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From zero to hero: buying options
Koen Hoorelbeke
Investment and Options Strategist
Summary: In our new series "from zero to hero" we explain option techniques and strategies and make them accessible for everybody. This article provides an introduction to options trading, covering the basics of buying and selling options, how to make money with them, and the risks involved.
From zero to hero: buying options
Introduction
You've been navigating the investment waters, putting your money into stocks, ETFs, and other assets through Saxo. You've seen gains, maybe some losses, but overall, you're thinking there must be a way to optimize this. You've probably heard of options trading—a term often thrown around in financial circles—but haven't really taken the plunge to understand what it's all about.
If this sounds like you, you're in the right place. This mini-guide is designed to give you a straightforward introduction to options. We'll cover what you need to know to get started, the basics of buying and selling options, and important factors you'll want to consider. So, let's embark on this journey to potentially diversify your investment strategies and open up new avenues for profit.
Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.
Basics of buying options
What is an option?
In the financial world, an option is a contract that gives you the right, but not the obligation, to buy or sell an asset—like a stock—at a predetermined price within a specific timeframe. Think of it like this: It's similar to making a small down payment to reserve the right to buy a house at today's price, with the decision to buy or not to buy needed by a certain date.
Why buy options?
- More with Less: One of the great things about options is that you can control a large amount of stock for a fraction of the cost. This means you can potentially earn more while risking less of your hard-earned money.
- Safety Net: Options can also act like an insurance policy for your investments. If you own a stock that you think might go down soon, you can use options to help limit your losses.
Types of options: call and put
- Call Option: This type of option lets you buy a stock at a fixed price within a certain time. It's like seeing a gadget you want but thinking the price will go up, so you 'reserve' it at today's price for a small fee.
- Put Option: A put option is the opposite. It gives you the right to sell a stock at a predetermined price. Imagine you own a gadget that you think might lose value soon; a put option lets you lock in a selling price for a certain period.
Navigating the option chain
An option chain is essentially a menu of all available options for a given asset. It shows different strike prices and expiration dates, along with the bid and ask prices for each. On our SaxoTrader Go platform, you'll find it displayed like in the screenshot below (our SaxoInvestor and SaxoTrader Pro platforms show the options chains in a similar fashion and although there might be some differences, the principles remain the same). To open a trade ticket, simply click on the bid or ask price—click on the ask price if you're looking to buy.
Some extra info with the numbered bullets in the screenshot:
- In this example I'm navigating to a stock using a watchlist, in this case I took the European Stocks
- Next I clicked on f.e. LMVH. I used this as an example solely on the fact that the price is nominally higher than all the other stocks. I, nor Saxo, have a specific view on that stock, it's just being used as an educational example!
- Option Chain is showed when you click on it in the right upper part of the window. If all's well you should see the ticker symbol (in this case MC:xpar) just below it, indicating you see the option chain for that stock
- At the right hand side of the option chain you'll see all available expiry-dates. Some stocks will have few, others will have many depending on the popularity of the options for that stock. Popular stocks will have, besides monthly options, also weekly options, showing expirations for each week. Less popular stocks can have less expirations, some even only show quarterly expiries.
- When you click on an expiry, in this example I clicked on the december 2024 expiry, the list with available strikes becomes visible.
- Equal as with the number of expiries being showed, the number of strikes showed (more or less) depends on the time left till expiry. Options which are closer to the expiry will usually have more strikes. There might also be a difference in the number of strikes available depending whether it's a weekly or a monthly expiration.
- On the left hand side of the option chain, the calls are displayed. In this article we cover buying options, so if we'd want to buy an option, we'd have to click on the "ask" prices, showed in the green rectangle
- Similarly, on the right hand side of the option chain, the puts are showed. Again, if we'd like to buy a put option, we'd have to click on the "ask" prices for the puts, again showed in that green rectangle
How to make money with buying options
The traditional way: using the option
When you buy an option, you can choose to actually use it. For example, if you bought a call option and the stock price goes up, you can use your option to buy the stock at the lower price you locked in. This is called "exercising" the option. Some people do this, especially if they want to own the stock for the long term.
