What Is Options Trading: Costs, Redemption, Premium, & Risk


Trading options and futures involves buying and selling the right to an item. The underlying commodity can basically be anything: a ship, a property, a company, a stock, a stock index, gold, nickel, soybeans, etc.

What is an option and how do they work?

There are many reasons why you want to trade options. There are also many strategies that options traders usually invest in. However, the purpose of options trading is usually to either increase your leverage (and then also your risk) or minimize risk by protecting (hedging) your positions.

These strategies are quite advanced and should only be taken when you as an investor have sufficient knowledge and understanding of what risk you are actually taking and what can happen in different market scenarios.

Buying and selling options

An option is thus an agreement between two parties, a buyer and a seller. The buyer of the option is the one who owns the option (the right).

The buyer thus gets the right (but not the obligation) to complete a transaction at a certain price on a certain date. The seller (exhibitor), on the other hand, takes the opposite position in the deal.

The seller sells the right to the buyer and creates an obligation to complete the transaction if the buyer (option holder) wants. The seller of an option is often called an “issuer”.

For the sake of simplicity, it is the term that will be used in the future If you issue an option to “buy shares for $100”, you must sell the share for $100 regardless of the market price the share has on the redemption date to the person who bought the option and requested redemption.

If the value of the share is $120 on the redemption date, the seller has made a price loss of $20, as it is forced to sell at a lower price.

What does the situation look like if the share’s value is $80 on the closing day? If it had been a forward transaction, the forward seller would have made a profit of $20, since both parties have an obligation to complete the transaction.

In this case, however, the buyer of the option will not want to exercise his option and buy shares for $100 when they are only worth $80.

The transaction will thus not be completed.

Why do you issue options?

What do you gain from being an issuer of an option? The answer is, the premium. The premium is the maximum an issuer can earn on an option deal, but the risk of loss is in theory infinite.

The issuer thus takes on a much greater risk than the buyer. The buyer can only lose the cost of the option, ie the premium, but the profit possibilities are in theory endless.

Regardless of how much the price develops negatively, the buyer will lose the maximum premium if the option expires useless.

When the share price moves above the exercise price, the profit begins to increase. The breakeven point for the buyer is found when the price of the share is the same as the exercise price + premium.

No matter how much the share decreases in value, the issuer can never make a larger profit than the premium.

However, the more the share price moves above the exercise price, the more the issuer will lose.

Basic positions in options

In a share transaction, there are two basic positions. You can buy a share and you can sell a share.

The same applies to futures trading. Either you buy an asset in the futures (long position) or you sell an asset in the futures (short position).

An option can also be sold and bought, but there are two different types of options, call options and put options.

This means that there are rights to either buy or sell the underlying asset depending on the type of option you have given the same end date and exercise price.

In total, there are therefore four basic positions in options trading.

  • You can buy a call option
  • You can issue (sell) a call option
  • You can buy a put option
  • You can issue (sell) a put option

Speculate in decline with options

The examples highlighted above have mainly dealt with call options. A buyer of a call option has the right to buy a share at a certain price.

A buyer of a put option, on the other hand, has the right to sell a share at a certain price at a certain time. Thus, options can also be used to speculate in stock declines.

If you believe that a share will be lower than it is today one month in the future, you can instead buy a put option and in that way lock in the price that the exercise price entails.

If the share is lower than the exercise price on the closing date, you may, if you wish, sell the share at the higher price (exercise price).

What is a premium?

Options are traded in their current premium. The option premium is the cost of the right (the buyer) and at the same time the price of assuming the obligation (the seller).

Just as for shares, there is an order book where the price of the premium is stated and where you can offer a price yourself.

The price of the prize can be divided into two values; real value and time value. The real value is the difference between the share price and the exercise price of the option.

The remaining value of the premium is time value, ie the difference between the premium and the real value.

Example

The price of a share is currently $100. A call option on the share has an exercise price of $110. The premium currently costs $15.

Real value: $0 (Because you get the right to buy the share for $110, but it is only worth $100 right now)

Time value: $15 (That is, the value of the probability that the option on the exercise date shall have a value)

Example 2:

The price of a share is currently $70. A put option on the share has an exercise price of $73. The premium currently costs $4.

