Options and binary options explained

Options and binary options explained

1. Option Basics

2. Intrinsic value of options

3. Risk and premium

4. Option strategies

Buying Options

Buying options means that you buy the right to buy or sell shares in the future. An option is therefore nothing more than the right to buy or sell shares in the future.

How does option trading work

The right to buy shares is what is called call options, the right to sell shares is called put options. When purchasing options, a price against which you could buy or sell the underlying shares is agreed upon in advance of the purchase. Additionally the exercise price, and expiration date (the date to which your right is valid) are agreed upon. For this right you will have to pay a premium. This premium will depend largely on the exercise price and maturity, but it also depends on the interest rate and the volatility of the underlying stock. Options are traded on the stock exchange and is rather similar to trading “normal” shares. The terms and conditions for options trading are standardized for all options. For example, one option always represents 100 shares and the option always expires on the third Friday of the month.

Basics

When you look on the Internet or read the newspapers you will inevitably encounter certain “codes”, the option naming convention. An example of such a code is: “ING C Dec 14 36.00”. This “code” means the following: the (call) option that provides the right to buy 100 ING shares at € 36.00 until the third Friday of December 2014. The price that is behind the option code could be, for example, € 1.50. As it relates to 100 shares, you pay € 150 for this transaction. To summarize: the strike price of the call option is € 36.00, the expiration date is the third Friday of December 2014 and the premium amounts to € 1.50. Now suppose that the underlying value – or the market price of ING shares – is currently € 34.00. This implies that in ordder to exercise the option the price of ING shares will have to rise at least € 2.00 before the end of December 2014. After all, if the price of ING shares is lower than € 36.00, the right to buy ING shares at € 36.00 is worth nothing. In that case your exercise right expires automatically. A price of more than € 36.00 at maturity however does not automatically imply that you make a profit. After all, you paid a premium for the option of € 1.50. So this transaction would be profitable only in case the share price of ING increases to above € 37.50.

Intrinsic value of options

It is possible for an option to have an intrinsic value. With call options, we speak of an intrinsic value if the share price exceeds the strike price (S>K). For put options, the opposite holds. If the strike price exceeds the share price (S<K) the put option has an intrinsic value. So in the example above the option has intrinsic value if the share price exceeds € 36.00. To indicate the relationship between the intrinsic value and the price of the underlying asset three different terms are used:

In-the-money. (S>K)
In case of a Call option, the option has intrinsic value because the share price is higher than the strike price.

At-the-money. (S=K)
The share price is equal to the strike price.

Out-of-the-money. (S<K)
In case of a Call option, the option has no intrinsic value because the share price is lower than the strike price.

Risk and premium

Suppose that in the aforementioned example the price of ING rises from € 34.00 to € 40.00 by mid-December. Shareholders certainly have obtained a decent return of 18%, but as option holder, you will be even happier. Your option premium has increased from € 1.50 to € 4.00 (€ 40.00 less the exercise price of € 36.00), or a profit of 167%!
If the price rises to € 42.00 instead of € 40.00, the yield difference is even more impressive: 300% for the optionholder compared to 24% for the shareholder! This effect of rapidly increasing yields with options is called leverage: high returns can be achieved with only a small investment.

But of course the probability of very high yields always brings higher risks. After all, it is also possible that you lose your entire investment. This is the case if the price of ING has not increased to € 36.00 by mid-December. And only above € 37.50 you will be able to make a profit. So suppose that by mid-December the price of ING equals € 36.00. As a shareholder you have made a return of almost 6% (2/34*100), while the optionholders are having a bad time as their yield equals -100%.

So carefully consider what you are doing when you begin trading options. The previous example shows that the yield depends largely on the price movement of the underlying stock. For the greatest part this will determine the price of the option. But there are other factors that influence the option price as well.

These are the following:

Maturity

The longer the maturity, the bigger chances are that the price of the underlying asset will increase to above the break-even point, and thus the higher the premium.

Strike price

The more positive the difference between the strike price and the price of the underlying asset (so the greater the difference in case of an out-of-the-money call option), the lower the risk for the writer (seller) of the option and thus the lower the premium.

Price of the underlying asset

A high share price often results in a relatively higher option premium. This of course in relation to the strike price. A clear vision of the price trend of the share can therefore also be of great help when trading options.

Interest rate levels

The interest rate has effect on the option price because in order to write (sell) an option a certain level of security has to be maintained. This requires money, money that is borrowed at an interest rate or that could otherwise have been loaned at an interest rate. Higher interest rates therefore result in higher option premiums.

Volatility

The volatility measure the size and extent of the movements of the share price. The more volatile the stock, the greater the chance that the price of the option will exceed the strike price at one point, and thus the higher the premium. As you may already have noticed from the descriptions above, you are never obliged to hold the option to the expiration date. You could sell it before the maturity date against a, hopefully, higher premium.

