Options trading has gained a lot of attention in recent years, providing investors with an array of strategic investment possibilities. But what are options and how do they work? Let’s explore the essentials of listed options and some commonly used strategies.
Option Jargon
Before diving further into options trading, it’s important to understand some key terminology:
- Strike Price: The fixed price at which you can buy or sell the underlying asset. The agreed-upon price is set when the option contract is created.
- Expiration Date: The date until which the option remains valid.
- Premium: The price of the option contract.
- In-the-Money: An option is in-the-money when you can make a profit by buying or selling shares at the agreed strike price, compared to the current market price. i.e. the option has intrinsic value.
- Out-of-the-Money: The option is out-of-the-money when it wouldn’t make financial sense for the owner to exercise their rights to the contract. This is because the agreed strike price for buying or selling shares isn’t better than the current market price. i.e. the option has no intrinsic value.
Getting Started: Buying a Call Option
A call option gives the buyer the right but not the obligation to buy an underlying stock at a predetermined price within a certain time frame.
When you buy a call option, you pay a premium upfront to secure the right to buy a stock at the strike price. If the stock’s price rises above the strike price (in-the-money), you can exercise your option and buy the stock at a discount. Otherwise, you let the option expire (Out-of-the-money), losing only the premium you paid.
Risk: Your total risk is known at the time of purchase and is limited to the premium paid.
Reward: Unlimited reward with the upside of the share price.
Selling a Call Option and Covered Calls
On the flip side, you can sell (or “write”) a call option. When you do this, you receive the premium but commit to selling the stock at the strike price if the option is exercised.
Writing/selling uncovered calls (commonly referred to as ‘naked’) can be high-risk as your underlying exposure is unlimited. This is where ‘Covered Calls’ come into play.
In a Covered Call strategy, you own the underlying stock and then sell the right for someone else to buy those shares at the agreed price (as part of the option contract). This provides the seller/writer with income (from the premium) and a cushion against minor price drops in the stock. However, you forgo any gains above the strike price if the stock continues to rise.
For example, Andrew F owns 10,000 FMG shares which equates to 100 call contracts.
FMG is trading at $20.00 a share.
Andrew F sells 100 x $23.00 calls for 3 months time and receives $1.00 in premium ($10k)
- If FMG is below $23.00 at expiry, Andrew F keeps the stock and the $10k premium.
- If FMG is above $23.00 at expiry, Andrew F will sell the stock at $23.00 and keep the $10k premium.
Risk: There’s little to no direct monetary risk to covered calls, however, there’s an opportunity cost of the stock continuing to rise that must be considered. E.g. FMG goes to $25 and Andrew has sold at the equivalent price of $24.00
Reward: Premium received from selling the call option
Zac Brabin‘s comment: The covered call strategy is best used when the seller is happy to sell the stock at the strike price, considering it a ‘win-win’ scenario. i.e. The seller gets to keep the initial premium and the stock is sold at the price they’re happy with.
Sideways or moderately bullish trends are your friend here.
Downside Protection: Buying a put option
A put option is the opposite of a call option; it gives you the right to sell a stock at a predetermined price. Investors often buy put options as insurance against potential declines in stock value. By buying a put option, you secure the right to sell your stock at the strike price, thereby limiting your downside risk. As the market decreases, the price of a put option increases.
Risk: Your total risk is known at the time of purchase and is limited to the premium paid.
Reward: Put prices increase as the stock decreases, making the maximum reward the difference between the strike price and $0.00 per share.
Zac Brabin‘s comment: Puts can be a powerful tool for both investors and traders to gain downside exposure. Outside of a raging bear market, puts are generally best used in the short term when share prices reach lofty prices and are sold after a correction in the stock.
Utilising a covered call strategy with a protective put can create a ‘Zero cost collar’ strategy for a shareholder.
Selling Put Options to Buy Stock
Selling a put option means you’re on the other side of the insurance contract, you’re receiving a premium and committing to buy the stock if it falls below the strike price.
Writing/selling uncovered puts (commonly referred to as ‘naked’) is considered very high risk. This is where cash-covered puts come into play.
Selling cash-covered puts with the intention of purchasing the underlying stock can be an effective way to build a portfolio.
For example, Warren B wants to own 5,000 BHP shares (50 contracts) but thinks the stock is currently overvalued at $45.00 a share.
Warren B sells 50 x $43.00 puts for 3 months time and receives $1.00 in premium (+$5k)
- If BHP is below $43.00 at expiry, Warren B will buy 5,000 BHP at $43.00 and keep the $5k premium.
- If BHP is above $43.00 at expiry, Warren B will keep the premium received and will not purchase the stock.
- If BHP is still at $45.00, Warran could opt to sell another $43.00 put for $1.00 premium making his effective buy price $41.00 if exercised at $43.00.
Risk: Your risk involves having to buy the stock at the strike price even if its market price drops below it. Your potential loss is the difference between the strike price and the market price at the time of purchase.
Reward: Buying the stock at a discount after considering the premium you’ve received. Or, keeping the premium if the stock stays above the strike price.
Zac Brabin‘s comment: Cash-covered puts are best used in a choppy or sideways market and only when you’re willing to take up the underlying stock if exercised. Sizing is very important here.
Summary
Options trading can be intricate financial instruments, but when used judiciously, they offer a range of strategies for different market conditions. They can serve as both insurance and strategic investment tools, and when used without leveraging, can contribute to steady income. Whether you are a conservative investor looking to protect your portfolio or an active trader seeking opportunities, options offer a flexible avenue for diversification and risk management.
Curious about our options trading advisory services? Learn how we can assist you in navigating the options market effectively here👉 Exchange Traded Options – iInvest Trading & Advisory (iinvestadvisory.com)
When considering options, ensure you’re aware of the risks involved. For more information, here’s a link to the ASX-option guide: https://www.asx.com.au/documents/products/Options_Simple_Guide.pdf
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