Options Trading - Uses and Benefits

Options trading has many uses, benefits and associated risks. Before deciding to trade options, it's imperative to understand the basic functions of options contracts and how you can potentially use them to your benefit.

There are two types of options you can trade on the ASX, and this includes call options and put options. Call options give you the right to buy an underlying asset while put options give you the right to sell an asset. As the name suggests, it is your option to exercise the right to buy or sell an asset - you can simply let the options contract expire and you will have no further liability.

While is not desirable to let options expire, it does potentially minimise losses to the cost of the initial margin for the contract. According to the ASX, about 30% of options contracts expire worthless. The remainder are exercised or closed out beforehand.

Both types of options on the ASX allow you to take advantage of leverage, which means you pay a small initial margin to access a large underlying asset. Taking an options contract means you can only lose your initial outlay, but options contracts are still considered riskier than other stock market vehicles and the chances for loss cannot be ignored.

One of the main reasons traders are interested in options is price fluctuation. Whether you are using options to protect your shares or portfolio, earn extra income or sell contracts for a profit, it all revolves around price fluctuation.

For clarity, the following examples do not include brokerage fees or tax considerations. When planning to trade options on the stock market, it's important to consider these elements too.

Options Trading on Price Speculation

For whatever reason, you think the share price, index price or commodity price will rise. Here is what you do:

Take A Call Option
Taking a call option allows you the right to buy an underlying asset at a set price. For example, you buy a call option to trade shares at the price of $40 for an initial margin of say $800. Let's say the price rises to $43 dollars before your contract expires.

You are then considered 'in the money' because you can buy shares at $3 cheaper than market value. Theoretically, you could buy the shares and then resell them for an instant profit. However, most likely you would simply close out your position and sell your contract for an appropriate profit, or in some cases, simply cash settle the contract without actually having to buy shares.

Of course, if the price falls below $40 and you cannot settle before expiry, your contact will be worthless and you will lose your initial margin.

On the other hand, let's say you believe the underlying asset in question will decline in value over the coming months. Here is what you do:

Take A Put Option
Taking a put option gives you the right to sell an underlying asset. Using the same example as before, let's say you purchase a put option to sell a share at $40 for an initial margin of $800. The price falls to $38, and now you are in the money because you have the option to sell the shares at $2 above market value.

Again, if the market moves against you and prices rise, you may have to let your options contract expire worthless. You do not have to actually own the shares before you take a put option, but you should close out your position and sell the contract before expiry. Otherwise, you will have to buy the shares before exercising the contract.

In some cases, options contracts are simply cash settled, and in fact this is always the case with index options.

Options Trading To Protect Your Portfolio

Market speculation is only one aspect of options trading, and many people use options as a method to lock in a price for trading. Let's say you have held a portfolio for a long time, you are happy with the return on the investment and you are planning to monetise it soon. However, short-term volatility has you concerned - you don't want a short, sharp drop to eat into your profits.

Here's what you do:
Take A Put Option
Taking a put option on shares or assets you already own locks in a price and allows you to hedge a position while still taking advantage of any potential price rises. If the price of the underlying asset falls, you can exercise your put option to sell assets at the listed price.

If prices rise, you can simply allow your put option to expire and sell your assets at their increased market value. In some cases, an options contract on an overall index can help you protect a diversified portfolio.

The downside is you will have to pay an initial margin to cover the cost of an options contract.

Options Trading To Earn Income

At this point, you might be wondering who is on the other side of an options contract. If you own shares, it is possible to write options contracts and collect an initial margin from any takers. You can write a put or call option contract and collect any initial margin that is paid.

If the options contract is left to expire, you keep the initial margin with no obligation. However, if the contract is exercised (likely), you will have to either buy an asset at a set price (when you have written a put option) or sell an asset (when you have written a call option).

Obviously, writing an options contract means you are obliged to buy or sell when a contract is exercised, so it's important to recognise the reduction of choice and potential risks of writing options. In some cases, collecting the initial margin for options contracts can partially offset and potential losses, but in a worst-case scenario, the potential for loss is almost limitless.