Besides, it is not only possible to buy options, but also to write them. After all, if you buy an option, you do so from someone who sells it, the option writer. Please note that the writing of options is even riskier than buying options.

Option Strategies

Options can also be used to reduce the risk of losses. A simple strategy for example, is to hedge positions in certain stocks with put options so that your losses stay limited in case of a declining market. That is, the losses on the shares are partially offset by the increase in the premium of the put option. However, if prices rise such an “insurance” has inhibitive effects on your return instead.

Suppose you posses 100 shares of ING with a value of € 34.00 per share. Based on fundamental analysis you expect a price increase in the medium and long term. Yet you fear for the market developments of the next few months. You decide to buy a put option to protect your shares against a possible price decrease. With a put option you basically buy the right to sell shares at a predetermined price.

You buy the following put option: “ING P Jun 15 34.00. For this option, you pay a premium of € 1.50, or € 150 for the total of 100 shares. You basically spend € 150 to hedge against a price drop, because in June you own the right to sell 100 shares ING for € 34.00.

Put options may prevent you from having any sleepless nights, while you keep reaping the profits from a possible price increase. But it wise to implement this strategy? My opinion is that when you do implement this strategy you are having two opposing thoughts. On the one hand you believe the share price is going to rise, but at the same time you think it is going to decrease. If you have doubts about a stock, don’t buy it at all. Hedging with put options is not a beneficial strategy, in my opinion. A better way to reduce risk is to diversify your trading portfolio. Options as “insurance” are almost always too expensive.

Good to know

Investing in options can entail great risks if not used properly. But options offer many possibilities: with options the yields can be many times greater than they would be if you invest in regular stocks. Additionally, options can be used to minimize risk through hedging. Finally, you can use options to speculate, not only on price increase, but also on price decreases.

Binary Options

What are binary options

Trading binary options has become very popular in a very short time. Many people even earn a living trading binary options. But what exactly are binary options? How do they differ from regular options? And how can you actually make money with binary options? In this article we will discuss these questions and hopefully provide you with a satisfying answer.

Binary options (also called “digital options” or “all-or-nothing” options), are a special type of options. As with “regular” options binary options have an underlying financial instrument. That could be a share, but also gold, oil, the S&P500 index, or the US Dollar. How much you gain or lose with a binary option depends on the price development of the underlying financial asset.

The characteristics of binary options

Two important characteristics of binary options are:
• The option is independent from the underlying asset. If the option expires it does not implicitly mean that you actually receive or have to deliver the underlying asset. You only receive the predetermined amount of money on the option.
• There are only two possible outcomes (hence the name “binary options”): up or down. No matter how much the underlying asset changes in value. If the price at the time of expiration trades above (or below) the opening price, the option pays off; if it is lower (or higher), it will become worthless.

Because of these characteristics binary options are much simpler and easier to understand than traditional options (read the article “The difference between binary options and regular options). From the moment you open a position in a binary option, all important parameters are fixed:

• The moment at which the option expires (expiration date).
• The price where the underlying asset should be above or below (strike price).
• Whether you bet on an appreciation or a depreciation (“high” or “low”).
• What option pays out in case you are right (typically 80-90% above the amount risked) and in case you lose (often nothing).
• The amount risked.

Because all these details are fixed, the only question one has to answer is: will the price of the underlying asset go up or down. If you are able to predict this, you can earn a lot of money with binary options. And because you can determine exactly how much money you are willing to risk when you open a position, you can never lose more money than you are willing to risk.

An example of binary options trading

Suppose you believe that Apple’s shares are currently overvalued and will fall in value within the next trading day. You choose to open a binary option on the stock Apple Inc. (AAPL) to take advantage of the expected price decline. At the time of opening the option has the following characteristics:
• You choose an option with an expiration of 24 hours.
• The strike price is the current price of $ 672.81.
• You expect the price to fall, so choose ‘low’.
• This option will pay 87% in case of a profit and 0 in case of a loss.
• You are willing to risk 50 Euros.

After the transaction has been completed you no longer have to keep track of the price of Apple. So you can immediately focus on other options, or just do something fun. After 24 hours the option expires automatically and the result will be incorporated into your trading account. In this case it appears that the shareprice of Apple initially rose slightly, but eventually dropped to $ 670.24. This means that the option was “in the money” at the time of expiration. You have obtained a yield of 87%, so your total payout will be 93.50 Euros, a profit of 43.50 Euros. Not bad!

Different types of binary options

There are some special variants of binary options (such as “touch / no touch” or “boundary in / out”) and some more advanced features (such as “high-yield” or “early closure”). This gives you the ability to perform more complex trading strategies. Would you like to know more them, read the article “Different types of binary options”.