Options are powerful financial tools utilised by investors and traders. They can increase leverage, provide income, and modify market risks. Some investors are surprised to learn that when options are used alongside other investments they can reduce overall market risk.
Traders use options in a huge variety of ways. Some are attracted to the one-sided and limited risk of buying options. Others act as market-makers, optimising profits by facilitating investors’ option trading. The mathematics underlying options is complex, but anyone who can add, subtract and calculate a percentage return can harness the power of options to increase overall market returns.
What is an option?
An option is an agreement between two parties. Although there is a huge variety of options, they all involve a seller of an option (the writer) granting certain rights to the buyer of an option (the taker) in return for a payment (the premium).
What are call options?
A call option gives the taker the right, without obligation, to buy a specified trading instrument at a specified price, on or before a specified date. The writer of a share option must deliver the underlying shares, at the specified price, if the taker decides to exercise their option (to buy).
The writer receives a payment, known as a premium, for granting the taker this right.
What are put options?
A put option gives the taker the right, without obligation, to sell a specified trading instrument at a specified price, on or before a specified date. The writer of a share option must buy the underlying shares, at the specified price, if the taker decides to exercise their option (to sell).
The writer receives a payment, known as a premium, for granting the taker this right.
Risks to trading options
The risks involved in using options depends on the strategy employed. Option strategies may involve a single option series, or a number of option series, both puts and calls.
One little understood aspect of options is that when they are used in conjunction with other investments they can lower overall market risk. At the other end of the risk spectrum, writers of options can face large or even theoretically infinite risk. Its vitally important that users understand the risks of any particular strategy before transacting.
Reasons to trade options
Just as in every other investment choice, circumstances of the individual are important in determining the "right" options strategy. However the sheer power and versatily of options does multiple the ways options can be traded for both investors and trades.
Here are some of the reasons that investors and traders may want to trade options:
- Earn income from your share portfolio - Investors can generate income from their portfolio by writing call options against their stock holdings. This is known as a covered call, or buy-write, and is one of the most commonly employed strategies by investors.
- Protect share holdings – investors concerned about the near term outlook for a stock holding can protect against a share price fall by taking a put option in that stock. Options are available over more than 70 of the top shares listed on Australian exchanges.
- Protect portfolios – investors worried about the market outlook can offset potential portfolio losses by taking put option over the index. If the market falls, the put options increase in value as the portfolio declines. The effectiveness of this strategy depends on a number of factors, including the composition of the individual portfolio.
- Lock-in attractive prices – where investors identify an opportunity in a stock, but don’t have funds on hand to buy immediately, they can lock in a purchase price by taking a call option now and exercising the right to purchase later
- Buy stocks cheaper – investors can reduce share purchase costs by writing put options in stock they’d like to buy. If the share price is below the option strike price at expiry, the investor buys the stock at the strike price and keeps the premium for the original put option write. A risk is that the stock rises quickly, and the put is not exercised, meaning the investor doesn’t buy the share. However in this scenario the investor still keeps the original premium. This is often referred to as a cash-covered put write.
- Trade more opportunities– Option prices are sensitive to more factors than just the movement in the underlying share or index. Changes in volatility, interest rates and dividends can affect the value of options. This means traders can choose positions that reflect their views on more instruments and markets.
- Increase capital efficiency through leverage – traders use the leverage options provide. As an example, a trader who thinks a stock may rise from the current price of $20 could invest just $1 in a call option. A stock rise of $2 could mean a $1 rise in the option. The return on capital invested in the stock is 10%, in the option it is 100%. This leverage comes at higher risk. If the stock falls $1 and stays lower, the loss on the share position is 5%, whereas the trader could lose 100% on their option.
- Tailor market exposures – there are many option structures and strategies available. A proper understanding of the risks involved opens up the world of collars, straddles, strangles, vertical and horizontal spreads, butterflies and condors, among many others. Traders can profit from a stock or index rising, falling, or standing still. Some option strategies are particularly sensitive to changes in volatility, interest rates, and/or changes in the size and timing of dividends. Traders can construct positions that give more exact exposures to a potential event.
- Limit position risk – the taker of an option can only lose the initial premium. Traders take advantage of this characteristic in many ways. Examples include investing a small percentage of the value of a basket of stocks in put options, reducing the overall risk of the traders position. A trader who believes Bank A is cheap relative to Bank B could take call options in Bank A, and put options in Bank B, reducing the risk of the trade to the premium spent. The possibilities in combining options, and options and other asset positions, are limited only by a trader’s imagination.
An example of an option
This is how an option order appears on CMC’s Pro-platform:
- Buy (B) or Sell (S): The buyer of the option is the taker. The seller is the writer.
- The quantity of option contracts to trade: Most share options have a contract size of 100 shares. Index options have a value of AUD $10 per point.
- The code of the option: The first three letters of the code are the underlying instrument. In this example, it is the XJO – the ASX 200 index. The last three characters are unique for each option.
- The strike price of an option: This is the price of the underlying share or index at which a future transaction could take place. Also known as the exercise price.
- Call or put option: This outlines whether the taker has the option to buy (call) or sell (put). See above for explanation.
- The style of the option expiry: There are two main types. American options can be exercised at any time up until the expiry of the option. European options can only be exercised on the expiry date. American Call options over shares are sometimes exercised early for dividends. Index options are usually European.
- The expiry date is the date on which the option expires: On (or up until) this date the taker of the option decides whether to exercise their rights under the option contract.
- The order price: This is the level at which a person wishes to buy or sell.
- The theoretical price of the option: Option prices depend on multiple factors. The current price of the underlying share or index, the dividend or dividend yield, the interest rate until expiry, and the volatility of the underlying are all used in determining the theoretical price.
- The current bid price for the option.
- The current sell price for the option.
What are multi-leg options?
Deliverable and cash-settled options
Most share options are deliverable. This means if they are exercised a stock transaction occurs. If the taker of a call option decides to exercise, and buy the underlying shares, the writer of the call option must deliver those shares at the strike price. In contrast most index options are cash settled. The difference between the strike price of the option and the expiry price of the index is paid or received in dollars.
Qualifying in options
Investors and traders seeking to harness the power of options must have a suitable depth of knowledge. A structured study and exam program is available to all.
Intended users must demonstrate they understand the characteristics of the strategies they wish to implement by passing a short quiz. There are five levels of option qualifications. At level 1, users are restricted to well-known and lower risk option strategies. Users qualified to level 5 may implement any strategy.
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