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 THE ABC OF... |
ABC of...
Options in a nutshell
CS journalists
Are you ready to impress your friends with your grasp on options trading? Well, get started now and learn the lingo.
Why trade options?
If you don't know anything about options - don't fret. We're about to give you the lowdown on options trading.
Trading options is like driving on a multilane freeway, with roads splintering off into underpasses and tunnels, and veering onto bridges. Trading shares, in comparison, is like putting down a single-lane country road.
When you buy a share, you hope that its share price will rise. It's as simple as that. Options, on the other hand, can be used to place on bet on almost any outcome that you deem possible - such as a price rise or fall within a certain timeframe, say within a month or six months. I think that Telstra shares, at $4, will rise to $4.20 within two months, for example; or I will place a bet that Telstra shares, at $4, will fall to $3.90, within the next three months.
You might think that the share price will instead sit within a range - neither rising above nor below a specific level for a period of time. You can place a bet on that. You can even invest according to where you think the share will not trade. I believe that Telstra shares will not hit $4.20. Indeed, an options strategy can be based on that premise.
You can now see why analysts find the activities of options traders so revealing. The type of options traded (either calls or puts) and strategies undertaken can hint at investor sentiment towards a particular security or the overall market.
A touch of theory
Derivatives
Options can be lumped in with other derivatives such as futures, warrants and contracts for difference (CFDs). A derivative simply means that the price is "derived" from some underlying instrument, either a share, for example Rio Tinto, a commodity such as gold, or a financial instrument like the 90-day bank bill.
Derivatives, such as options, are traded on margin, which means that you don't have to fork out the entire cost of the investment upfront, but instead utilise borrowings to boost your exposure. This means that possible profits and losses are much heftier trading derivatives than many other investments, such as direct shares.
What is an option?
Options appear pretty tricky at the outset to understand, but can be simplified to just a couple of core points to remember.
Basically, an option is a financial contract between two parties, the buyer and the seller of the option. It's worth remembering that the seller of the option is also referred to as the "writer," and the buyer of the option is often referred to as the "holder" of the option.
The definition of an option is as follows: An option gives the holder the right - but not the obligation - to buy or sell an underlying instrument at a specific price at or before a specific date. Technically speaking, the specific price is labeled the "strike price" and the specific date is called the "expiration date".
To enter into an options contract, the buyer of an option must pay a fee (called a premium) to the seller of the contract. The seller is obligated to offload the instrument to the buyer on demand.
Types of options
There are two types of options - calls and puts. You can choose to buy or sell either type. This means that you can buy or sell a put option, and you can buy or sell a call option. Hands down this is the most confusing part about options, and takes some time to get your teeth into.
A call option gives the buyer the right to BUY the underlying security at the strike price at or before the expiration date. The writer (or seller) of the options is obliged to SELL the shares to the buyer at this point in time.
A put option gives the buyer the right to SELL the underlying security at the strike price at or before the expiration date. The writer (or seller) of the options is obliged to BUY the shares to the buyer at this point in time.
Put simply, as a buyer of an option you can decide to buy or sell the underlying security for a possible profit and an initial outlay, or premium. This means that your potential loss is always limited to the initial premium. As a seller or writer of an option - while you don't pay a premium to enter the contract - you must reverse the transaction (either buying or selling) when the buyer decides to "exercise" his or her right.
Why buying a put option can beat shorting a share
Some brokers let you short-sell certain shares - allowing you to profit from a price fall. When you short-sell a share you're basically borrowing money from the brokerage account, and selling the shares into the market. In order to close the position out, you buy the shares - and if the share price has fallen in the meantime, you make a profit.
Let's say you decide to short-sell 1,000 shares at $50 for a $50,000 outlay. Over a matter of weeks, let's say the shares increased to $60. To cut your losses, you decide to buy the shares at $60, outlaying $60,000, and hence losing $10,000 on the transaction. Had the shares increased to $70, you'd be looking at a $20,000 loss, and so on.
Many traders argue than rather than doing this, you'd be better placed to buy a put option on the share instead. Losses from buying a put option will be limited to the amount you outlay (or premium) to buy the option. Let's say you purchased the option for $2, you'd be looking at a $2000 loss (options are usually purchased in lots of 1000). Clearly, this loss is a far sight better than the potential loss from short-selling the share.
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