Options quite often get put in the ‘too hard’ basket for many investors. To begin with, there is a lot of jargon that gets thrown around. Some of the option strategies sound more like exotic species than anything to do with the markets.
There are iron condors, butterflies, straddles, collars and strangles. In fact, there are dozens of other strategies that might put you off before you’ve even started!
While these all sound way too complicated, it’s important to understand that all option strategies are derived from just two building blocks — a call option and/or a put option. These two types of options can be put together (or used individually) to form a range of strategies which can be applied to any market condition.
Once you get your head around these two building blocks, you’ll soon start to understand how options work.
Let’s start with a call option. A call option gives the buyer the right to buy shares in a company at a specified price until the option expires. That might still sound a bit jargon-y, so let me give you an example.
If Telstra is trading at $5.30, and you think the price is about to go up, you could just buy the shares directly. 1,000 shares would cost you $5,300 plus brokerage.
Instead, you could buy a call option with an exercise price of $5.40 that expires in around three months. This might cost you around 15 cents per share.
Each option contract is typically for a hundred shares. So to buy the equivalent of 1,000 shares, you’d need to buy 10 call option contracts. These 10 call options cost you $150 plus brokerage.
Why $150? It’s 10 contracts times 100 shares per contracts times 15 cents per share (known as the premium).
The option market trades like any other market. It’s a mix of buyers and sellers making offers to arrive at a price at which a trade takes place. In the share market this is often called the ‘last trade’ price. In option vernacular, this trade price is known as the ‘premium’.
Like a share trade, options have two parties to a transaction. The call option buyer pays a premium for the right to exercise their option at any time up until expiry.
The call option seller takes on an obligation in return for receiving the premium. If the option is exercised, they must hand over the shares at the exercise (also known as ‘strike’) price, even if the shares are trading at a higher value.
Let’s go back to the Telstra example. The investor who bought the shares used $5,300 of capital. Every cent that Telstra goes above their $5.30 entry price makes the investor $10 in profit.
Meanwhile, the call option buyer has only committed $150 in capital to give them exposure to any upside in Telstra. Straight away you might think that the call option trade is a much better deal. However, the option trade comes with its own limitations.
First, the share price has to get to $5.40 (the exercise price) before the option has any underlying value. You might have seen this referred to as ‘intrinsic’ value.
As all options have expiration dates, it also has to get to this price before the option expires. Once an option expires without being exercised, it ceases to have any value.
On top of this, the option buyer needs to recoup the money they spent buying the option. In this Telstra example, that’s 15 cents. The Telstra share price would have to get to $5.55 before the call option buyer could make any money. That’s the $5.40 strike price plus the amount they paid in premium, 15 cents.
You’ll see this referred to as the ‘breakeven’. For the share buyer, the breakeven is $5.30 plus brokerage. For the call option buyer in this example, that’s $5.55 plus brokerage.
While the call option uses much less capital, it also relies on the price increasing much further than the share trade before it makes any money. All the while, the value of the option is depreciating each day as the time ticks down to expiry.
You can see how it’s a trade-off between the two. One uses less capital but comes with its own set of limitations.
At expiry, what can happen?
If Telstra is trading below $5.40, the call option buyer won’t exercise their option because there is no reason to. There’s no point paying $5.40 (the option strike price) if they can buy the shares cheaper in the market. If the option isn’t exercised, the option seller keeps the premium.
If Telstra is trading at $5.40 or above, the call option buyer will exercise their option. They’ll do this because the option enables them to buy the shares cheaper than if they had to buy them on the market. In this case, the call option seller has to hand the shares over at the strike price ($5.40 in this example) even if the share price is trading higher in the market.
Options aren’t available on all the shares listed on the ASX. They’re mostly available on shares in the ASX’s top 50 stocks and a handful of others. Options also come with a range of different strike prices and expiration dates, giving them a great deal of flexibility.
If you want to find out if you can trade options on a company you’re interested in, here’s what you do. Go the ASX website at www.asx.com.au and click on the ‘Prices and research’ tab on the top left.
Next, click the ‘Prices’ tab, and then enter the share code of the company you’re interested in. Click ‘Go’ and the following page will come up. For this example, I’ve selected BHP [ASX:BHP].
Find out if you can trade options on a company
Source: ASX website
Click on the ‘Options’ link that I’ve circled in red above. This will take you through to a page that lists all the options available for that share, including both call and put options, and the different strike prices and expiration dates.
To buy a call option, you want to be confident that the share price will increase above your breakeven price before the option expires. Otherwise you’re just wasting the premium you’ve spent in buying the option.
But what about if you think a share price is about to go down? That’s when you’d buy a put option.
Next week I’m going to run through how a put option works. I’ll also give you a real example of how you can use a put option to protect your portfolio if you think the share price might be about to take a tumble.
Editor, Options Trader
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