In this chapter we will explore in more detail the various
types of options that are available and how they work. We
have included two summary tables at the start of this chapter
for you to refer to as you read through the detail, which will
give you an overall picture of how the options work.
Towards the end of the chapter we will introduce
some different types of options that are available, including
company issued options and index options and how they
vary from exchange traded stock options. Here's a good article
on different type of binary options
Option buyers (takers)
An investor or trader who is buying options is generally
anticipating a significant movement in the price of the
underlying security before the expiry date of the option.
Options provide the buyer with the opportunity to profit from
this expected price movement, without having to provide
capital to cover the full cost of the underlying security.
However, this leverage does come with a cost inherent in the
time value of the options.
Options also provide option buyers with limited risk.
Their maximum loss on any option trade will be the amount
they pay for the option (plus transaction costs). For example,
let’s assume you purchase a call option on CBA for $1, and
over the next few weeks the price of CBA falls by $2. If you
had purchased the CBA shares, you would have lost $2 per
share. However, by purchasing the options, your loss is
always limited to the option premium you paid, which in this
case is $1 per share.
It is important to remember that option buyers have the right
but not the obligation to exercise their options. If the option
holder does not wish to actually exercise the option and effect
a transfer to the underlying stock, they can close out their
position (effectively sell their options).
According to the ASX, as at November 2010 on average
only 15 per cent of all options traded on the exchange are
exercised. Of the remaining 85 per cent, 60 per cent of
these are closed out and 25 per cent expire worthless. So
a significant number of options are bought and sold by
investors and traders for purposes other than acquiring the
underlying stock.
Option sellers (writers)
Option writers charge a premium for selling options. Many
options writers sell options with the intention of generating an
income from the option premiums. As a result, these option
writers are generally expecting that the price of the underlying
security will remain flat or steady. This will result in the option
losing value as the time value of the option decreases.
Option writers may also be looking to generate larger
profits from the movement in the underlying security. The
writer of call options will be speculating on a fall in the price
of the underlying security and the writer of put options
will be speculating on an increase in the price of the under
lying security.
As the decision to exercise an option rests with the
buyer, option writers can have their options exercised at
any time before expiry. They will not know if or when their
options may be exercised. However, they are more likely to
be exercised when the option is ‘inthemoney’ and close to
expiry. An option is inthemoney when it contains intrinsic
value. That is, for a call option, the market value is above the
strike price of the option and for a put option the market
value is below the strike price of the option.
Option writers also carry a much higher level of risk
compared with option buyers. Whereas the total risk for the
option buyer is limited to the option premium, the situation
is quite different for option writers. A writer of uncovered call
options is theoretically exposed to unlimited risk as they are
exposed to increases in the value of the underlying stock. As
the market value of the underlying stock increases, the option
writer has the risk of having to purchase the underlying stock
at its market value, however high that might be.
A writer of put options is exposed to the value of the
underlying stock at the strike price. The option writer has
the obligation to buy this stock from the option holder if it is
exercised at the strike price. If the market value of the stock falls
to zero and the option is exercised, the option holder is required
to buy the worthless stock from the option holder at the
strike price.
Call options
A call option is the right to buy 100 shares of the underlying
stock at the strike price. This right can be exercised by the
taker (buyer) of the option at any time from when they
purchase the option until the expiry date of the option.
Buyers of call options
By investing in a call option you will generate a profit on your
option if the market value of the underlying stock rises by
enough to cover the premium you paid for the call option
and any reduction in time value that occurs while you hold
the option. This increase in market value must occur before
the expiry date of your option. The buyer of a call option
faces a time deadline in which to generate a profit from the
transaction. If you decided to invest in the underlying stock
directly, you can wait for your predicted increase in market
value in order to realise a profit on your investment. However,
by investing in a call option over the same stock, you do not
have this benefit. You will fail to generate a profit on your call
option if the market value of the underlying stock does not
increase by a sufficient amount before the expiry date of the
call option.
The buyer of a call option is speculating (and hoping!) that
the market value of the underlying stock will increase in
value before the expiry date of the option. If the market value
of the underlying stock increases, and the strike price is less
than the market value of the underlying stock, the value of
the option will also increase. This means that the buyer of the
call option can either sell the call at a profit, or acquire the
stock at a price below the current market value.
Sellers of call options
The seller of a call option is hoping that the market value
of the underlying stock will fall, or remain flat, as this will
result in a decrease in value of the call option. The seller can
then buy back the option at a lower price and realise a profit.
Alternatively, if the value of the underlying stock is below the
strike price of the option, it is highly unlikely that the option
will be exercised. The buyer of the call option is not going to
buy stock at a price higher than the current market price! In
this event, the seller will simply wait until the expiry date, at
which time the option will expire worthless. In this example,
the seller would retain the premium they received on the
initial sale of the option as a profit.
