What is options trading? A beginner’s guide
Learn how options trading can protect your portfolio and enhance profits.
While trading options can be riskier than standard share trading, it can also be used to protect shares against losses and amplify profits. Just make sure it’s handled correctly by an experienced trader.
Options contracts are derivative investments, which means you’re exchanging contracts rather than buying and selling physical assets. While there’s always an underlying asset attached to the contract, such as shares or commodities, you don’t need to actually own the assets at any point in order to make a profit.
This means that options traders can profit regardless of whether stock, commodity or forex prices are rising or falling.
In this guide, we cover how options trading works, the risks involved and how experienced investors can apply it to earn additional income from shares.
What is a share option?
A share option is a contract to purchase or sell a set number of shares for a specific price, at a predetermined future date, from its seller. They’re popular among traders because they require comparatively less initial capital than share trading, and they have the potential to earn greater amounts.
They’re unique from share trading because it’s completely up to the buyer whether the contract will be executed. Say you have an options contract to buy 100 shares of a stock before a certain date. Instead of buying the shares and incurring brokerage fees, you could simply sell the contract on the market and take home the profits.
In fact, options traders rarely engage in the actual buying or selling of shares – rather they earn profits from share price movements. Although share options are the most popular type of contract, you can also trade options on other assets such as indices, bonds, exchange-traded funds and commodities.
In New Zealand, options are typically traded over the New Zealand Stock Exchange (NZX) as exchange-traded options (ETOs). These ETOs allocate 100 shares per contract. By trading over the NZX, you can purchase share options of most major New Zealand public companies, including Spark, TradeMe and Fletcher Building.
Platforms to access options trading
How do you trade options?
The two main participants in an options contract are the “buyer”, who is the person that purchases the contract, and the seller of the contract, dubbed the “writer”. Whichever role you decide to take, you’ll first need to find a broker that offers options trading. The comparison table above shows some of the online trading platforms that offer this service.
There are two types of options that you can either buy or write. A call option gives its buyer the choice to purchase shares from its writer at a specific price (aka the strike price) before a set period of time, or the expiry date. A put option is the opposite, where the buyer enters a contract to sell the shares to the writer at a set price within a specific time frame.
For this reason, the buyer of a call option is hoping that the underlying shares will rise in price, while the put option buyer is betting that prices will fall. The writers of the contract are hoping for the opposite.
What can you trade with options?
What is the price of an options contract?
One of the most important factors in an options contract is the premium price. This is the price paid by the buyer to the writer for the contract and calculated on a per-share basis.
As an example, let’s say you buy a call option for 100 shares in a company with a stock price of $80 and a premium of $0.40. The buyer must agree to pay the stock price of $80 along with the premium price per share, totalling $8,040 ($80.40 X 100 shares) before the expiry date.
This means the buyer will only earn a profit if the share price rises above $80.40 before the end of the term. As the expiry date draws close, the premium price will shrink relative to the stock price as it becomes easier to predict. If the share price rises above $80.40, the buyer can sell the option contract on the market without buying the shares or choose to buy the shares at a discount price. Either way, the buyer makes a profit.
What are the broker fees for options?
The brokerage fees charged by brokers for exchange-traded options are usually higher than share trading. For example, the starting price to buy shares with a company might be $10, while the options trading fee starts at $34.95. If you bought an ETO through the company and then bought the underlying shares, your total brokerage fees would be $44.95.
However, most options trades won’t involve share brokerage since the buyer typically sells the contract back to the market. In options trading, you only pay a share brokerage fee if you do one of the following:
- Buy an option and decide to exercise your right to buy or sell the underlying stock
- Sell an option and the buyer exercises their right to buy or sell the underlying asset
Why do people trade options?
There are several practical ways that options trading can be used. First, by taking on more risk, you have the opportunity to earn higher profits than you ordinarily could through regular share trading. Or alternatively, it can act as an “insurance” policy for your share portfolio by offsetting losses if the market falls.
