Options Made Simple

A Beginner's Guide to Trading Options for Success

Davin Clarke, Jacqueline Clarke

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780730376378
• eBook ISBN: 9780730376392
• Edition: 1
• Topic: Business
• Subtopic: Investimenti e titoli
• Index: Business

The sixth book in the Wrightbooks Made Simple series, Options Made Simple is an uncomplicated guide to trading options for beginners. This book outlines some simple, easy to understand strategies anyone can use to start trading options. The book will be a succinct paperback with lower price point, and provide the perfect first step into trading options.

An option is a binding contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date it has strictly defined terms and properties.

Options are very versatile and allow you to change your position according to the situation they can be speculative or conservative depending on your trading strategy, but the risk can be mitigated by having a firm basic understanding.

The Made Simple series is the perfect vehicle for this content as readers are taken step\by\step through everything they need to know about trading options. Including what can go wrong and can work out which strategies they are most comfortable with.

Chapter 1: What are options?

Option markets have been operating through the major stock exchanges in many countries since the 1970s. In most cases, these markets have experienced significant growth since then in both the number of options traded and the range of options available. Why? Because options are an amazing trading tool that can be used in a wide range of strategies. Option strategies can vary in time frame, risk and purpose to suit the needs of a wide range of investors and traders. In this chapter we will define what options are, how they work and some of the many ways in which they can be used to enhance your trading outcomes.

In this book, we will be referring to exchange traded options over stocks or shares, unless specified otherwise. These are options that can be bought and sold through a central exchange such as the Australian Securities Exchange (ASX), and are the most commonly traded type of option. This allows us to simplify the discussion as we introduce the various components and attributes of options.

Options also exist over exchange traded funds (ETFs), indices and currencies. There are also company issued options that have different terms and conditions from exchange traded options.

What are options?

Options are exactly as their name suggests: they provide the purchaser with an option to buy or sell an underlying financial security. Although this may sound limiting, options are amazing tools that can provide both the seller of the option and the buyer of the option with the ability to protect or hedge current stock positions, reduce their market risk, or generate additional income.

Options can be issued over a range of financial securities, including stocks, indices and foreign currency. In order to simplify the discussion, for the most part we will refer to options issued over stocks. However, the same concepts generally apply to options issued over other underlying financial securities.

An option is defined by a contract between the seller of the option and the buyer of the option. The contract gives the buyer of the option the right (or option) to buy or sell a set amount of stock at a specific price on or before a specific date. The buyer pays the seller a premium in order to acquire this right. If the buyer decides to use their option, this is referred to as ‘exercising’ their option. When an option buyer exercises their option, they are taking action to buy or sell the stock as specified in the option contract.

Tip

It is important to note that the buyer of an option pays a premium to have the choice to exercise their right to buy or sell a stock. They are not obligated to exercise this right. Thus, in purchasing an option they have purchased the option (not the obligation) to buy or sell the underlying stock.

The buyer of an option is referred to as the taker, as they are taking up the right to buy or sell the underlying stock.

The seller of the option is providing the buyer with the right to buy or sell the underlying stock. The seller has no control over whether the option they sold will be exercised or not. They have created an obligation to fulfil the option contract if the buyer decides to exercise the option. The seller of the option is referred to as a ‘writer’, as they underwrite or accept the obligation contained in the option.

Tip

The seller of an option has accepted an obligation to fulfil the option contract, if and when the buyer decides to exercise the option.

Options can be broadly divided into two categories: call options and put options.

Call options

Call options give the buyer the right (but not the obligation) to buy the underlying stock at a specified price on or before a specified date (expiry date). The price specified in the option contract is referred to as a strike price or exercise price. As a buyer of call options, you are hoping for the value of the underlying stock to rise. An increase in the price of the underlying stock will result in an increase in the value of your options.

The seller of call options receives a premium for taking on the obligation to sell the underlying stock to the buyer of the options at the strike price if the buyer decides to exercise the option before expiry. If the buyer exercises the option, the seller must sell the underlying stock to the buyer at the strike price. If the buyer does not exercise the option, the seller simply retains the premium and the obligation expires with the option on the expiry date. This process is illustrated in figure 1.1 (overleaf).

Figure 1.1: call option

Let’s run through the process of buying a call option in example 1.1.

Example 1.1

Let’s say BHP has a current market price of $44 per share. You believe the market value of BHP will rise in the next few months. In order to take advantage of this expected price rise, you decide to buy a $44 call option over BHP.

This gives you the right to buy 100 shares of BHP at the strike price of $44 any time before the expiry date. If the value of BHP rises to, say, $46, your options will increase in value by $2 less a component for expired time value (we discuss this later).

You have a choice (or the option!) to either sell your option for a profit or purchase the BHP shares for $44, $2 below their current market value.

Put options

Put options give the buyer the right (but not the obligation) to sell the underlying stock at a specified price (strike price) on or before the expiry date. As a buyer of a put option, you are hoping the value of the underlying stock will fall as this will result in an increase in the value of your options.

The seller of a put option receives a premium for granting this right to the buyer. If the option is exercised, the option seller must buy the underlying stock at the strike price. This process is illustrated in figure 1.2.

Figure 1.2: put option

Put options are a little harder to understand, as you will make a profit if the value of the underlying stock falls. You are also buying a right to sell an asset which you may or may not own. Let’s run through the purchase of a put option in example 1.2.

Example 1.2

CBA has a current market price of $52 per share. You believe the market value of CBA is too high and will fall in the next few months. You decide to buy a $52 put option over CBA.

This gives you the right to sell 100 shares of CBA at $52 any time before the expiry date. If the value of CBA falls to, say, $50, your options will increase in value by $2 less a component for expired time value (we discuss this later).

You have a choice to either sell your option for a profit or, if you own 100 CBA shares, you can sell your CBA shares for $52 per share, $2 above their current market value.

Tip

The scenarios outlined in examples 1.1 and 1.2 are shown in respect of buyers to option contracts. The scenario for the seller of the option contracts is quite different.

Option contracts

Option contracts for exchange traded options contain standard terms and conditions. Each option contract specifies the following four components for any exchange traded option:

• the underlying security

• the contract size

• the expiry date

• the exercise price (or strike price).

The option premium is not part of the standard terms of the option contract as the option premium is variable and is primarily determined by the market value of the underlying security and the time left to expiry.

Tip

It is important to understand the terms and conditions of any option before you enter into an option contract. Check the terms of the individual options to ensure ...

Table of contents

• Cover
• Table of Contents
• Title Page
• Foreword
• Chapter 1: What are options?
• Chapter 2: Advantages and risks
• Chapter 3: Types of options
• Chapter 4: Option pricing
• Chapter 5: The mechanics: how to buy, sell and exercise options
• Chapter 6: Buying options: the scenarios
• Chapter 7: Selling options: the scenarios
• Chapter 8: Choosing your option strategy
• Chapter 9: Strategies for buying call options
• Chapter 10: Strategies for buying put options
• Chapter 11: Strategies for selling covered call options
• Chapter 12: Strategies for selling naked call options
• Chapter 13: Strategies for selling put options
• Chapter 14: Advanced strategies: using multiple option spreads
• Chapter 15: Advanced strategies: straddles and strangles
• Appendix