What is an Option?
An option is a contract between two parties giving the buyer the right but not the obligation to buy or sell a security at a predetermined price or before a predetermined date. The other party is known as the “writer”.
The two types of options traded on the ASX are Call Options and Put Options. There are four types of market participants depending on the position they take:
Main Features of an Option
- Underlying security – options may be listed over shares in a company, an index or an ASX exchange traded fund (ETF).
- Contract size – one option contract normally covers 100 underlying securities.
- Exercise price – This is the price at which you buy or sell the underlying securities if you exercise your option.
- Exercise style – there are two different styles: American (exercisable on or before expiry date) or European (exercise on expiry date only). Nb. Index options are only in European style.
- Expiry date – The day on which all unexercised options expire. Options typically last for around 9-12 months on the ASX. The expiry date for exchange traded options is usually the Thursday before the last business Friday of the month of your option. Index options expire on the 3rd Thursday of contract month provided it is a trading day.
- Premium – The cost of buying an option or the income received by the writer of an option.
- Maximise profit – Options provide exposure to movements in the share price for a fraction of the cost of purchasing the shares. This leveraged exposure means higher potential profit. E.g. You have $500. Instead of buying 5 CSL shares at $100, you buy 500 options worth $1.00. The price of the shares increase by $5 which means that you have profited $25 in the first instance. The options increase by 20 cents which means you have made a profit of $100.
- Earn income – writing an option means that you will receive a premium for taking on the obligation to sell or buy shares. E.g. You own 100 CBA shares and the current price is $76. You would be happy to sell the shares at $77. The broker is instructed to sell a call option at $77 which they do for 80 cents. You now have the obligation to sell your CBA shares for $77 any time between now and expiry. For undertaking this obligation you received $80.
- Value protection (Hedging) – options can be an insurance policy against market downturns. You have 100 KGN shares and you assume the share price will likely fall. Current price is $1.58 and you take a put option to sell at $1.50. The loss has been limited to $1.50 per share and if the price rises, the option can be allowed to lapse.