Understanding call options from a seller’s perspective is a
little more difficult to begin with. As a buyer of a call option,
you are following a buyholdsell pattern, which is much the
same as investing in the stock directly. The main differences
are that you are able to expose yourself to the stock at a
fraction of the price of the actual stock and you have a limited
time period in which to sell or exercise your option.
When selling a call option, you are reversing this pattern
and following a sequence of sellholdbuy, or just sellhold.
You are selling your option first, hoping for the price of
your option to fall and then buying it back at a lower price.
Put options
A put option gives the option buyer the right to sell
100 shares of the underlying stock at the strike price. This
right can be exercised by the taker (buyer) of the option at
any time from when they purchase the option until the expiry
date of the option.
Buyers of put options
The value of a put option will increase as the market value
of the underlying security decreases below the strike price of
the option. This is because the option holder has the right to
sell their stock at a set price, even though the market value of
the stock is falling. By buying a put option you will generate
a profit on your option if the market value of the underlying
stock falls by enough to cover the premium you paid for the
put option. However, as with all options, this fall in market
value must occur before the expiry date of your option.
Put options provide the option buyer with an opportunity
to speculate on falls in the market value of a stock. Speculating
on falls in stock prices directly in the stock market is referred to
as trading short or short selling. Short selling of stocks directly
can be difficult and expensive. As such, put options can provide
an effective means for trading short. However, once again time
is a factor to consider when trading or investing in options. In
order to generate a profit on your put option, the market value
of the underlying stock must decrease by a sufficient amount
before the expiry date of the put option.
The buyer of a put option is speculating that the market value
of the underlying stock will decrease in value before the expiry
date of the option. If the market value of the underlying stock
decreases, the value of the option will increase (if the option
is inthemoney). This means that the buyer of the put option
can either sell the put option at a profit or, if they hold the
underlying security, sell this stock at a price above the current
market value.
Instead of purely speculating, the buyer of a put option
may also be taking the option position to protect profits on
existing share holdings. For example, if they hold shares that
have experienced a recent increase in price and they believe
that the stock value will fall in the short term, rather than
selling their stock they could buy a put option that would
protect their profit. If the market value of the underlying
stock did fall, the fall in value of their stock holding would be
offset in part by the gain on their put options.
Sellers of put options
The seller of a put option is hoping that the market value
of the underlying stock will rise, or remain flat, as this will
result in a decrease in value of the put option. The seller can
then buy back the option at a lower price and realise a profit.
Alternatively, if the value of the underlying stock is above the
strike price of the option, it is highly unlikely that the option
will be exercised. The buyer of the put option is not going to
sell their stock at a price lower than the current market price!
In this event, the seller will simply wait until the expiry date,
at which time the option will expire worthless. The seller
would retain the premium they received on the initial sale of
the option as a profit.
When selling a put option, just as selling a call option,
you are following a sequence of sellholdbuy, or just sell
hold. You are selling your option first, hoping for the price of
the option to fall and then buying it back at a lower price. Or,
even better still, you sellhold and if the market value of the
underlying security is above the strike price, the option has
no intrinsic value and you have no need to buy back at all.
Company issued options
Company issued options are options that are issued directly
by a company. The company sets the terms and conditions of
the options and they are not listed on an exchange. Generally,
these options are issued to current shareholders or key
personnel for the purposes of raising additional capital. These
options give the shareholders the right to purchase new
shares at a set price (exercise price) before a set date. In this
instance, the company is the writer of the options and has the
obligation to fulfil any options that are exercised.
As these options are issued by the individual companies
for specific purposes, the terms and conditions of these
options are determined by the company issuing the options.
Therefore, the terms and conditions, including expiry date,
exercise price and number of shares covered per option,
will vary. If you are issued these types of options, you need
to read the documentation carefully to determine the terms
and conditions and the procedures required to exercise
the option.
Index options
Index options are options over a share price index. A share
price index is a group of listed shares. Each share in the index
is given a weighting and a calculation is done using their
weighting and current market price to determine the index
value. This index value is expressed in points.
Consequently, index options give you exposure to a
group of securities that comprise the sharemarket index. This
allows you to trade a position on the market as a whole, or
the market sector or companies that make up the index you
wish to trade.
In Australia, the ASX has options over the S&P/ASX
200 index. This is an index that is calculated based on the
top 200 companies listed on the ASX. Trading these options
effectively exposes you to movements in the overall Australian
stock market.
The value of your index options will vary with
movements in the value of the index, which is reflective
of the overall value of the group of securities it represents.
Movements in the S&P/ASX 200 index are seen as reflective
of the movement in the overall sharemarket, as this index
covers the largest 200 stocks listed on the ASX.
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