Let's consider the example above where we would buy a call option with a strike price of 500. For that option we would pay the ask price, €283.48. If, at expiration (20 december 2024 in this example) the price of LVMH would be f.e. €900,-, we could exercise our option:
- We have the right to buy our stock at 500 (the strike)
- We could then immediately sell our stock for €900 (the imaginary price at expiration)
Note: we are not obliged to sell our stock after we exercised our option. If you think the stock will continue to rise, it might even be a good idea to just keep the stock you just bought at €500,-. - This would result in a profit of €400 per share (€900 - 500 strike)
- However, we did pay €283.48 for that right, so we have to deduct that too: €400 (gross profit) - €283.48 = €116.52 net profit (excluding fees and commissions)
- Our yield would be: (profit/investment*100): 116.52/283.48*100 = 41.10%
If we compare that with just buying and selling the stock:
- Buy the stock at 757.40 (last traded price of the stock mentioned in the screenshot)
- Sell the stock at 900.00
- Yield: (profit/investment*100): (900-757.40)/757.40*100 = 18.83%
The trader's way: buying low and selling high
Most people, however, don't end up using their options. Instead, they buy and sell the options themselves to make a profit. If you buy a call option and the stock price goes up, the option's price will likely go up too. You can sell the option for a higher price than you paid, making a profit without ever buying the actual stock (avoiding fees and commissions related to the buying of the stock). Similarly if you buy a put option, when the price of the stock goes down, the option's price will go up (NOT down), enabling you to make a profit on a declining stock price. Buy a put could be seen as an alternative of shorting stock, which is in many countries in the EU not allowed.
Cost and risk
When you buy an option, you pay an upfront cost called the "premium." This is your risk; you can't lose more than this amount. In the screenshot showed earlier, the premium you pay corresponds to the ask-price (fees and commissions not included) On the flip side, your potential to make money can be much greater, especially if the stock moves in the direction you're hoping for.
Understanding option prices (why are the numbers often so small)
When you see an option priced at $2.40, it's easy to think that's the total cost. However, that price is actually the price of 1 option for 1 share, and most option contracts cover 100 shares. So, in reality, buying that option would cost you $2.40 x 100 = $240. Always keep this in mind when considering the cost and potential returns of an option. In the screenshot showed earlier, this means that if you would want to buy f.e. the 500 strike call option, where the ask price is 283.48, you would need to pay for 100 shares in one contract: €283.45 * 100 = €28,345- (not including fees and commissions)
When do you break even?
The breakeven point is when the stock price is at a level where you neither make money nor lose money from your option. It's important to know this point so you can make informed decisions about whether to hold or sell your option. In the example/screenshot above, if you would have bought the call option at 283.48 (the ask price displayed for the 500 strike), your option would break even if the price of the underlying stock (LMVH) would go above the strike price (€500) plus the price you payed for the option (€283.48). So once the price would reach and exceed €783.45, you would make money if you were to exercise the option.
Extra things to know
Price changes over time
The value of an option doesn't stay the same. As time goes by, the price you can sell it for may go up or down based on a number of factors, such as changes in the stock price and how much time is left before the option expires. If you buy options it's therefor quite often a good habit to buy your options with a far enough expiry date, so the stock has enough time to reach your intended price.Odds of making money
In the world of options, people often talk about your "odds of making money," or how likely it is that you'll make a profit. This is something you'll want to consider when choosing an option, along with all the other factors we've discussed. The "odds of making money", often referred to as the "POP". POP stands for "Probability of Profit" and refers to the (theoretical) probability of your option being profitable at expiration date (profitable = 1 cent or more profit). More on this topic can be found in my articles about "Understanding Delta" (here and here)
Time until the option expires
Every option has an expiration date, and as that date gets closer, the price of the option can change more quickly. This is why knowing how much time is left can help you make better decisions about whether to hold or sell. The closer you get to expiration the faster the value of your option will deteriorate. Which is absolutely normal, since at expiration, your option will have no more value if it's out of the money. If your option is in the money, the price of that option will match the "intrinsic" value of your option.
In the money, at the money, out the money: what do they mean?
These phrases help describe where the stock price is in relation to the option's strike price—the price at which you can buy or sell the stock if you use the option. "In the Money" means the option can be used profitably right now. For a call option, the stock price is above the strike price; for a put option, it's below. "At the Money" means the stock price and the strike price are the same. Finally, "Out of the Money" means using the option right now wouldn't be profitable; the stock price is lower than the strike price for a call and higher for a put. These terms give you a quick way to gauge an option's current value and potential for profit.
Conclusion
Options can seem complicated, but they offer another way to potentially make money in the stock market. By understanding the basics, how to make a profit, and what to consider in terms of cost and timing, you'll be well-equipped to add options to your investment toolbox. So why not take that next step and explore what options can do for you?
Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.
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