Options trading can provide an investor with a range of opportunities to improve returns, speculate on equity/index prices and hedge risk on a portfolio. Below we discuss some basics for investing in options.
At Trading Equities we employ a wide range of options trading strategies ranging from the basics to some of the most advanced strategies. If you actively trade options we encourage you to contact us for more information.
Investing in Options
Investing in options provides both traders and investors the opportunity to increase returns, generate income, speculate and hedge portfolio exposures. Options trading strategies are often a underutlised due to their percieved complexity.
Trading Equities aims to educate our clients on the wide range of options strategies available which may enhance returns, provide income and portfolio protection when trading options. We aim to make the strategies as clear and relevant as possible, without underestimating any associated risks.
Options trading can also minimise risk not only through hedging strategies, but by constructing trades designed to capture exposures from fluctuating share prices while limiting the risk to the purchase price of the option.
An option is a part of a larger group of securities known as derivatives. A derivative gets their name, because they are priced based on another underlying product.
For example, the ASX 200 Index or the XJO has a range of options available for investors to access.
Below is an example of an options series screen.
Prices of the options are based on the underlying value of the ASX 200 Index. Should investors wish to protect their share portfolio from a downward move, they are able to use a derivative product, like a put option, to hedge their portfolio.
There are also multi-leg protection strategies which reduce the cost of portfolio insurance or protection against a stock falling by setting up options spreads. Please contact us for more information.
An option by definition grants the holder the right (but not the obligation) to buy or sell a particular product at a certain time in the future.
There are two types of options, calls and puts.
An American call option is the right to buy the underlying security at a paticular price on or at expiry. A European call option also has the right to buy the underlying, but only at the underlying price when the option expires.
A put option is the right to sell.
Put options may be purchased to protect the underlying should the market move down, or conversely put options may be purchased as a speculative tool when negative returns are expected for the underlying.
How Options Work
Options are traded on an exchange just like a stock. However the actual pricing of an option is based on a range of different factors. The actual price an investor pays for an option is called the premium.
Before looking at how the mechanics of using options works, it is important to understand some of the common terms associated with options.
Options also gain a degree of value from the overall volatility in the underlying product. If the market is expecting a significant move in either direction – potentially from an upcoming announcement – then that volatility is priced into the options premium at that point in time.
Strike or Exercise Price
The price at which the option can be used to buy or sell the underlying product.
The date at which the options contract expires.
In The Money
An option is said to be in-the-money if the price of the underlying stock or product is below the strike price for a call option or if the underlying price is above the strike for a put option.
Out Of The Money
An option is said to be out-the-money if the price of the underlying stock or product is above the strike price in the case of a call option or below the underlying for a put option.
Because options expire at a certain point in the future, they have what is effectively a time value. This is an amount a trader or investor may be prepared to pay to own the right to the call or put option until expiry. The options time value will decrease in value gradually until expiry. This is known as time decay.
The options premium is the amount paid for the right to buy or sell an option.
The value of premium is a combination of two factors. The intrinsic value of the option and the time value.
The intrinsic value is the amount an option is in-the-money. So if a call option has a strike price of $50 and the underlying stock is trading at $40, the option is $10 in-the-money.
The other element is time value. As time nears the expiration date of the options contract, the time value of the option decreases.
Premium = Intrinsic Value + Time Value
A practical example trading options.
The best way to understand how to trade options is to look at a practical example that investors can apply to their own portfolio.
Let’s say an investor believes BHP is going to increase in value in the coming months.
The investor could purchase an in the money call option with a strike price of $23 and pay a premium of $1.50.
BHP is this example would be trading around $24.15
The call option expires in 60 days time.
In this example the intrinsic value of the call option is calculated as follows.
Intrinsic value = Stock Price – Strike Price
$1.15 = $24.15 – $23.00
If the option was priced at $1.50 and $1.15 is intrinsic value then $0.35 is the remaining time value.
Premium = Intrinsic Value + Time Value
$1.50 = $1.15 + $0.35
If in 30 days time the price of BHP shares, rises to $25.00, then the value of the call option will also increase in value.
The intrinsic value of the option will increase, while the time value will decrease which is also known as time decay.
If BHP increased to $25.00, an increase of 85 cents then using the above calculation shows the intrinsic value will increase by the same amount. The option will now be worth a total of $2.00 (intrinsic) plus any remaining time value. If the option was trading at $2.20 the remaining time value would equate to $0.20 cents.
Premium = Intrinsic Value + Time Value
$2.20 = $2.00 + $0.20
So in this example, after holding the in-the-money call option for only 30 days, the position would have increased in value by 46%, not including commissions.
If the stock price fell into the expiry and was trading below the strike price then the option would have expire with no value and the holder of the call option would realise a loss, limited to the purchase price of the call option.
If the BHP price was trading above the strike at the options expiry then the remaining value at expiry would equal the intrinsic value.
If at expiration the option falls below the strike price, then the option will expire worthless and the holder of the call option will realise a loss limited to the purchase price of the call option. This is one of the benefits to purhasing a call or put option. In the case of the call option, the holder will participate in the appreciating share price, however risk is limted to the purchase price of the call option. The risk is therefore pre-determined and could be implemented into a trading system where stop losses are neccesary.
Investors also have the opportunity to simply exit the position by selling the call option at the market value and lock in a profit (or a loss) prior to expiration.
Put options can be used in a similar fashion to protect your overall portfolio from down moves.
Assuming you are a long only investor with a portfolio of stocks, you can purchase put options in the ASX 200 Index or XJO to hedge your position from a move below the put strike price.
If the XJO was trading at 5766 and the investor was concerned that the market is ready to sell off in the coming months, a put option with a strike price of 5700 could be purchased. The actual strike chosen depends on several factors, however this is just a practical example.
A put option gives the holder the right to sell at the put strike or exercise price.
So should the market break below 5700 before expiration, the put option will increase in intrinsic value effectively hedging a long share position/portfolio. There are more factors to consider, including how many contracts to purchase and volatility levels. For clients looking for protection trading equities will discuss various strategies so that the investor will be armed with several ideas when looking for the best options trading setup.
Flexibility of options
Options offer investors an incredibly flexible way to both speculate and leverage their portfolio, or simply to protect it from dramatic falls.
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