If you’re new to options trading and feeling confused or overwhelmed, please know you’re not alone. While the learning curve for trading options is steeper than for share trading or investing in indexes, you will see that the concept is not complicated once you grasp the basics.
However, trading options is a double-edged sword – because it involves risks that could devastate your finances, namely leveraging.
Let’s discuss the potential risks and rewards of trading options, the financial markets you can trade in, and how to start trading options in Australia.
(Related: How To Invest In Futures).
What Exactly Is An Option?
An option is a financial contract that grants the holder the right, but not the obligation, to buy or sell an underlying asset by a specific date and price.
To obtain this right, the buyer pays a premium to the seller of the contract.
In a nutshell, options trading allows you to speculate on:
- How much the price of the underlying asset will rise or fall.
- The date that this price changes will occur on.
Unlike trading shares, you won’t own a piece of a company until you exercise the option and take ownership of the underlying stock.
Here’s another way of looking at things:
- Say you want to buy a house, but you’re still undecided on whether to go through with it because it depends on a job offer.
- You can agree with the real estate agent to take an option on the house, which you’ll pay a premium for, locking in that price.
- Depending on whether or not you land the job, you can choose whether to proceed with the house purchase at the initially agreed price (even if the price has increased), or you can walk away from the deal, losing only your premium.
(Related: Best Share Trading Platforms For Australians).
What Are Put And Call Options?
There are two main types of options. Both allow you to speculate on the price of the asset.
|Call options||Give the option holder the right (but not the obligation) to buy the underlying asset at a predetermined price (“strike price”) within a specific timeframe.|
|Put options||Give the option holder the right (but not the obligation) to sell the underlying asset at a predetermined price (“strike price”) within a specific timeframe.|
Options allow investors to make strategic bets on how the asset will perform in the future.
When the stock price rises, the call option increases in value, and the investor benefits. At that point, the call buyer can “exercise” the call option or buy the underlying stock at the strike price.
Meanwhile, investors who believe the underlying asset’s market price will go down, sell or “write” a call option.
At that point, they can also “exercise” the put option or sell the underlying stock at the strike price.
What Is An Underlying Asset?
This refers to the type of financial instrument the option is linked to, such as stocks, currencies, commodities, currencies, and indexes.
With options, you can speculate on the price of any of these underlying assets without the obligation to buy.
What Is A Derivative?
A derivative is a financial contract in which the market value is derived from the price of the underlying asset (e.g., stock, bonds, index or currency).
Options are a type of derivative.
What Is A Strike Price And An Expiration Date?
The strike price (or exercise price) is the predetermined price at which the owner of an option can buy or sell the underlying asset.
A trader must exercise their options before or on the expiration date. After the expiration, the option ceases to exist, and its market value is reduced to zero.
There are two different exercise styles – American and European.
|American style||The option can be exercised at any time prior to the|
|European style||The option can only be exercised on the expiry day.|
What Are Intrinsic And Extrinsic Values?
The intrinsic value of an option’s price represents the immediate profit that would be realised if the option was exercised and sold immediately.
The extrinsic value, also known as time value, is how much an option’s price exceeds its intrinsic value, and it’s influenced by factors such as time to expiration and market volatility.
Are You A Writer Or A Taker?
- Option sellers are also known as ‘writers’ – because they underwrite the obligation to deliver or accept a parcel of shares covered by an option.
- Option buyers are known as ‘takers’, as they take up the right to buy or sell shares.
How Options Work.
Let me reiterate this key point – when trading options, you speculate on the movement of a market without ever owning the underlying asset.
You’re under no obligation to exercise an option if a trade turns out to be unprofitable.
In many ways, the premium can be considered insurance.
Here’s a quick example:
- Nearing expiration, the share price of Tesla has risen to $280 per share.
- As the holder of the call option, you can exercise your right to buy 100 shares of Tesla at the predetermined strike price of $250 per share.
- After doing so, your profit per share would be $280 (stock price) – $250 (strike price) = $30.
- After deducting the premium ($10), your net profit would be $30 – $10 = $20 per share.
- Since one contract represents 100 shares, your total profit would be $2,000.
Don’t worry if the example above doesn’t sink in straight away. We’ve all been there. Just keep reading and let your subconscious process it for a while.
What Is Leverage?
Something worth reiterating is that many investors are attracted to options because they offer leverage. Leverage is essentially borrowed money that’s invested in financial assets.
Here’s a scenario:
- If a trader has $2,500 to invest, they could purchase 10 ordinary shares at $250 per share.
- However, with a leveraged option, the trader could control 100 shares with the same $2,500 investment – a contract value of $25,000.
While leveraging means your profits can be magnified, so can your losses.
Leveraging is something beginners should steer well clear of. Lack of knowledge and experience only heightens the associated risk.
How To Read A Stock Option.
Stock options are often the first port of call for options traders. You must know exactly how to interpret a stock option quote before executing a trade.
When you’re reviewing quotes for trade options in an options chain (a matrix listing all available options contracts for underlying securities), they’ll appear as a string of text like the following:
(From left to right: stock symbol, expiry date, strike price, type, premium.)
Sometimes, to confuse matters, the date is written in numbers with no spaces. So you may see the above example written as follows:
Not all matrices display the same information in the same order, so it’s best to get familiar with your options trading account before executing any put or call options.
What Assets Can I Trade Options With?
Broadly speaking, there are four different types of options you can trade. Most beginner investors should stick with shares and ETF options before understanding the complexities involved with other financial assets.
1. Shares (Equity Options).
Share options, also known as equity options, are options on an individual company’s shares.
If you’re options trading in Australia, you can only trade equity options on ASX-approved companies (typically the ASX100).
(Related: What Is The ASX200 And How Does It Work?)
