Options

Exchange traded options or ETOs, are an agreement that gives the holder the right, but not the obligation, to buy or sell a specific security at a specified price within a stated period of time. To acquire this right, the taker (buyer) pays a premium to the writer (seller) of the contract.

Options may be listed over shares in a company listed on the ASX, over a share price index, or an ASX exchange traded fund (ETF). You can trade options over most of Australia’s largest companies and banks.

Options have the potential to protect your shares against market falls, generate additional income over and above dividends, or produce leveraged returns in both rising and falling markets. However these benefits can hold significant risks.

Trading ‘put’ and ‘call’ options on the ASX

Buying (taking) a call gives you the right, but not the obligation, to buy the underlying asset e.g. shares at a predetermined (strike) price from the seller of the option. As a simplified example, if company A has a last sale price of $10, you could buy a call option which would give you the right, but not the obligation, to buy company A at $10 before the option expiry date. If company A’s share price rose to $12, you would have the right to buy the shares at $10 and sell at the higher market price for a profit. When buying options your downside risk is limited to the initial capital invested.

Buying (taking) a put gives the buyer of the option the right, but not the obligation, to sell the underlying shares at a predetermined (strike) price to the writer. By buying a put option, you can lock in a selling price for the underlying shares for the life of the option.

It is also possible to sell an option, however this carries more downside risk – which will often be more than your initial investment. When selling (writing) a call, you are obligated (if requested by the counterparty/buyer) to sell the underlying shares at a predetermined price. And when selling (writing) a put, you are again obligated (if requested by the counterparty/buyer) to buy the underlying shares at a predetermined price. The advantage of writing options is that you can collect the premium, which may increase the income earned by your investments.

The buyer of the option must pay the writer (seller) a premium for the option. This dollar amount paid to the writer varies depending on factors such as supply and demand, duration of the contract and volatility of the underlying share price.

Why consider options:

• Easy to speculate. Trade in and out of options without ever intending to exercise them. Buy call options if you expect the market to rise, or buy put options if you expect the market to fall. Either way, the option holder can easily sell the option prior to its expiry to take a profit or limit a loss.
• Minimise the impact of market volatility on your holdings. For example, investors holding shares can use put options to hedge against a possible fall in their value.
• Potentially higher ROI. Options provide the potential of making a higher return on investment from a smaller initial outlay than investing directly. You can benefit from a change in the price of the share without having to pay the full share price.
• Generate income. Shareholders can earn extra income over and above dividends by writing call options against their shares and receiving the option premium upfront.
• Make time to decide. A call option gives the call option holder time to decide whether to buy the shares, and a put option gives time to decide whether to sell the shares.

Look out for:

• Considerably higher level of risk. Investors can lose all of their invested capital.
  • Options may fall in price or become worthless. Changes in the price of the underlying security may result in changes to the price of an option, but the change may be in a different direction or of a different magnitude.
  • As options are a leveraging tool, losses may be created and magnified quickly. A small market movement may have a larger impact on the value of the contract.
  • The premium received by the writer (seller) of call options is fixed and limited, however the writer of put options may incur losses greater than that amount.
  • If the market moves against your position or margins are increased, you may be called to pay additional funds at short notice. If you don’t pay, your position will be closed and you will be liable for any losses.
  • Market conditions, like lack of liquidity, can increase the risk of loss by making it hard to effect transactions or close out existing positions.
  • Time value erosion may negatively affect the price of bought option positions even if the underlying instrument moves in the right direction.
• Options have a limited life and they need to be closely watched and managed.
  
  
• Unlike the underlying securities, you don’t receive dividends.
  
  
• You will be trading options under the ASX’s broad powers, as well as ASIC rules. To maintain fair and orderly markets, they have the power to suspend dealings in products or cancel or amend a trade.