Traders use options in a huge variety of ways. Some are attracted to the one-sided and limited risk of buying options. Others act as market-makers, optimising profits by facilitating investors’ option trading. The mathematics underlying options is complex, but anyone who can add, subtract and calculate a percentage return can harness the power of options to increase overall market returns.
An option is an agreement between two parties. Although there is a huge variety of options, they all involve a seller of an option (the writer) granting certain rights to the buyer of an option (the taker) in return for a payment (the premium).
A call option gives the taker the right, without obligation, to buy a specified trading instrument at a specified price, on or before a specified date. The writer of a share option must deliver the underlying shares, at the specified price, if the taker decides to exercise their option (to buy). The writer receives a payment, known as a premium, for granting the taker this right.
A put option gives the taker the right, without obligation, to sell a specified trading instrument at a specified price, on or before a specified date. The writer of a share option must buy the underlying shares, at the specified price, if the taker decides to exercise their option (to sell). The writer receives a payment, known as a premium, for granting the taker this right.
The risks involved in using options depends on the strategy employed. Option strategies may involve a single option series, or a number of option series, both puts and calls. One little understood aspect of options is that when they are used in conjunction with other investments they can lower overall market risk. At the other end of the risk spectrum, writers of options can face large or even theoretically infinite risk. Its vitally important that users understand the risks of any particular strategy before transacting.
Just as in every other investment choice, circumstances of the individual are important in determining the "right" options
strategy. However the sheer power and versatily of options does multiple the ways options can be traded for both investors and trades.
Here are some of the reasons that investors and traders may want to trade options:
Earn income from your share portfolio - Investors can generate income from their portfolio by writing call options against their stock holdings. This is known as a covered call, or buy-write, and is one of the most commonly employed strategies by investors.
Protect share holdings – investors concerned about the near term outlook for a stock holding can protect against a share price fall by taking a put option in that stock. Options are available over more than 70 of the top shares listed on Australian exchanges.
Protect portfolios – investors worried about the market outlook can offset potential portfolio losses by taking put option over the index. If the market falls, the put options increase in value as the portfolio declines. The effectiveness of this strategy depends on a number of factors, including the composition of the individual portfolio.
Lock-in attractive prices – where investors identify an opportunity in a stock, but don’t have funds on hand to buy immediately, they can lock in a purchase price by taking a call option now and exercising the right to purchase later
Buy stocks cheaper – investors can reduce share purchase costs by writing put options in stock they’d like to buy. If the share price is below the option strike price at expiry, the investor buys the stock at the strike price and keeps the premium for the original put option write. A risk is that the stock rises quickly, and the put is not exercised, meaning the investor doesn’t buy the share. However in this scenario the investor still keeps the original premium. This is often referred to as a cash-covered put write.