The investment world has many well-known and lesser-known terms. Think of stocks, bonds, options, futures, or swaps. In a special series, we explain the characteristics and history of the various investment categories. In this episode, Alex Tiebout, Expert Portfolio Manager at APG, discusses options, which are derivative instruments.
What is it?
In the stock market, an option is the right to buy or sell stock before a certain date and at an agreed price (call options) or strike price (put options).
When did it originate?
The history of options goes back to classical antiquity.
What else is involved?
Options are widely used to hedge investment risks.
What is it?
Options are a derivative. This means that it’s a derivative product, based on the price of an underlying value. That value could be a stock, but may also be an index, exchange rate, interest rate, or commodity. The most common option is the stock option.
There are two types of options. A call option gives the buyer the right to buy shares at a predetermined price. In addition, the date on which the right may be exercised, the ‘expiration date’, is also established. In a put option, the buyer has the right to sell shares at a predetermined price. The expiration date is also established in this case. For the prospective buyer, it is expressly stated that this is a right, not an obligation. The seller, on the other hand, must carry out the transaction if the buyer so wishes. An option premium is paid for both put and call options. This can be thought of as the purchase price of the option.
“Options work like leverage,” explains Alex Tiebout, who has worked at APG since 2010, and previously worked as a trader on the ABN Amro trading floor. “An option usually involves multiple shares. If an option represents 100 shares, each priced at 15 euros, you pay 100 times the option premium, which is 15 cents in this case. So, you invest a much smaller amount than you would, if you were to actually buy 100 shares. You also have a chance of much greater profit. However, leverage can also increase the risk. In the event of a ‘wrong’ move, the loss can increase faster than with a direct investment in, for example, a stock. The potential buyer bears the least risk. After all, they may elect to refrain from purchasing the shares and then only lose the premium paid. Compare it to buying a house. You aren’t obliged to cash in on an option you’ve taken.”
When did it originate?
The history of this goes back to classical antiquity, well before the birth of Christ. For example, during the time of the Ancient Greeks, options were traded on the use of olive presses. It wasn't until the twentieth century that options trading reached the trading floor. Chicago pioneered the first options exchange in 1973. Amsterdam followed in 1978, with the first European options exchange, the European Options Exchange. In the late 1980s, options trading gained momentum. In 1997, the options exchange merged with the stock exchange to form Amsterdam Exchanges, establishing itself in the trading hall at Beursplein 5, which had recently become vacant due to the automation of securities trading. By the end of 2002, options trading had also fully transitioned to electronic.
What else is involved?
Options are traded on the stock exchange and come in numerous forms, ranging from daily options to options that are valid for many months. Buyers and sellers (hedge funds, pension funds, investors, banks) anticipate price declines or increases in stocks and/or indexes, and price changes in commodities such as oil, agricultural products, or raw materials. “Like other derivatives, such as futures and swaps, options are often associated with speculation,” Tiebout continues. “For investors, this is the case. They want to take a high risk in the hope of a good return. However, this is different for companies and organizations such as pension funds. They want to ensure that they can buy or sell something, for example stocks, on a certain day for a guaranteed amount and can secure their financial position in this way. To achieve this, they’re prepared to incur costs and potentially take losses. By diversifying the portfolio, you can spread out and minimize risks. At APG, this is also our guiding principle when we work with derivatives: hedging risks for pension funds and their participants. Options can be used to hedge the risks of declining stock prices. Options are part of our total portfolio, but due to the high premiums due to the high volatility in current stock prices, their allocation is currently limited. We’re currently increasing our investments in long-term stocks.”