What are Exchange Traded Options?
An option is a contract between two parties conveying a right, but not an obligation to buy (Call option) or sell (Put option) an underlying security at a specified price, within a specified time for an agreed price. Exchange Traded Options or ETO’s offer client’s the potential to benefit from share price movements without having to hold the underlying shares. Client’s are able to profit from both upward and downward movements in the underlying shares over which the options are traded.
For a call option, the value of the option will increase as the underlying asset goes up.
For a put option, the value of the option will increase as the underlying asset goes down.
Every option contract has an underlying security (or index): ANZ, BHP, RIO, TLS, XJO etc, an expiration date: June, July 2020 etc, type: Call or Put, premium or price, and a strike price.
COMPONENTS OF AN OPTION
Rights vs Obligations
Call Options
Put Options
EQUITY OPTIONS
Contract size – 100 shares
Expiry day – Last Thursday of the month for monthly contracts
Every Thursday for weekly option contracts
INDEX OPTIONS
Contract value – $10 per point
Expiry Day – Third Thirday of the month
Sold Put Option
You decide which stock you want to buy, at what price you want to buy it, place the trade and collect the premium.
- The sale of a put option creates an obligation for the investor to buy stock
- If the share price drops below the strike of the option – the investor is called upon to buy the stock.
- If the share price stays above the strike of the options – the investor keeps the premium – which can be seen as profit
- The investor must be prepared to purchase the shares at the strike price if called upon at any time during the life of the options
- In selling a put option – you’re agreeing to buy the shares if the price falls to, or below the agreed price. In this way – selling a put option is a way of generating income by agreeing to buy someone’s shares should the price fall.
- Example:
- XYZ is trading at $28.50
- Target purchase price: 8% lower ($26.25)
- Strategy: Sell (10) XYZ June $27.00 Put for $0.75
- Scenarios on Expiration:
- Stock closes above $27.00 – June put expires worthless, $0.75 retained as profit
- Stock closes below $27.00 – Put assigned – Client buys 1000 XYZ shares (at $27.00 less $0.75 from sale of put) at $26.25 – 8% lower than current price
- Effective purchase price = Strike of Option less premium received
The Collar
The net income from this strategy will be lower than a covered call by itself, however, you have the added benefit of the protection that the bought put provides. The collar strategy uses part of the income from the covered call to pay for the bought put protection.
The collar provides enhanced income along with the peace of mind of downside protection. You know right from the start of this trade strategy what your potential gains or losses from the trade will be.
Covered Call
A covered call is where the seller of the call options owns the underlying stock. If the trader buys the stock and sells the call at the same time – this is called a buy & write strategy. Writing a call option generates income in the form of the premium paid by the options buyer.
Covered Call Seller:
- Agrees to sell shares at an agreed price (the strike price)
- By a certain date (the expiration date)
- In exchange – the seller received the premium
Reason for selling covered calls against shares currently owned:
- Enhance returns from investment
- Pre-set sale price for the shares
- Provide limited downside protection
Example:
- Own XYZ shares – now trading at $3.25 a share
- Outlook is neutral to moderately bullish on XYZ
- Want to increase stock return
Sell 1 XYZ May $3.36 Call at $0.16 each
- Long 1000 XYZ shares @ $3.25
- Short 10 XYZ May $3.36 Call @ $0.16
- Position investment (break even) $3.09
Results:
- Break-even lowered from $3.25 to $3.09
- Receive credit for selling call
- Limited downside protection
- Maximum gain = premium plus gain on stock ($0.16 + $0.11 = $0.27)
- There is no further profit participation above $3.36
At Expiry:
- If XYZ is above $3.36 – option is assigned – investor must sell shares at $3.36 (keeps call premium of $0.16)
- If XYZ is unchanged – option expires worthless (keeps shares and call premium of $0.16)
- If XYZ price falls – option premium provides limited downside protection (losses will occur below break-even point of $3.09)
Buyer Rights Vs Seller Obligations
Option Buyer Rights
The option buyer (holder of a long position) has the right to purchase or sell the underlying security at a:
- Specific price (the strike price) for a
- Specified time (until the expiration date)
The option buyer pays a premium for this right. Once you have purchased an option (established a long position) you can:
- Sell it
- Exercise your right
- Let it expire
Option Seller Obligations
The option seller (creator of a short position) is obligated to sell or purchase the underlying security at a:
- Specific price (the strike price) by a
- Specified time (until the expiration date)
The option seller receives a premium for assuming this obligation. Once you have sold an option (established a short position) you can:
- Buy it back
- Let it expire
- Be assigned to fulfil your obligation
Margins
What are Margins?
Margin obligations can be covered by either cash or collateral (stock). The cash or collateral is held by the OCH to cover the margin obligations of each client’s options positions. Stock lodged with the OCH remains beneficially owned by the investor.
Not all stocks listed are able to be used as collateral to cover options margins. The ASX stipulates a list of acceptable collateral stocks which is updated from time to time.
Table of ASX Acceptable Stock Collateral
To protect against a sudden fall in value of collateral held, the OCH will value securities at approximately 70% of their current market value. This 30% reduction is known as a haircut. Cash will be get 100% of it’s value used to cover margins.
It is only when you write or sell options that margins may be payable.
Premium Margins – the component of the total margin that represents the current liquidation value of the option position. The Premium Margin is the market value of the particular position at the close of business each day.
Risk Margins – the component of the total margin that represents the effect that the largest most likely inter-day change in the value to the underlying security will have on the value of the option position. Share Price x Margin Interval (calculated by OCH) to give a worst case theoretical option price. The risk margin is the theoretical option price less the current option price.
The premium margin protects the current value of the option, while the risk margin protects possible losses in the future.
Trading Psychology
- Have a trading plan
- Preservation of capital is your underlying goal
- If in doubt, close it out
- Take losses on the chin and learn from your mistakes
- If the market moves against you, take unemotional action to limit risk
- Analyse your winning and losing trades to learn from you experience
- Trade to follow your rules and to trade well, not chase profits
Options Trading Plan
- Know the direction of the primary and intermediate trend for the sector you are looking at and for the overall market.
- Write down a plan for defensive action before opening a position.
- Ensure that there is adequate liquidity in the stock and option series you are considering.
- Ensure that premiums are fair on the stock – Don’t sell undervalued options.
- Preferable enter trades at the start of week 1 or the start of week 2 for an end of month expiry, but don’t let this rule over a good deal presenting itself at another time.
Defensive Action
- A stop price must be placed on all trades based on closing prices. A stop price can be placed at the strike price of your open position of (at a minimum) the share price equal to the strike price plus the net premium received.
- Never let a loss run past your stop position on the close.
- If a position is going against you and it is risking more than 10% of your capital, do not enter any new positions until you have closed out the losing position.
- If a position crosses your stop price and the weekly charts have changed direction, close out the position, don’t roll it up. Consider covering the cost of closing with an out of the money short position with the opposite view (same expiry date).
