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Introduction to financial markets

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Trading options

2-minute read

Options are a financial derivative instrument that gives you the right, but not the obligation to purchase or sell an asset at a specified price, known as the strike price, before a certain expiry date.

They differ from futures because there is no obligation on behalf of a trader to take delivery of an asset when the option expires. When you buy an options contract it comes with a premium – this is the price of owning the option. The premium acts a bit like insurance, you pay for the right to exercise the option in the future.

Like futures, options have a limited shelf life – they have a date at which they expire. The advantage of trading options is that they provide the potential for an investor to acquire something cheaper than the market price, or to sell something at a more expensive price than the market is trading at.

Options exist for a broad range of asset classes including stock market indices and commodities.

Types of option contracts

There are two types of option contracts which can be bought to speculate on the direction of an asset:

Call option
This gives you the right to BUY an asset at a future price. Buyers of a call option are speculating on an increase in the price of the asset. They have the right to buy the asset at the strike price of the contract.

Put option
This gives you the right to SELL an asset at a future price. Buyers of a put option are speculating on a decline in the price of the asset. They have the right to sell the asset at the strike price of the contract.

Example:

On Jan 1st, the stock price of company ABC is $57 and the premium is $2 for a February 60 Call. This indicates that the expiration of the contract is the third Friday of February and the strike price is $60

When you buy an option it represents 100 shares so the total price of the options contract is $2 x 100 =$200.

Loss making option
When the stock price is $57 it’s worth less than the $60 strike price. You have also paid $200 premium. If the stock price declined further to $55 in the next couple of weeks, you would choose not to exercise the option because you could buy the stock for $5 cheaper per share on the stock market. Overall, you will have lost your premium of $200

Profit making option
If the stock price rose to $67 in 3 weeks, the options contract will have increased and you would be able to sell your option and make a profit. You would make a profit of $700 minus the $200 premium.

Exchange traded options

Options are traded in a standardised format on options exchanges. The largest options exchange in the world is the Chicago Board Options Exchange (CBOE).

Options trading can also take place directly with another counterparty, this is known as over-the –counter (OTC).

Why use options?

Options are frequently used by investors to help them manage the risk in their portfolios. For example, an investor with a portfolio of Australian shares might buy a put option on the AU 200. This will go up in value as the AU 200 falls.

Options can be more flexible than futures, as they come in both buy (call) and put (sell) versions, plus it comes down to the trader to decide when to exercise them. The premium paid for an option can be more cost efficient than a futures contract too.