Understanding options trading
Trading options quite often gets 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 trade options work.
What is a call option?
Let’s start with a call option. A call option gives the buyer the right to buy underlying stock in a company at a specified price until the option’s expiration date has been exceeded. 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 underlying stock. So to buy the equivalent of 1,000 shares, you’d need to buy 10 call option contracts. In this example, these 10 call options will cost you $150 plus brokerage.
Why $150? It’s 10 contracts times 100 shares of underlying stock per contract 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 after the expiration date.
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 see how our call option example works out
Let’s go back to the Telstra example. The investor who bought the underlying stock 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’s expiration date. 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 when it comes to buying call options, it’s a trade-off between the two. One uses less capital but comes with its own set of limitations.
What happens when a call option expires?
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 the $5.40 strike price 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.
Note that options aren’t available on all shares listed on the ASX. They’re mostly available on shares in the ASX’s top 50 stocks and a handful of others. Trading options also comes with a range of different strike prices and expiration dates, giving them a great deal of flexibility.
If you want to find out if trading options on a company you’re interested in is possible, 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 stock price will increase above your breakeven price before the option’s expiration date. Otherwise you’re just wasting the premium you’ve spent in buying the option.
Let’s do a quick recap on call options trading
To give you a quick recap, a call option gives the buyer the right to buy shares (the underlying asset) in a company for a specified price (called the exercise or strike price) at any time until the option expires.
The person who sells this call option to them, the option ‘writer’, takes on an obligation. They must hand over the shares at the strike price if the buyer exercises their option. For taking on this obligation, the option writer receives a premium.
But what about if you think a stock’s price is about to fall? That’s when you’d buy a put option. Let’s take a look at them now.
What are put options?
You buy a put option when you think the share price might be headed for a fall.
A put option gives the buyer the right to sell shares in a company for a specified price (also called the exercise or strike price) at any time until the option’s expiration date. As with a call option, the put option writer receives a premium for taking on this obligation.
There are two main reasons for buying a put option. First, you can buy a put to protect your existing shares from a potential fall — like a form of insurance.
Second, you can buy a put option to speculate. The value of a put option increases as the stock’s price falls. Even if you don’t own the underlying shares, you can buy a put option with the hope of selling it later for a profit before it expires.
Rather than using options to speculate, let’s concentrate for now on how you can use put options as a way to protect your shares.
Buying a put option for insurance
Let’s say that you owned 300 shares of underlying stock in Westpac and they are trading at around $30.85 a share.
Please note that this example is shown for illustrative purposes and is not a recommendation.
You want to hold your Westpac shares for the long term, but you’re worried about the recent level of volatility. What happens if the stock price takes a tumble?
If you sell your underlying stock — instead of falling, the stock price might do the opposite. They could go up in value. Plus you want to collect any dividends Westpac pays you along the way.
Buying a put option is one way of covering both angles. It allows you to participate in any upside, while also protecting you from any potential downside. Let me explain.
As a put option buyer, remember you are buying the right to sell your shares at the strike price, at any time up until the option’s expiration date. If you exercise that right, the option seller must take delivery of the shares at that strike price.
However, if the stock price goes up or even trades sideways, then you won’t need to exercise that right. You just keep your shares and let the option expire without exercising it.
It’s easiest to think about it the same way you do about your house insurance. You pay a premium to your insurer to protect you if something happens to your house. Like a fire or a wild storm. If nothing happens to your house, then you have no need to make a claim.
And so it is when you buy a put option on a share. It allows you to sell your shares if they fall below a predetermined price. That is, the strike price. If they don’t fall below that price, then you won’t need to exercise your option. Or in insurance speak, you won’t need to make a claim.
Westpac put option example continued
But back to the Westpac example. Take a look at the following table — it shows a range of put options available for Westpac.
Put options available on Westpac
On the left hand side are a range of strike prices. Each strike price represents a price at which the put option buyer can sell their Westpac shares to the option seller, if they buy that option and later exercise it. For example, a put option with a strike price of $29.80 means that the put option buyer can exercise their right to sell their Westpac shares to the option seller at $29.80.
Likewise, the buyer of a put option with a strike price of $30.20 can sell their Westpac shares to the option seller at $30.20. They can do this at any time until the option’s expiration date.
All trading options have expiries — just like your home insurance. An option has no value once it expires. These Westpac put options listed above all expire on Thursday 28 January 2016.
One of the great things about options is their flexibility. You can choose from a range of different strike prices and expiry dates.
I’ve circled a Westpac put option above with a strike price of $29.30. If I buy that put option, that gives me the right to sell my Westpac shares to the option seller at $29.30 at any time until the option expires in January.
The next column is the option code. Each option has its own unique six digit code designated by the ASX. This is the code you quote when you place your trade.
The next columns are the bid and offer prices. That is, how much the option buyer is willing to pay for that option. And, how much the option seller wants to receive for selling that option. In the option I’ve circled, that’s a 52 cent bid and a 61 cent offer.
Let’s say you put your bid price in at 55 cents to buy that option and the trade goes through. That is, the option seller agrees to sell you that option at 55 cents. Let’s work out how much your option is going to cost and what happens from here.
Each option contract is typically for 100 shares of the underlying stock. As we have 300 Westpac shares, we would need to buy three put option contracts. At 55 cents, that would cost us $165 plus brokerage. That’s calculated by three contracts times 100 shares per contract times 55 cents per share (called the premium).
That buys us insurance on our Westpac shares until the option expires on 28 January. Let’s look at two different scenarios to see what can happen from here.
What happens when a put option expires?
First, if the stock price is trading above $29.30 when the option expires, there is no point in exercising the option. That’s because you could sell the shares for a higher amount than the strike price in the market.
Second, if the share price is trading below $29.30 when the option expires, then you’d look to exercise your option. In this case, it allows you to sell your shares for a higher amount than what you’d receive in the market.
In this second scenario, the option is referred to as in-the-money at expiry. That is, the share price is below the strike price of the put option when it expires. One thing to keep in mind is that your broker will usually exercise any in-the-money options at expiry, so you need to advise them if you don’t want them to do this on your behalf.
Let’s do a quick recap on put options trading
A put option gives the buyer the right to sell shares in a company for a specified price (also called the exercise or strike price) at any time until the option expires. As with a call option, the put option writer receives a premium for taking on this obligation.
If the put option buyer exercises their option, the put option writer must buy the shares at the exercise price, even if the shares are trading much lower.
Irrespective of whether the option is a call or a put, the rights are with the option buyer. The obligation is always with the option writer/seller.
To find out more about other types of investment, why not check our our guide on How to Buy and Sell Shares?