Options serve as a versatile investment tool
Exchange Traded Options (Options) are a versatile and flexible tool. They can be used to compliment or refine your existing share strategies, or take advantage of opportunities in other ways to owning direct shares. Options strategies can be as simple or as complex as you want.
You can use Options to limit risk or to protect your existing share portfolio against a fall in value. When the market is flat you can write Options over your existing share portfolio to generate income in times of low capital growth
An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or to sell a parcel of shares at a specified price on (or before) a specified date.
There are two types of options traded on the ASX: call options and put options.
- Call options give the taker the right, but not the obligation, to buy the underlying shares
- Put options give the taker the right, but not the obligation, to sell the underlying shares
You can trade options over most of Australia’s largest companies, including News Corporation, Telstra, BHP Billiton and the major banks.
How Options work
There are two types of Options – Call Options and Put Options. Both can be bought or sold, or used in combinations to create strategies suited to your risk tolerance. Options positions should be looked at from both the standpoint of the BUYER (or taker) and the SELLER (or writer).
- Bought Call Options give the BUYER the right (but not the obligation) to buy a specific number of securities, for a specific price, on or before a set date.
- Bought Put Options give the BUYER the right (but not the obligation) to sell a specific number of securities, for a specific price, on or before a set date.
- Sold Call Options oblige the SELLER to deliver stock if required (exercised) by the BUYER, at the agreed price and quantity up until expiry of the option.
- Sold Put Options oblige the SELLER to buy the stock if required (exercised) by the BUYER at the agreed price and quantity up until expiry of the option.
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- Risk management – A simple strategy is to use put options which allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.
- Time to decide – By buying a call option, the purchase price for the shares is locked in. This gives the call option holder until the expiry date to decide whether or not to exercise the option and buy the shares. Likewise, the buyer of a put option has time to decide whether or not to sell the shares.
- Ease of trading – The ease of trading in and out of an option position makes it possible to trade options even if there is no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options and vice versa. Either way the holder can sell the option prior to expiry to take a profit or limit a loss.
- Leverage – Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risk than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share.
- Diversification – ASX’s options market allows investors to build a diversified portfolio for the same or even lower initial outlay than purchasing shares directly.
- Income generation – Share holders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is the possibility that they have to sell their shares to the buyer of the option at the exercise price. This is called a ‘covered write’ strategy.
- Small initial outlay – With Options, you can potentially make higher returns from a smaller initial outlay than investing directly. You may benefit from changes in share price without paying the full price of the share.
Options are not without a higher level of risk and therefore may not be appropriate for everyone.
- Market risk – Options may fall in value or become worthless. Changes in the underlying share price may change the Option price, but the option price change may be in a different direction or magnitude.
- Time decay – Options have an expiry date and therefore a limited life. An Option’s time value erodes over its life and this accelerates as an Option nears expiry.
- Leverage – As options can be used as a leveraging tool, losses may be magnified and created quickly. If your initial outlay is small relative to the total contract exposure, a small market movement may have a larger impact on its value.
- Option writers may face unlimited losses – Selling Options involves significant risk. If you sell and the position moves against you, you may lose more than any premium received. Where the position is naked, losses are potentially unlimited.
- Liquidity risk – Your ability to trade out of a strategy may depend on a quote from a Market Maker. Market Makers are important to provide liquidity, but their obligation to provide quotes is not unqualified
- Calls for additional margin – If the market moves against you or margins increase you may have to provide additional funds at short notice. If you do not, your position may be closed and you will be liable for any resulting loss.