In last week’s Analyst’s Eye article we considered the standardisation of options. This standardisation is important so that it is easy to understand exactly what it is that you are trading. Every option has an underlying share, is a call or a put, has an exercise price and an expiry date and the price you pay for the option is the premium.
With these five pieces of information in mind let’s consider a trade on ANZ below. We will consider trading a put option in this example, however the process of trading a call is identical if you believe a share is going up, instead of down.
Taking (Buying) a Put
You would buy a put if you believe the share is going down. Buying a put gives you the right to sell 1000 of the underlying share at an agreed price on, or before, an agreed date.
Call or Put
We have chosen the share we wish to trade which in our example is ANZ Bank. We believe from our analysis that ANZ is likely to fall from its current price. ANZ was trading at $23.34 on 2 September 2010. We could therefore buy a put option on ANZ.
So we now look up the put options available for ANZ. As an example through The Bourse charting software, on the toolbar and click the red O toolbar icon, for Exchange Traded Options. We have a choice of expiry dates and exercise prices to make before we can determine the premium (cost) of the option.
Type in the code of the share, which in our case is ANZ, and then select Put to display a list of Put options that are available on ANZ. You will see a list with different expiry dates in the month column, and different exercise prices in the Strike column. The most actively traded options will be near the current price, which is around $23.34.
Expiry Date
For any option position you must choose the expiry date you wish to trade. At any given exercise price there is a range of expiry dates. The expiry dates start on Oct 2010 which is about three weeks away, and go all the way out to 2014. The more time an option has until the expiry, the more expensive it will be.
As a guideline option traders would normally take options with between six weeks and three months until the expiry. So on the 21st of July 2010 an options trader would normally consider an expiry date of September the same year. Remember you must allow the share time for the expected move to occur. Most of the time decay for an option occurs during the last month so let’s take a look at the November expiry dates.
Exercise Price
Now we can select the exercise price we wish to trade.
With ANZ trading at $23.34 the closest exercise price is $23.50. This would be regarded as the at-the-money option. The $23.00 option is out-of-the-money and the $24.00 option is in-the-money.
An in-the-money option costs more than an out-of-the-money option and is lower risk. The in-the-money option already has some intrinsic value, while the out-of-the-money option is all made up of time value. The different options will behave differently based on the movement in the share.
Premium
It will depend on which option you choose as to the premium that you pay for the option. Assuming that you chose the $23.00 November Put option and you bought the option at market price, you would pay a premium of $1.12 per share. Remember that each option contract is for 1000 shares so the cost of 1 option contract would be $1.12 x 1000 = $1120.
The success of the trade will be determined by the movement of the underlying share, but will also be affected by your choice of option. We will consider three different options and how they perform in different scenarios.
Possible Outcomes
There are three possible outcomes: the share is higher, lower or goes sideways. The change in the price will be determined not only by the direction of the move, but also by how quickly the move occurs. The option is a wasting asset, and the time value decreases as time passes.
Share Moves Down
All put options will increase in value, with the out-of-the-money option increasing the most. The out-of-the-money option could move into-the-money which would result in a sharp increase in value. Call options would decrease in value as the share moves down.
Share Moves Up
All put options will drop in value with the sharpest drop shown in the out-of-the-money options. The chance of the out-of-the-money option having value on, or before the expiry date, has become much less, and consequently the value of the option will drop dramatically. Call options behave in the reverse, with prices rising.
Share Moves Sideways
All options drop in value as time passes, regardless of whether they are puts or calls. Options are decaying assets and lose time value every day they are owned.
The out-of-the-money option will normally provide the biggest return coupled with the biggest downside if the trade does not go in the direction the trader expected.
Trading Puts
There are two main reasons that a trader would trade put options. The first is if the trader wanted to profit from a fall in value in the share. A put option increases in value as the underlying share falls, allowing a trader to buy the options and sell it at a higher price.
Put options, like call options, are wasting assets. The trader must pick both the direction and timing to enter the trade. Strong returns can be made trading put options when shares fall away rapidly, as they did in January 2008. It is important that the expiry date that is chosen provides the trader with enough time for the move to play out, so they can benefit from it. A share moving sideways or upwards is going to cost the trader money.
Investors may want to employ put options as a protection mechanism for their portfolio. The put option increases in value as the share drops, but it also gives an investor the right to sell their shares at the exercise price. If you owned WBC shares and were concerned that the shares might drop, you could purchase put options as protection.
If you were correct and WBC did drop you now have the right to sell WBC at the exercise price of the put option. Alternatively you could sell the put option for a profit and continue to own the shares. This is known as hedging.
Adding put options to your trading toolkit offers you the flexibility to profit in different market conditions. Share traders are limited to making money from a rising share price, but options traders just want the share price to move.
By Jeff Cartridge
Education Manager
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The information provided within this blog is general advice only and you should consult the services of a financial professional in order to ascertain whether the information is applicable to your investment strategies and risk profile.
