Flexible Traders and Investors Embrace Options As Market Falls
When the markets turn down many investors and traders run for cover, but is there an alternative?
There are derivatives available to make money regardless of the market direction, and one of the most flexible of these derivatives is options.
So just what can you do with an option? The answer is almost anything. You can profit when markets are moving up, down and even sideways (unlike most derivatives).
Mechanics of Options
An option works just like insurance. If you take out car insurance you get access to insurance that covers you for a year in exchange for a small premium. If you crash your car sometime during that year (depending on the circumstances) you would normally receive a large payment to repair the car. If you don’t crash your car, then you forfeit the premium if no claim is made. A new premium is payable for the next period of time, usually a year, whether you crash your car or not.
The options market works in the same way. You pay out a small premium, which gives you access to the movement in the share for a set time. If you are right you receive a large amount of cash back and if you are wrong you forfeit the small premium.
Why does the insurance company offer insurance? It receives a number of small premiums and occasionally will have to pay out when someone crashes their car as not everyone will crash their car. In the options market you can choose to be the insurance company or the insured.
Standardisation of Options
Option contracts have been standardised into five basic components:
- Share
- Type of option
- Date of expiry
- Exercise price
- Premium
1. Share
In terms of the Australian options market, a trader’s choice of a share is largely made for them due to the limited nature of the market. There are approximately 80 available share options, of which only a few may offer a trader the chance to participate adequately. Despite the presence of market makers, which are compelled to deal in options in order to overcome poor liquidity, many options are notoriously illiquid and traders may find it hard to deal in these.
It is important to remember that you should only deal in the most liquid share options, or more importantly, never deal in the illiquid share options. Being able to buy and sell your options quickly at the price you want is far more important than the actual return you make, because if you cannot close out your position when you want, your profit could disappear very quickly!
2. Type of Option
An option to buy shares is known as a CALL option.
An option to sell shares is known as a PUT option.
If you buy a CALL option you believe the price of the share is going up, if you buy a PUT option you believe the price of the share is going down.
A great way to remember this is to imagine you are using a telephone. You pick UP the phone to CALL someone and you PUT DOWN the phone when you finish the call.
3. Expiry Date
All options have an expiry date. The option must be sold or exercised before the expiry date otherwise it becomes worthless.
The expiry date for a particular company will fall into one of the following 3-month cycles:
- * January/April/July/October
- * February/May/August/November
- * March/June/September/December
In addition to these expiry dates the more active options also have expiry dates every month with the front (closest to today) three months available at any time.
The Australian Clearing House (ACH) stipulates that trading in options ceases at the close of trading on the Thursday preceding the last working Friday of the maturity month. If the Thursday falls on a public holiday, trading will cease on the last business day proceeding the last Friday of the expiry month.
An easy way to work this out is to find the last Friday of the month when the market trades – the day before is expiry date for the month. A calendar of the expiration dates for 2010 is also available on the ASX Website.
In September 2010 the last Friday that the market trades will be the 24th, so the expiry date will be Thursday September 23rd. http://www.asx.com.au/products/pdf/2010.pdf
4. Exercise Price (strike price)
The exercise price is the price at which an option buyer may exercise their right to buy or sell shares covered by that option. In Australia the terminology ‘exercise price’ is used, in the US this is referred to as the ‘strike price’. The Australian Clearing House sets the exercise prices when it issues the options.
Dependent on where the exercise price is in relation to the current share price gives rise to three different ways to describe options: at-the-money, in-the-money or out-of-the-money.
In-the-Money
When an option is in-the-money, the owner could exercise the option immediately and make a profit. This immediate profit is known as the intrinsic value of the option.
At-the-Money
An option is described as being at-the-money when the exercise price is equal to the current share price. It is extremely rare for a share to be trading exactly at the exercise price and the closest option is often called at-the-money even though it is strictly referred to as near-the-money.
Out-of-the-Money
An option is out-of-the-money when the option has no intrinsic value. That is, if the owner were to exercise the option, they would not make a profit; in fact, they would make a loss.
5. Premium
The quoted price of the option is referred to as the premium. Option prices are quoted on a per share basis, thus to obtain the full contract price a trader has to multiply the quoted price by the number of shares that make up the contract. If BHP 3050 July calls were trading at 60 cents, the price of one contract would be $0.60 x 1,000 shares = $600.00.
In Australia, each option contract is generally for 1000 shares while in the US each option contract is for 100 shares. Under some circumstances, this may change during the life of the option if the underlying share is involved in a bonus issue. If for example a company declares a 1:1 bonus then there will be an additional 1,000 shares created with an exercise price half that of the original exercise price.
To illustrate this, consider the following situation. A trader has taken a position in TLS by buying one call contract with a strike price of $5.00. During the life of the option, TLS declares a 1:1 bonus. After the issue of the bonus, the trader will hold two contracts each comprising 1,000 shares at a strike price of $2.50.
Summary
The standardisation of options allows the trader to confidently enter the market being clear on exactly what it is that’s being traded. With all options traded on the Australian Securities Exchange they are readily accessible to traders and investors who wish to diversify their approach to the markets. You can use options to profit regardless of the market direction.
By Jeff Cartridge
Education Manager
Through Trader Dealer, clients can execute Exchange Traded Option (ETO) orders online. From as little as $26.40 per trade, you can buy call or put options, or sell call options as part of a covered-call or buy write options strategy with ease. Visit the Trader Dealer website for more information and also get details of how to open an account through Trader Dealer.
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.
