Options Trading: Bet On the Right Courses

Options trading is tempting, but risky as well. Because basically it is nothing more than financial bets. Options trading is one potential way to diversify and build a serious cash horde.

Options allow investors to participate more in price changes – both in the positive and in the negative. Institutional investors therefore use options primarily for risk management, while private investors often speculate. Through options trading, investors with an understanding of where the market is moving can capitalize off their knowledge.

The business is high risk, so you should only consider options trading if:

• you have dealt with the subject intensively and understood it, and

• You have the money left and do not need it for a living.

If you speculate, the total loss threatens.

Incidentally, banks are even prohibited from entering into futures transactions such as warrants and options trading with people who are unfamiliar with the matter. So, it may be that your bank first checks whether you are familiar with derivatives.

This is how options trading works

The value of options depends on a base value. That is why they are called derivatives in the jargon (Latin derivative = derive). The Underlying may be a stock, a commodity, a currency or an index that aggregates different investments. With an option, you acquire the right to buy or sell the underlying at a specified price in the future. The difference is paid out in cash at the end of the term.

Options are available in different versions. Warrants are widely used among private investors. They are standardized, which makes their trading on the stock market easier. The publishers of the papers are mostly banks, that act as sellers. The terms warrant and option are often used synonymously. Knowing this is critical if you want to start options trading.

Option warrant bond

The warrant is purchased by investors either alone or together with a warrant bond. The bond then offers a fixed but comparatively low interest rate.

For companies’ option bonds offer a favorable source of financing because the attached warrant reduces the interest payments compared to a normal bond. For investors, this financial derivative combines the security of a bond with the opportunities of stocks. As the stock price rises, a significantly higher return can be achieved. Conversely, if prices fall, investors must be content with the much lower interest on the warrant bond.

The warrant price for an option bond develops in line with the price of the share (or the price of another asset). The warrant thus loses value as the share price falls, for example. If the share price at the end of the term of the warrant is less than the previously agreed purchase price, the warrant is worthless.

Meanwhile, warrants are increasingly issued whose warrants no longer rely on the purchase of equities but on foreign exchange, bonds and other assets. Warrant bonds are not to be confused with convertible bonds. Convertible bonds can be exchanged for shares, whereby they expire upon exercise of this right.

You should know these features of options trading

Strike

The most important feature of a warrant is the exercise price, also called Strike. It determines the price at which the underlying can be bought or sold when the option is exercised. The price of the underlying and the exercise price do not have to be identical: a share can currently cost 100 USD and the warrant may have an exercise price of 105 USD.

Call

With a call warrant, you acquire the right to buy the underlying asset in the future at the specified exercise price. You bet on a rise in price, as you only benefit if the future price is above the exercise price.

Put

With a put warrant, you acquire the right to sell the underlying asset in the future at a specified price. Here you bet on a decline in the price and then profit if the future price is below the exercise price.

Premium

The price of a warrant is also called premium. It is based on the probability that the exercise price will be exceeded or fallen short of at the end of the term. An important factor for the amount of the premium is the maturity itself: the shorter the residual term of an option, the lower the probability that the price of the underlying will change significantly during this period. For two identical warrants with different maturities, the one with the longer maturity is therefore always more expensive.

At the end of the term, you receive the difference between the price of the underlying and the exercise price. In order to determine your profit, you must additionally deduct the price of the warrant.

Example: Call option

You buy a call option with a Siemens share as the underlying. The premium of the option is 10 euros with an exercise price of 105 euros. At the time of purchase, the price of Siemens shares is 100 euros. If the price of the share rises to 120 euros, it is 15 euros above the exercise price. Since the warrant cost 10 euros, you have a profit of 5 euros at the end of the term. This equals 50 percent of the purchase price.

An important landmark for you is the break-even point. It describes the point at which your investment makes neither loss nor profit. In the example, it would be the price of 115 euros for the stock, because offset here costs and proceeds. How much the price of the underlying should rise (call) or fall (put) in order to reach the break-even point expresses the premium or agio. In our example, the premium is 15 percent. The price of the underlying must therefore rise by 15 percent, so that you reach the break-even point.

To summarize how call or put warrants behave when the price of the underlying rises: in order for you to make a profit, the price of the underlying for a call option must go up and down for a put option. The loss is limited to the amount of the purchase price. Reaching past the breakeven point in options trading is the goal.

In our examples we assume a ratio of 1:1. This means: With a warrant, you acquire the right to buy or sell one unit of the underlying. The subscription ratio may vary, however. With a subscription ratio of 10:1, 10 warrants correspond to one unit of the underlying.

Distance to the strike (Moneyness)

The distance to the strike describes the ratio of the strike price of a warrant to the price of the underlying asset – also called moneyness. Here are three different scenarios possible, as the following table shows:

Technical term Meaning call option Meaning of put option
in the money Strike is below the current price Strike is above the current price
at the money Strike is the price of the underlying Strike is the price of the underlying
out of the money Strike is above the current price Strike is below the current price

Since only one payout is made for a warrant when it is in the money, the distance to the strike is an important measure of the valuation of an option.

