An option is a type of derivative, which, like shares, bonds and warrants, is a financial instrument. Being a type of derivative, it is therefore linked to, or derived from, an underlying asset. This is where the term derivative comes from.

The main reason for the creation and widespread use of options lies in their leverage. The flexibility of options allows them to be used as high risk trading instruments, insurance and hedging or as fine-tuning tools for a large portfolio.

WHAT IS AN OPTION?

An option is an agreement, or contract, between two parties giving the buyer the right, but not the obligation, to buy or sell a parcel of shares (or any other thing) at a pre-determined price either on, or before, a set date. To acquire this right, the buyer pays a premium to the seller (or writer) of the contract. The contract is then called an option.

Equity options are options over parcels of ASX traded fully paid ordinary shares. An options contract is usually (but not always) over a parcel of 1000 shares. Options are traded on about 100 of the ASX's largest and most liquid companies.

There are two different types of exchange traded equity options:

CALL OPTIONS (CALLS)

A call option gives the holder (or buyer) the right, but not the obligation, to buy the underlying parcel of shares at a set price, on or before a pre-determined date.

If you are the holder of a BHP May 2008 $45 call option, you have the right, but not the obligation, to buy a parcel of 1000 BHP shares at $45 on or before the expiry in May 2008.

If you are the seller (or writer) of this call option, you must sell 1000 BHP shares at $45 to the buyer of the option if they choose to exercise the option.

PUT OPTIONS (PUTS)

A put option gives the holder or buyer the right, but not the obligation, to sell the underlying parcel of shares at a set price, on or before a pre-determined date.

If you are the holder of a NAB May 2008 $40 put option, you have the right, but not the obligation, to sell a parcel of 1000 NAB shares at $40 on or before the expiry in May 2008.

If you are the seller or writer of this put option, you must buy 1000 NAB shares at $40 from the buyer of the option if they choose to exercise the option.

Option Uses

LEVERAGE

The advantage of using options, and for that matter all derivatives, is due to the leverage that they provide. Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly in the underlying asset.

For example, a $2000 investment in BHP call options could provide leverage to 2000 BHP shares during the life of the option (if the option premium is $1). To get the same exposure (to 2000 BHP shares) by buying shares directly, it would cost you $90,000 if BHP is trading at $45! So a $2000 investment in call options gives you the same exposure as a $90,000 investment in shares… now that's what leverage is!

Risk management

Options can be used very much like insurance to protect a portfolio or to guard against extreme movement in a particular stock. This is also referred to as hedging.

For example, if you own 5000 BHP shares at $45 and you are worried that the share price may fall, you can buy 5 BHP $45 put options to hedge your position. This enables you to lock in an acceptable future sale price, protecting you should your fears be correct and the stock falls.

One thing to take note of is that as the BHP share price falls, BHP put option premiums rise. Why is this? As the share price drops, those same put options that you bought become more valuable. You see, if BHP drops to $42, your $45 put options still give you the right to sell BHP at $45. So the lower the share price falls, the more 'in the money' (more on this next) your put options become, resulting in a greater premium.

This profit on your put options should offset your loss on the physical shares… that's what hedging is. You then have the option of either exercising your right to sell your BHP shares at $45 or, if you want to keep your BHP shares, simply selling your BHP put options at a nice profit.

Buy time

If a market participant wants or needs to defer an investment, they can buy the equivalent market exposure for a short period of time.

For example, let's say you want to buy 1000 NAB shares at the current price of $40, but you won't have the $40,000 in capital (required to make that investment) for another three months. You could simply wait three months, however, you are concerned that the stock will rise between now and when you can buy it, resulting in you missing out on the upside.

You can lock in the future buy price today by buying a NAB $40 call option which expires in roughly three months time. That way, if NAB goes up between now and when you have the $40,000 in three months time, you won't have missed out on any upside.

One thing to take note of is that as the NAB share price rises, NAB call option premiums rise. Why is this? As the share price rises, that same call option that you bought become more valuable. You see, if NAB rises to $45, your $40 call option still gives you the right to buy NAB at $40. So the higher the share price goes, the more 'in the money' (more on this next) your call option becomes, resulting in a greater premium.

This profit on your call option should make up for what you missed out on by not being able to buy the physical shares when you wanted to. You then have the option of either exercising your right to buy NAB shares at $40 or simply selling your NAB call option at a nice profit.

Diversification

A portfolio can be diversified by different option strategies. If a portfolio is overweight or underweight in a specific sector of the market, a strategy may be considered to shift the risk exposure of the portfolio.

For example, if a portfolio is particularly overweight one stock such as Telstra (TLS), the investor may choose to protect that part of the portfolio via an options strategy, such as buying TLS put options. As mentioned, this is basically the same as buying insurance on those TLS shares.

Basic Options Terminology

Strike price

This is the price at which the option holder is entitled to either buy or sell the underlying parcel at (and the price at which the option seller must either sell or buy the underlying parcel if the option holder exercises the option).

In the above examples, the strike price for the BHP call option is $45 and the strike price for the NAB put option is $40. The strike price is also referred to as the exercise price.

Expiry date

The pre-determined date of an option is known as the expiry date. The expiry date is always the last Thursday before the last business Friday in the month of expiry. For both the call and put option examples above, the expiry would be the Thursday, 29 May 2008.

One thing to take note of… for both types of option (calls and puts), there are also two styles of expiry; American-style and European-style. With American-style options, the holder of the option has the right to exercise either on or before expiry. With European-style options, the holder of the option may only exercise at expiry, not before. Equity options in Australia are generally American-style expiry.

Premium

This is the price at which the option trades. It is the price that the buyer pays and the price the seller accepts for the option.

Market value

As an option contract represents a number of shares (usually 1000), the total cost of buying a contract is the number of shares (1000) multiplied by the premium. So if the BHP call option in the example above is bought at 60c (the premium), the value would be 1000 x 60c, which equals $600 (for one contract). This is the amount that the buyer will pay (plus brokerage etc) or the seller will receive.