Options can amplify profits
Although it can be risky, options have the potential to earn a much higher profit than if you’d simply traded the underlying share. This is because the investment price (the premium) is much smaller than the price to buy stocks directly, but you can benefit to a greater degree from its price movements.
For example, if you believed the stock price of a company was going to increase, you could buy shares in the company. If you bought 100 shares at $40 and the price rose to $45 per share, you could sell the shares for a $500 profit, minus the brokerage costs. Your initial $4,000 capital has increased to $4,500.
On the other hand, if you had used the same $4,000 to buy $1 call options in the same company with a strike price of $40, you’d have the potential to earn profits from many more shares. Since each options contract has 100 shares, you would have purchased 40 contracts at $100 each, holding a total of 40,000 shares. When the price of the company increases to $45, the price of the contract premium also increases, although by a much lower percentage (see below).
This leverage means you can benefit from the premium price increase on 40,000 underlying shares, instead of the share price rise on 100 shares in the first example. It’s important to note that while your profits would be significantly higher through options, any losses are also amplified (see risks below).
Options can protect shares from loss
Investors can use put options to safeguard their shares against a fall in the share price. This is commonly referred to as “hedging”. For example, if the current price of a company’s shares is $50, and you think it could fall lower in the future, you can purchase a put option to sell them for $50 each in the future.
If the price of the shares falls in the future, the writer of the option will be obliged to buy them off you. If the price of the share rises, you can simply not exercise the option. In this strategy, the most you lose is the premium you initially paid – you’re not actually obliged to sell your shares.
Fundamentally, you can also use a share option to simply buy yourself time. You can lock in the transaction price now and decide whether you want to go forward with it in the future. This strategy can be useful in times of high market volatility.
As extra income from shares
If you think that the price of shares you own is going to remain flat in the future, you can also write call options to boost your income. With this strategy, the buyer of the option believes that prices will rise and is agreeing to buy the shares at a certain price point.
However, if (as you have predicted) prices remain flat or fall, the buyer will most likely not exercise their right to buy the shares from you, leaving you with the premium they paid along with your shares. This is similar to the previous strategy, where you’ve offset your losses, despite the value of your shares dropping.
The risk is if the price of the shares increases significantly, you’re now obliged to sell the shares at a lower price than what they’re currently worth.
As with all other tradable financial securities, options can be used to speculate on the market. The price of a call option will increase if the price of its underlying security increases. Conversely, the price of a put option will do exactly the opposite. Each player – the buyer and a seller – is betting on the opposite occurring.
While this approach is risky and not recommended for new investors, you may be able to use the difference in risk exposure and smaller initial cost involved with options trading to diversify your portfolio, though you will have to take into account the complex risks of options.
What risks are involved with share options?
It is important for investors to understand that options are a strictly zero-sum game. That is, in each transaction, one of the parties makes a gain at the expense of the other party. You need to make sure you fully understand the inherent risks involved.
The position you take through options will be a leveraged position. As such, a change in the price of the option is bound to be disproportionate to a change in the price of the underlying share. The ratio of this change is represented by the term “delta”. Delta is positive for call options and negative for put options.
You may lose your entire investment
If the share price changes in an unforeseen way, an option may completely lose its value. For example, your company’s call options with an exercise price of $50 will be worthless at the expiry date if the share price turns out to be only $49. Here, if you have purchased a contract with 100 units, you would have lost the entire premium you paid. This is a loss of 100%. In contrast, unless the company goes bankrupt, their shares will never become completely worthless.
So long as the company stays afloat, there’s always a possibility that its shares may increase in price over time. Since options have limited lives, they naturally decline in value at an exponential rate as they approach their expiry dates.
While the potential loss you can face as the buyer of an option is limited to the premium you paid, as a seller, your loss can be unlimited. If the buyer chooses to exercise the option, you will be obliged to deliver the purchase or the sale of the shares at the preset price irrespective of their market value.
The takeaway message for beginner investors is that, ideally, options should be used to complement their current shareholding positions. Standalone positions should only be taken out after consultation with a broker or a financial adviser.
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