Note that the opposite is the case for a put warrant: the current price of the underlying must be below the strike price for the option to be in the money. The distance to the strike is expressed as a percentage and states how many percentage points the current price of the underlying is above the exercise price.

Example

With an exercise price of 105 euros and a share price of 120 euros, a call option on the Siemens shares is 15 euros in the money, which corresponds to about 14 percent.

Inner value and time value

The value of an option can be divided into the time value and the intrinsic value. The intrinsic value is the difference between the current strike price and the exercise price. It is therefore zero if the warrant is not in the money.

To find the fair value, subtract the intrinsic value from the current value of the option. Similar to the remaining time it decreases constantly. For two identical Siemens call options with different terms, this results in different time values.

Example

You buy two identical call warrants with different residual maturities with one Siemens share as the underlying. The option with two years remaining time then costs 14 euros, with a year remaining time only 10 euros. The difference lies in the higher fair value of the two-year option.

At the end of the term, the value of an option only corresponds to the intrinsic value, because there is no time value left. How fast the time value decreases is also determined by how big the distance to the strike is. The following chart shows the fair value loss for an on and in the money warrant:

My Tip: You do not have to hold the warrants until the end of the term: By selling early you can benefit from a higher time value.

If the option is due to money, the fair value decreases unevenly. The closer the end of the term comes, the more the time value decreases. The reason for this is that the likelihood of being in the money at the end of the term is getting smaller and smaller. For options far in the money or out of the money the time value decreases relatively evenly.

Lever mechanism (Omega)

Warrants reflect a change in the price of the underlying asset disproportionately: If the base price rises by one percent, a rise in the price of the option by ten percent is not uncommon. This mechanism is called leverage and this is why warrants are so popular with private investors. Omega is the action of the lever. It indicates by how many percentage points the option price changes if the price of the underlying changes by one percent.

Example

The Siemens call option costs 10 euros and has an omega of six. At the time the option was bought, the Siemens stock cost 100 euros and now rises by one percent to 101 euros. Since Omega is six, the option price increases by six percent to 10.60 euros.

If you had bought one Siemens share and ten warrants each for the same capital, the stock would now be worth € 101 and the ten warrants € 106. Because of the lever, you would have earned a sixfold profit.

Price fluctuations of options: the Greeks

The value of options is affected by various parameters, such as stock price or maturity. The so-called Greeks express how the price of a warrant varies when the corresponding indicator changes. The basis for the calculation is the so-called Black-Scholes model, with which the price of options can be calculated.

The following table gives you an overview of the effect of changing a characteristic to the value of an option if all other parameters remain constant:

Parameter (increasing) Name Value of the call Value of the put
Price of the underlying Delta +
Implicit volatility Vega + +
Remaining time Theta + +
Interest rates Rho +

Delta: the effect of a price movement of the underlying

The Greek letter Delta defines the price change of the warrant when the price of the underlying changes. It can accept values between 0 and 1 for call options and 0 to -1 for put options.

Example

The Siemens call option with the strike price of 105 euros has a delta of 0.6 at a price of 120 euros. If the value of the share increases by 1 euro, then the price of the warrant rises by 0.6 euro.

Delta is not a constant: If the price of the underlying changes, the delta also changes. For cash options, Delta is approximately 0.5. The call option from the example is in the money because its delta is greater than 0.5. For in-the-money options delta is greater than 0.5 – for smaller out of the money.

The delta also tells you how likely it is that the option is in the money at maturity. If a warrant is far in the money, the value for delta approaches one, the maximum. So, it’s becoming more and more likely that the option will end up in the money.

Vega: the change depending on the implied volatility

The price of an underlying may move up or down. The volatility expresses how strongly the price turns out. With an option to bet on a change in the price, volatility is very important. The letter Vega expresses how the value of an option behaves when volatility changes. Not the historical volatility, which is calculated from old data, but the implied volatility. It expresses the expected fluctuations in the price of the underlying, which are determined by supply and demand.

Example

The Siemens call option has a Vega of 0.36. If the implied volatility increases by one percent, then the value of the warrant increases by 36 cents. The behavior of implied volatility is influenced by whether the option is monetary or not. The further the price of the underlying asset moves up and down from the exercise price, the greater the implicit volatility becomes. The course is called volatility smile.

Do not underestimate the impact of implied volatility on price. A change in the price of the underlying often causes a change in volatility. It can negate or increase part of your profit.

Theta: the effect of decreasing residual maturity

The letter theta expresses the change in the price of an option as its duration changes. It shows how much the time loss is in a period. Mostly the loss is calculated per day or week. Since the remaining maturity is constantly decreasing, theta is always negative.

The time value loss of warrants also depends on the distance to the strike: Theta has a constant course for lying well in the money and out of the money warrants. Theta behaves differently in the case of a cash option: the theta remains lower for a long time due to the uncertainty about the final result, but it grows even more in the last month of the term.