Real value: $3

Time value: $1

The real value can never be negative, but as long as there is maturity left in the option, there is always a time value because there is a possibility / probability that real value can arise during the time that is left until the closing day / redemption day.

Example

The price of a share is currently $100. A call option on the share has an exercise price of $90. The premium currently costs $15.

Real value: $10

Time value: $5

Options trading

However, there are a number of important differences between options trading and stock trading that are important to know.

First, options are traded in stock exchange items, or so-called contracts. Each contract normally comprises 100 underlying assets / shares.

In the order depth above, we see that there are 50 contracts for sale for $7.5, ie a total of rights / obligations for a total of 5,000 shares / assets (100 * 50).

Anyone who wants to buy 1 contract must therefore pay a premium of 7.5 * 100 = $750.

What does it mean that an option goes to redemption?

An option is an agreement to make a deal in the future. The deal is called a redemption transaction. The exercise of an option means that the buyer exercises his option to buy or sell shares, depending on whether it is a call option or a put option.

Options are exercised on the closing day after the stock exchange closes. In practice, this only happens if it is profitable to exercise the option, ie the option has a real value.

An option that has a real value on the closing day is usually said to be “in the money”. The opposite is called “out of the money”.

When can you request redemption?

There are two groups of options, American and European. The fact that an option is American means that the buyer can request redemption at any time during the term.

A European option can only be exercised after closing on the closing day.

Swedish stock options are of the American type. This means that the holder with the right can request redemption at any time during the term.

The opposite is the option type European options which can only be redeemed on the final day of the contract.

What are options called?

On the Stockholm Stock Exchange, it is possible to trade options on more than 50 shares. There is a call option and a put option for virtually every month during the year and some months a couple of years ahead.

In each final month, you have a number of redemption prices to choose from. So there are a lot of different option contracts.

To keep these separate, option codes have been developed that act as short names for each option. From these you can read, underlying, end year, end month, redemption price.

What does it cost to trade options?

When trading options, you need to pay a commission to your broker. This varies depending on which broker you trade through, so it can be good to review each player’s price list.

In addition to brokerage, you also pay a so-called clearing fee to the stock exchange. The clearing fee and commission are paid both when you buy and when you sell an option.

Conclusion

Risks

1. Lose the premium when buying options

Buying an option involves a clear level of risk. You may lose the premium paid when the option is purchased. But never more than that. In addition to the premium, a small commission is paid when buying / selling an option.

However, this amount is extremely much smaller than the premium itself.

2. Risk losing larger sums when issuing options

Issuing (selling) options involves greater risk than buying them. There is no predetermined level of risk here. Upon sale, you receive the premium from the buyer – but are forced to sell the option at a predetermined price on a set date.

In the event of major price changes, this can mean a very large loss. For this reason, marketplaces use security requirements in order for a put option to be opened.

Stick to buying (and closing) options until you are fully familiar with how these work. They have a clearer and limited level of risk.

3. Difficult to understand pricing

It is more difficult to understand the pricing of an option against, for example, CFD contracts.

Never trade in securities that you do not fully understand.

4. Attracted to high leverage and high risk

The advantage of options is the leverage effect that can be achieved. Too many, on the other hand, are attracted by the high return that can be obtained – without realizing the very high risk.

Sources

https://www.sciencedirect.com/science/article/abs/pii/S0304405X09001470

https://onlinelibrary.wiley.com/doi/abs/10.1111/0022-1082.285595

file:///C:/Users/kevin/Downloads/8160786277be7680fd9459eaa64a5b465745.pdf

https://www.jstor.org/stable/2353269

https://academic.oup.com/rfs/article/33/11/4973/5732665?login=true

https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/abs/informational-content-of-options-trading-on-acquirer-announcement-return/E19A6D4369586A56B9C81D757623FE7B

https://books.google.se/books?hl=en&lr=&id=eCvSMeLhvhkC&oi=fnd&pg=PT9&dq=Options+Trading&ots=rHViYo_Rcc&sig=iYklBy4L4jFp02hfxTJoxf_jgT8&redir_esc=y#v=onepage&q=Options%20Trading&f=false

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2441606

https://meridian.allenpress.com/accounting-review/article-abstract/88/1/261/53411/Options-Trading-and-the-Cost-of-Equity-Capital

https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6288.1988.tb00773.x

Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

Recent Posts