Options Trading: Part 1 - The Basics

 

Options are financial instruments that allow traders to gain leveraged exposure to different underlying assets. Simply put, an option is a contract that gives you the right to buy or sell an asset such as as stock at a specific price (the 'strike') at a specific point in time (the 'expiry'). This first article in our Options Trading series will focus on the use of exchange-traded options (ETOs) which are traded on the Australian Stock Exchange (ASX).

Exchange-traded options are ideal for the retail investor as they are standardised products that are based on a diverse range of underlying shares and stock market indexes and are traded on a transparent exchange - the ASX. Options are traded similarly to shares themselves, with a bid and ask system of price discovery. This allows a trader to sell options to close an existing bought position or to open a new sold position, much like short selling a share.

Why use Options?

Traders use options for:

  • Access to leverage
  • To insure or hedge their portfolio
  • To create income against their portfolio
  • To trade a falling, sideways or rising market
  • To trade increases or decreases in market volatility

Before you start trading

Some of things you need to have before trading an option:

  • An account trading account with a broker
  • A reason – Or a view on direction
  • A suitable option strategy
  • A trading plan
    • Risk management
    • Money management

You either need an adviser who you trust to guide you through this or you need education to do it yourself.

There are two main types of options

Call Option

A Call Option is a financial instrument that gives the owner the right to buy an underlying asset (such as stock) at a nominated price at a nominated point in time.

If the market price of the underlying asset rises in value then the call option also rises in value. This is because the owner of the call option has the right to buy the underlying asset at a cheaper price than the rising market price.

However if the market price of the underlying asset falls in value then the call option also falls in value. This is because anyone can buy the underlying asset at a lower price than what the call option entitles you to.

The holder of the call option has the right to (but not the obligation to) purchase the underlying asset at the nominated price when the nominated time is reached.

Put Option

A Put Option is the opposite of a call option. A put option is a financial instrument that gives the owner the right to sell an underlying asset (such as stock) at a nominated price at a nominated point in time.

If the market price of the underlying asset falls in value then the call option rises in value. This is because the owner of the put option has the right to sell the underlying asset at a higher price than the falling market price.

However if the market price of the underlying asset rises in value then the put option falls in value. This is because anyone can sell the underlying asset at a higher price than what the put option entitles you to.

The holder of the put option has the right to (but not the obligation to) sell the underlying asset at the nominated price when the nominated time is reached.

There are numerous components to an option

 

Underlying

The underlying is the asset that the option holder has the right to either buy or sell at a specific price at a specific point in time. The underlying asset of exchange-traded options are usually stocks or stock market indexes. The difference between the market price and the nominated or 'strike' price of the underlying asset is what creates value in the option.

Strike

The strike price, or exercise price, is the price at which the holder of the option can buy or sell the underlying asset at expiry. This price can be lower, higher or at the current market price and is determined by whoever buys the option.

Expiry

Each option has a finite life. The expiry refers to the last point at which the Option can be exercised or traded. There are options available with expiry dates ending at the end of this month to several years in the future.  Any option not exercised or traded by the end of its expiry date will expire worthless. In Australia, stock options expire on the Thursday before the last business Friday in the month. Index options expire on the third Thursday of the contract month providing this is a trading day.

Exercise

Exercise refers to the actioning of the right conveyed by the option. There are two different exercise styles on exchange-traded options; American and European.

American Style options

American style options are options that can be exercised at any point during the life of the option. In this regard, one must be careful when selling American style options as you can be exercised and forced to buy or sell shares at any point before the expiry date of the option.

European style options

A European style option can only be exercised on expiry day. Therefore it is often desirable to sell European options to ensure that there are no obligations to buy or sell shares before the designated expiry point. A European option will usually have a strike price $0.01 higher than an American option in order to differentiate the two. For example, at $10.00 American style option might have an equivalent European style option with a strike of $10.01.

Settlement

Settlement refers to the delivery of the obligation by the option's seller to the option's buyer. Since an option is the right (but not the obligation) of the holder to transact on an asset, settlement only occurs if the options are exercised. Stock options are usually settled "physically" which means that the option's seller must sell shares to the option holder in the case of a call option, or buy shares from the holder in the case of a put option. Index options are cash settled will be transferred from the seller to the buyer in the case of an "in the money" option. Cash settled options that are "in the money" will be exercised automatically on expiry day. An "out of the money" option will always expire worthless and will therefore not be exercised and settled.

It is important to note that the holder of the option is not obligated to exercise the option. If there is profit in the option then the holder will excercise their right at expiry. If there is no value in the option then the holder doesn't excercise thier right at expiry, and the option expires worthless.

There are several terms we use to refer to the value of an option

In the money

An option is "in the money" if it could be exercised on expiry for a better price than the equivalent transaction on the stock market. A call option with a strike below the current underlying price is considered in the money because you can buy shares for cheaper than the current market price. A put option with a strike above the current market price is also considered in the money as it allows the holder to sell shares for more than they can purchase them on the stock market.

At the money

An "at the money" option is an option with a strike price that is the same as the current market price of the underlying asset. In this way, assuming there were no transaction costs buying or selling the asset via exercise will have the same monetary outcome as replicating the transaction on the stock market. For example an option with a strike of $10 is at the money when the underlying is trading at $10 on the live market.

Out of the money

An "out of the money" option is an option that if exercised would result in a worse price than the equivalent transaction on the stock market. For example, a call option with a strike of $11 allows the holder to purchase shares at $11. If the shares are trading below the $11, it would be cheaper to buy them on the stock market. Similarly, a put option with a strike price below the current underlying market price is considered out of the money. An out of the money option has no intrinsic value and any price of the option reflects only the remaining time value.

Intrinsic value

Intrinsic value is the measurement of how far in the money an option is. For call options, intrinsic value is how far below a strike price is from the current underlying price. For put options, intrinsic value is how far above the strike is from the current underlying price. For example, a call option with a strike of $10 and an underlying stock trading at $11 will have an intrinsic value of $1. An option with intrinsic value is considered "in the money".

Time value

Time value is the price of an option minus the intrinsic value. In this way, it is a measurement of the premium being charged for the possibility of the share price moving in your favour between now and expiry. Therefore, time value will decrease as an option approaches expiry. Consider a call option trading at $1.10 with a strike of $10 and an underlying of $11; in this case, the intrinsic value of the option is $1 and the time value is $0.10.

Although exchange-traded options are multifaceted, they provide the flexibility of constructing an exposure that fits your view on the market or an individual stock. Unlike simply trading shares, trading options allows greater possibility to customise the risk and return, volatility or time-period of a trade.

 

 
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