Example

A Siemens call option with a price of 10 euros is the money. It has a theta of EUR -0.007 per day for a year remaining, so it loses 0.7 cents per day. It loses 0.5 percent of its value per week. The same option has a theta of -0.05 euros two weeks before the due date. The loss of time value is more than seven times higher here. Per week, the option loses 3.5 percent of the value. Since there is a threat of a large loss of fair value especially towards the end, in case of doubt you should always opt for the warrant with the longer maturity.

Rho: The effect of a change in interest rates

The influence of the interest rate on the value of the option is expressed by the Greek letter Rho. Rho denotes the change in value of a warrant when interest rates change by one percent. To determine interest rates, the risk-free interest rate is used. This represents the interest on a short-term loan without default risk – in practice, a short-term federal bond.

In general, Rho is positive for call options and negative for put options. Compared to the other Greeks, however, the rho is less important, as the price of the option changes only slightly even with larger interest rate shifts.

This is how you find the right option

To understand how options work, we recommend that you experiment with a warrant calculator on the Internet. This allows you to understand the effects of different parameters on the value of a warrant. You can also compare different warrants and find out what the risk of trading is.

So that you do not have to deal with the search settings the first time, you first use the option search in Internet. There you will find ready-made search settings, which you can use to get an initial overview.

The results are given the following key figures:

SIN: the securities identification number. Each warrant has its own SIN and is identified by it.

Issuer: is the issuer of the warrant, in most cases a bank.

Bid/Ask: also called letter and bid price. The first is the purchase price, the second is the selling price. The purchase price is always higher than the selling price.

Spread: is the spread between buying and selling price. In most cases, the homogenized spread is used: it calculates the spread for a ratio of 1:1.

In the next step, you can refine the search settings. The comparison portals available on the web offer more than 20 parameters, three of which can be displayed simultaneously. We advise you to pay special attention to the Omega, the premium, the implied volatility and the spread to find the right warrant. When selecting the option, proceed as follows:

·       Choose the omega. The more risk you want, the higher the omega should be.

·       Choose an option that requires you to pay the least possible premium.

·       Make sure that the selected warrant has the lowest possible implied volatility and a small spread.

Scenario calculator

With the right scenario calculator for warrants, you can calculate the value of an option for different scenarios. First, you can choose a base value. You then enter the data for up to five scenarios – for example, a changed implied volatility. As a result, the calculator shows how the price of the warrant would change and how big that change would be in percent and absolute.

My Tip: Stay up to date on stock market issues – with our free Google Alerts

This is how you trade with options

We have put together some tips for trading in warrants for you:

Pay attention to transaction costs

Trading in warrants involves costs. Depending on the business, stock exchange fees, brokerage fees or fees for your securities account will be charged. These costs must be taken into account when calculating your profit.

Do not risk the total loss

If your warrant at the end of the term from the money, then it expires worthless. Therefore, do not speculate with securities that have a high omega, but expire soon and are far from the money. You can reduce the risk of total loss by investing in longer-term options that are not too out of the money. Once again: Do not spend more money than you could afford to totally lose!

Remember the taxation of your profits

For profits from trading in warrants, usually in most countries a withholding tax of a flat rate applies. It is usually debited directly from your deposit. Remember to give your depot an exemption order or to adjust an existing order. This will prevent you from deducting your annual allowance automatically. Otherwise you will have to wait until the next income tax return until you get your money back from the state.

Claim losses as a cost of income

You can claim the transaction costs as expenses in your tax return. If a warrant expires and you have lost your stake, you have been able to do so for some time. This reduces the sting of a loss in options trading somewhat.

You no longer need to sell your warrants for a symbolic revenue of about 1 cent, as they did before, before they expire. Instead, your custodian bank should provide you with a corresponding tax certificate upon expiry of the option.

Your timing is crucial

Your success in options trading depends on the timing of your choice: the time value changes as a result of the implied volatility and maturity, as the following example shows:

Example 

A put option on Siemens shares with a strike of 80 euros has an implied volatility of 21 percent and costs 2.50 euros. The price of the share is 100 euros. The implied volatility increases by two percentage points to 23 percent without the share price changing. This increases the price of the option by 0.5 euros, which corresponds to 20 percent.

Generally, volatility increases when prices fall. This was especially noticeable in the last financial crisis. Indices such as VDAX and VIXX reflect implied volatility.

Compare by volatility

To find out if an option has a fair price for options trading, compare the implied with the historical volatility of the underlying. The higher the implied volatility, the higher the price of a warrant. Comparison with historical volatility shows how justified the assumed implied volatility is. The less the implicit deviates from the historical volatility, the fairer is the price of the option.

The online comparison calculators do not show the historical volatility of the underlying. However, you can see these directly on the portals at the respective underlying: For example, you can find the volatility of stock shares.

Dividends affect the price of the underlying

A portion of the profits of a company is distributed to the shareholders as a dividend. This reduces the price of the stock. Since expected dividends are already included in the price of an option, the exercise price does not change. Therefore, pay attention to the timing and amount of the dividends, because a warrant in the money after the distribution can suddenly be out of the money, heavily affecting your options trading goals.

I hope that this post will provide you with the necessary information so that you too can now trade warrants to achieve the goal of your financial freedom and an early retirement. Of course, if options trading isn’t for you, there are other methods.

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