options.

Basics of options

Options are the right to either sell or buy 100 stocks. In case of a call option it's the right to buy, in case of a put option it's the right to sell. Of course these are the inverse of each other. When the price of stock goes up the call option increases in value and vice versa for a put option. Put options increase in value when the stock price goes down.

Of course this is a way too quick conclusion as we also need to pay attention to time to expiration, strike prices, volatility and interest rates. Long time ago options were introduced to create more opportunities for both the buyer and the seller of a stock. Normally you should always had to own a stock in order to benefit from it.

But with options that is not necessary as these are so-called derivative products. We mean that the option's value is directly dependent of the underlying value.

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Short about calls

Let's start with a brief introduction about call options.

payoff diagram call option

A call option is the right to buy a stock a pre determined price (strike prices) and for/at a pre determined date (expiration date). So these to variables are fixed: the strike price and the date.

In case you think that a certain stock will rise in price then of course you can buy the stock. In case the stock rises 10 percent then your return is 10 percent. But it could have been (way) more in case you bought a call option. In case the Daimler share is now trading at 32 dollars then you could buy the call option with a strike price of 33 dollars with a time to maturity from 3 months for 20 cents. Then you only need to pay 20 dollars as 1 option is for 100 stocks (so 20 cents times 100).

This call option gives you the right to buy the Daimler stock over 3 months or earlierfor 36 dollars. This is also the case when the Daimler stock is trading at for example 46 dollars. The investor who bought these 100 Daimler shares at 31 dollars directly paid 3100 dollars (100 x 31 dollars).

At a price of 41 dollars the buyer has a profit of 1000 dollars (100 x 10 dollars). The total return is then a huge 27,78 percent: 1000 dollars profit / total investment of 3600 dollars.

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Moneyness in short

There are 3 categories that state whether an option has intrinsic value. These are:

In the money: for call options the strike price below the stock price, for put option strike price above the stock price

At the money: for both calls and puts the strike price (almost) equal to the stock price

Out of the money: for call options strike price above the stock price, for put options the strike price below the stock price

Leverage in short

The buyer who bought a call option has a way higher return. His or her pay was only 20 dollars (100 x 20 cents). Imagine that at the expiration date the stock is trading at 41 dollars.

If we deduct the excercise price of 39 dollars then we have an intrinsic value of 9 dollars. That invested 20 cents is now worth 9 dollars. So an extreme return of 4400 percent with having a low nominal investment of 20 dollars euro for the call option versus 3500 dollars for the 100 stocks. Of course this is a massive difference which is explained by the leverage.

In case you buy the shares you pay 100% of the stock's value. Here that 42 euros. But in case you buy an option you more less enter the market on a way higher level and you don't need to spent the full amount the buying of the stock would have costed. Of course this seems very tempting but there oh so many risks as well with call options.

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What are put options

Put options are the inverse of call options. Where a call option (""call"" is from 'calling a stock') the right is to buy, a put option is the right to sell it ('to put a stock away'). Of course this is only relevant in case you think a stock will go down.

value put option

We again take a look at the Daimler that is now trading at 32 dollars. Lets assume we think the stock will go down in the next months. We could buy the put option with a strike price of 36 dollars for let's say 20 cents. You will agree that this put option doesn't have much value.

When the stock is trading at 39 then the right to may sell it 30 dollars then has hardly any (or even no) value. And in case the stock rises to 37dollars then the right to sell it at 35 is then even less. You already see it, the value of a put option is of course extremely dependent of the price of the underlying stock. Let's say the Daimler shares now drops from 32 dollars to 28 dollars.

Then the right to sell the share at 36 dollars has then way more value: 36 minus 32 dollars = 4 dollars. In case you bought the option at 20 cents then you made an extreme return of 1500 percent.

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Risks of options

The potential returns from trading options are absolutely extreme. Nevertheless we absolutely don't recommend to take big positions in options. The majority of the options expires without any value as many investors are often way to positive (bullish) or negative (bearish) about stocks.

In practice we see a way lower volatility: stocks move up and down relatively close so most of the out of the money hardly get in the money so they expire worthless. Bertrand Sluys, a famous hedge fund manager told us this. Trading in options can be a nice extra thing for your portfolio but it should never be dominant in your portfolio. Not the buying but selling (read: writing) is in our view a very interesting strategy.

This is the case for both covered calls as well as puts. In the next articles we dive deeper into this.

Time influence

The time till expiration is one of the most dominant variables on the option prices. This is easy to explain as it's mostly about game theory (calculating of chances). See it like a sport match with a 0-0 score, then is there is still a relatively fair chance to win (in case of equal teams).

When there is only 2 minutes left to play that chance is way lower of course. This is also for the chances that stock options get into the money. The further the expiration date the more time value an option has and so has a higher price.

In case the remaining time till the expiration date is very limited we see a huge drop of the option price (the time value decreases then a lot). The approaching of the expiry date is also called 'approaching the option-ravine' as there is hardly time left for options to get in the money.

Volatility

Volatility is the level of how much a stock moves. Stocks move up and down more often have bigger chances of getting 'in the money'.

Think for example of the tech stocks or the FANG stocks of which many investors have very high expectations. Investors pay relatively more for these options as these move up and down a lot more. The more boring (read: defensive or stable) stocks tend to have way lower volatility so the options on these stocks have a lower volatility premium.

The explanations here are just a basic introduction of the option world. In case you want to start trading in options we clearly recommend to pay more attention to our other more deeper articles about options.