Topic: Share Market - Options

So you want to trade an option?

by Guy Bower

You may have heard of the term derivatives. In the past it has had negative connotations, inferring complex trades involving massive risk or massive losses. That view, however, is a little unfair. There are, in fact, thousands of different types of derivative securities around the world and, therefore, making generalisations is not an accurate thing to do. The term itself simply means a security, the value of which is derived from the value of another security.

Options are a derivative. In the more popular exchange trade format, they have been around for several decades and they serve a number of purposes.

To use the standard definition, an option gives the buyer the right (not obligation) to buy (or sell) the underlying asset at a specific price on or before a specific date. The buyer of this option pays a premium for this privilege. The seller of the option receives this premium in return for taking on the risk of having to sell (or buy) the underlying asset.

A non-standard definition might be ‘an option is a tradable asset with which you can create many forms of risk/return on many different assets’.

This brief article is not designed to teach you everything about options. While there are some technical terms for general interest, we are not about to have a technical discussion. The purpose here is to give a brief overview and then some direction on where to get more information.

Who trades options?

First of all there are hedging or commercial interests. These are people that are actively involved in the underlying market itself use options for a degree of price protection. For example, a coffee producer could use coffee options to protect against a fall in the coffee price. Likewise, a fund manager might use Telstra options to protect against a fall in the share price.

These commercial interests are really what the options markets were created for.

That said, the majority of the volume in the options markets comes from speculative interests. In this context, this is anyone that takes an option position to make money specifically from that option position. So it will also include (option) fund managers, large traders and small traders.

There is another group of option market participants – the market maker. There are registered markets makers and others that through their style of trading act as market makers (eg local futures traders will often take the role of a market maker). Registered market makers are there to provide a buy price and a sell price for a particular option. This is why you will often see a bid and offer when an option is quoted.

Some might argue a market maker is a little like a bookie. Both do not tend to take outright bets on the market (or the race), but make their money on the continual transactions of others.

Why trade options

For anyone that is not hedging, there is really only on answer to this question: to make money. But, “Why trade options in preference to other derivatives or other types of investments?”

Firstly, there is the factor of leverage. Options generally cost only a fraction of the entire contract value or potential contract value. As an alternative to buying shares outright for example, an option position can cost you less, risk less but stand to make just as much or even more in certain circumstances. Many people trade options for this reason. (A point of note is that leverage can of course work against you as well as for you.)

There is however a much better reason for trading options. That is flexibility. Options allow the user to customise their investment to take advantage of very specific views. They can give you a very diverse range of risk/reward possibilities.

For example, if you are trading shares you can be long, flat and in some cases short. With options you can for example take on a position that will make money if the market goes sideways or if it goes up or down.

The ability to buy or sell a great range of different options means that you can take on an option position for a very specific view on the market, not just bullish, bearish or neutral.

So is options trading difficult? Well it does take some learning and practice, but anything requiring skill does. With a bit of time and perhaps the right advice, it is possible to make a decent dollar from options.

In what markets are options available?

You sometimes hear the term ETO. This means Exchange Traded Option and refers to options that are made available by an exchange such as the Australian Stock Exchange.

It would take quite a long time to list all the Exchange Traded Options available to us. Suffice to say, options are available all around the world on commonly traded shares, futures contracts, bonds, stock market indices and many other commodities. The best place to start your study of options markets are in those stocks or commodities with which you are familiar. Perhaps you own some shares in Telstra or WBC. This is the place to start because you already know something about the underlying security.

For the newcomer, it may seem that options on anything other than shares are just too complicated. In fact, they are all really the same thing. They have the same characteristics and behave in much the same way.

How to get started

The newcomer will first need to learn about options. The ASX website www.asx.com.au has some great information and their seminars are highly recommended. 

There are plenty of other exchange websites that also have some good information (most of it is free). These are:

www.cboe.com www.cbot.com www.nymex.com

Chicago Board Options Exchange (CBOE) Chicago Board Of Trade (CBOT) New York Mercantile Exchange (NYMEX)

My book OPTIONS: A Complete Guide is written for the beginner/intermediate level trader and as a reference guide for options trading.

Also, try asking experienced traders about which options markets are good to trade. Talk to a stockbroker, futures broker or adviser and get some opinions. Just be sure whoever you speak with actually has options trading experience.

The Bottom Line

It is possible to make some decent money from trading options, but like anything it takes some work. It is also possible to lose money – that takes less work. The newcomer is encouraged to spend a little time exploring options and talking to a few people in the industry to really gauge what they want or what they can get out of the options market.

Quick guide to options terms Call option: A contract that gives the buyer the right to buy the underlying asset within a certain amount of time as a specified priced. Put option: A contract that gives the buyer the right to sell the underlying asset within a certain amount of time at a specified priced.   Premium: The price paid or received for an option.   Expiry: The day on which trading for an option ceases. All option have a certain time before they lapse.   Strike price (exercise price): The price of the underlying at which an option can be bought or sold when exercised.   Long: A bought position in an asset with the expectation that the price will increase.   Short: To sell an asset without first owning it with the intention of profiting from a fall in the value of that asset. You can do this with options.   Flat: meaning no position in the market.   Spread: This refers to the difference between the bid and offer prices or a strategy involving buying and selling two or more options. (multiple options can be combined to create different risk/reward scenarios.)   Bid/ask: The most common way a price for an option is quoted. This is the highest bid price and the lowest ask price. For example, ‘the May 750 call is currently 50/55’. This means the highest bid is 50 and the lowest offer is 55.

 Article published in Shares Magazine.

Guy Bower is an adviser and trader in options markets. See www.guybower.com for more information.

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