Remember that you won’t receive dividends when holding a call option. It’s only when you exercise your option and own the underlying shares that you get such a benefit.
2. ETF Options.
Exchange-traded funds (ETFs) are traded on stock exchanges in a similar way to individual stocks.
An ETF gives investors exposure to multiple assets with a single purchase. It can be a cost-effective way of diversifying a portfolio.
With ETFs, you can also trade options and speculate on a particular sector, such as technology, or those belonging to a different market, such as Northern Europe.
3. Index Options.
Index options allow a trader to speculate on the performance of indices, such as the ASX 200 and XGD. The one difference to be mindful of with index options is that options can only be exercised on the expiry date (not before).
Since you won’t actually be buying shares or assets when buying options, all trades are settled in cash.
4. Low Exercise Price Options (LEPOs).
A LEPO is an Australian Stock Exchange-traded option with a low exercise price.
They’re designed to track the underlying asset’s price. But because the exercise price is comparably low to other options, the premium you pay is much higher.
You can find out more about Australian LEPOs here.
The Risks & Benefits Of Trading Options.
Investing and speculating are two different things.
According to Benjamin Graham, the critically acclaimed author of the bestseller The Intelligent Investor:
Above: Options trading is not for beginners. This Reddit post captures it perfectly: if you’re asking for options trading tips on Reddit, you should not be trading options.
Education, then, is the difference between the two. You must educate yourself about the risks associated with options trading and manage them accordingly.
3 Potential Risks Of Options Trading.
All forms of trading and investing carry risks. Make sure you’re familiar with what you stand to lose.
1. Limited Time.
Each option has an expiration date. The clock is always ticking, and the option’s value diminishes over time.
If you hold on for too long, and the underlying security’s price doesn’t move in the desired direction, an investor can lose their premium.
Leveraging is the riskiest aspect of options trading, which is the borrowing of money to gain greater exposure to an option.
You can multiply your gains this way, but your losses can also be magnified. It’s a dangerous move for a new investor.
As I’m sure you’re now aware, options are complex assets, especially for those who are completely new to trading.
Think about it… do athletes step onto a pitch without going through rounds of rigorous training?
Do performers step out on stage without rehearsing? Then why the heck would you invest your money without honing your skills first?
3 Potential Benefits Of Options Trading.
Options trading is attractive to traders because of its unique risk and cost profile.
1. Risk Management.
The right to buy but no obligation makes options trading attractive to new investors.
If your predictions for the price of the underlying asset are way off, and you choose not to exercise your options, then the most you stand to lose is the premiums paid – a fraction of the losses you would have otherwise incurred had you acquired shares.
With options trading, you know the maximum potential losses upfront.
2. Low cost.
The options premium is generally a fraction of the cost of buying the underlying asset outright. As such, trading options is attractive to first-time investors on a smaller budget.
Hedging is commonplace in options trading. Let’s say, for instance, that you own shares of Tesla.
You could buy a put option to mitigate the potential losses if you’re worried about an impending share price drop because of a bad earnings report or a company scandal.
- If the share price does drop drastically, you can exercise your put option and still sell your stock at the higher strike price.
- If the share price doesn’t drop and continues its upward trajectory, you can let your put option expire, only losing the premium paid for the contract.
(Related: How To Invest Money In Australia).
Start Trading Options In Australia.
Getting going is easier than you think. That’s why you need to be conscious of these three steps before making any rash decisions.
- Weigh up the best brokerage platforms. The fees vary by broker, as does the quality of their platform interface and tools.
- Set up a demo account. I know it’s tempting to start placing your bets with real money, but rushing into trading is a surefire way of haemorrhaging your hard-earned savings. Take it from Warren Buffet who says, “The stock market is a device for transferring money from the impatient to the patient.”
- Decide on your strategy. Long calls, long put, short put, married put, covered call strategy? You’ll likely employ a hybrid approach to options trading strategies. Research the pros and cons of each and test them out in your demo account to get a feel for the right ones for you.
Frequently Asked Questions About Trading Options.
Here are some additional insights into options trading that you should know before signing up for a trading account:
What Is Hedging In Options Trading?
Hedging is one of many investment strategies to mitigate the losses of an asset’s adverse price moves.
For example, an investor may want to hedge in the event of market uncertainty.
An asset may experience a sudden drop in stock price owing to some damning news, the effects of which are likely to be short term.
If an investor hedges, and buys a put option with a strike price close to its current market price, the option’s gains limit the investor’s losses.
Now, the investor can either cash out of the put option once the short-term volatility is over (pocketing the gain), or – if the downward trend continues – at least their losses are cancelled out.
Why Do People Lose So Much Money With Options?
Traders often incur financial losses by holding options too close to their expiration date.
The closer an option is to the expiry date, the faster the time value deteriorates.
Investors need to secure a favourable price and exit the trade with a profit while there is still some time value remaining. Timing is everything.
What Do The Greek Symbols Mean In Options?
You might be wondering what the heck Greek symbols have to do with options trading. As if options trading wasn’t complicated enough, you’ll need to familiarise yourself with some more jargon:
- Delta measures how sensitive an option price is to the underlying market’s movement. Delta can be used to work out how much impact the market will have on the value of your options.
- Gamma is a derivative of delta and measures how much an option’s delta moves.
- Theta measures the extent to which an option’s price decays over time. A high theta suggests that the option is close to the expiration date.
- Vega is a measure of an option’s sensitivity to volatility in the underlying market.
- Rho indicates how interest rate changes are likely to move an option’s price.
Bottom Line On Options Trading.
Now that you know the basics of options trading, you’re probably not as confused about what options are.
Remember that this is an advanced trading strategy, and one that carries a significant level of risk. Always consult a finance professional for personal advice – before you start trading options.