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 concept of an option has probably been around as long as commerce has. But the modern market listed and tradeable option first appeared on the Australian stock market in 1976. Australia has been a pioneer in the use and creation of derivatives.

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.

Options in Australia, like shares, trade on ITS (Integrated Trading System), the ASX electronic trading system on which the buying and selling of shares takes place. ITS matches all buying and selling orders by price and when a buy order and sell order are matched, the trade occurs. If two buy orders are at the same price, they are further sorted by the order in which they were entered in the system.

Many stock broking firms also operate as options brokers, although the operator or order taker is generally a specialist (accredited) options operator.

Many private client investors (or non professionals) use the options market. However, due to the high leverage and therefore high risk, a thorough understanding of the mechanics and fundamentals of the options market is required in order to capitalise on the potential benefits of this specialised market. Whilst there are several types of options, we'll be discussing Exchange Traded Options, or ETOs.

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 November 2009 $35 call option, you have the right, but not the obligation, to buy a parcel of 1000 BHP shares at $35 on or before the expiry in November 2009.

If you are the seller (or writer) of this call option, you must sell 1000 BHP shares at $35 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 November 2009 $30 put option, you have the right, but not the obligation, to sell a parcel of 1000 NAB shares at $30 on or before the expiry in November 2009.

If you are the seller or writer of this put option, you must buy 1000 NAB shares at $30 from the buyer of the option if they choose to exercise the option.

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 $35 and the strike price for the NAB put option is $30. The strike price is also referred to as the exercise price.

Expiry date

The pre-determined maturity 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, 26 November 2009.

One thing to take note of here… 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.

SUMMARY

Let's examine the process of buying two contracts in the BHP example above and what it means to you.

Let's assume that you buy 2 BHP May 2009 $35 call options at 60c. Therefore,

• strike price = $35
• premium = 60c
• expiry date = Thursday, 26 November 2009
• cost to you = $1200 (plus brokerage and fees)

i.e. 2 contracts x 1000 shares per contract x 60c premium.

Therefore, as the buyer of the call option, you have the right but not the obligation to buy 2000 BHP shares at $35 on or before 26 November 2009. If you are on the other side of the transaction, selling the call option, you must sell 2000 BHP shares at $35 to the buyer of the call option if they choose to exercise the option.

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.

To use the example above, a $1200 investment in BHP call options provides leverage to 2000 BHP shares during the life of the option. To get the same exposure (to 2000 BHP shares) by buying shares directly, it would cost you $70,000 if BHP is trading at $35! So a $1200 investment in call options gives you the same exposure as a $70,000 investment in shares… now that's what leverage is.

Buying the BHP options allows the option holder to benefit from changes in the underlying BHP share price without paying the full $35 price for the share.

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 $35 and you are worried that the share price may fall, you can buy 5 BHP $35 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 $32, your $35 put options still give you the right to sell BHP at $35. 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… now that's what hedging is. You then have the option of either exercising your right to sell your BHP shares at $35 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 $30, but you won't have the $30,000 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 $30 call option which expires in roughly three months time. That way, if NAB goes up between now and when you have the $30,000 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 $35, your $30 call option still give you the right to buy NAB at $30. 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 $30 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. This is basically the same as buying insurance on those TLS shares.

DEFINITIONS

Going forward, it is important for one to understand some new terms. Depending on the relationship between an option's strike price and the market price of the underlying share, the option will be referred to as being one of the following;

Out of the money

This means that the strike price for calls is above the share price and for puts, the strike price is below the share price.

At the money

This means that the strike price is the same as the share price.

In the money

This means that the strike price for calls is below the share price and for puts, the strike price is above the share price.

HOW CALL OPTIONS WORK

As mentioned, a call option is the right, but not the obligation, to buy a parcel of shares at a set price on or before a set date. The issuer or seller of the option accepts the responsibility to sell to the buyer of the option the parcel of shares at or before expiry at the strike price if the buyer chooses. The seller is paid the premium and gets to keep it no matter what. They are selling the flexibility that the buyer wants. Therefore, they have no flexibility and must deliver the shares if called upon. The buyer, on the other hand, has bought flexibility and has no obligation to exercise the option.

At expiry, the holder of an in the money call option will exercise the option, as they have the right to buy shares at a price below the current market price (and so why wouldn't they!).

A holder of an at the money call option may or may not exercise, it depends on their specific objectives. In our market, most at the money options are not exercised.

An out of the money call option will not be exercised as no buyer will pay more for shares via an option exercise than they can pay for the shares in the market.

The issuer of the option must deliver the shares if the option is exercised. They either must already own them or they must buy them in the market so that they can deliver what they are obligated to.

HOW PUT OPTIONS WORK

As mentioned, a put option is the right, but not the obligation, to sell a parcel of shares at a set price on or before a set date. The issuer or seller of the put option accepts the responsibility to purchase the parcel of shares from the buyer of the option at or before expiry at the strike price if the holder of the option chooses. The seller is paid the premium and gets to keep it no matter what. They are selling the flexibility that the buyer wants. Therefore, they have no flexibility and must buy the stock if called upon. The option buyer on the other hand has bought flexibility and has no obligation to exercise the option.

So what happens at expiry? At expiry, the holder of an in the money put option will exercise as they have the right to sell shares at a price above the current market price.

A holder of an at the money option may or may not exercise, it depends on their specific objectives. As mentioned, in our market, most at the money options are not exercised.

An out of the money put option will not be exercised as no seller will sell shares via an option exercise below where they can sell them in the market.

The issuer of the option must buy the shares at the pre-determined strike price if the option is exercised.

PRICING OPTIONS

At this point, you might be wondering how the actual option premium is derived. Like any investment security, price, or in the case of options, premium, is the single most important factor to consider when looking at buying or selling.

The option premium is influenced by 7 major factors, some of which are fixed and some variable.

These factors are:

• strike price (fixed)
• expiry (fixed)
• price of underlying security (known but variable)
• volatility (estimated)
• capital changes to the underlying company such as dividends and share splits (usually known)
• market expectations (variable and immeasurable)
• interest rates (fixed)

An option premium is made up of two value components:

1) INTRINSIC VALUE

The intrinsic value is the amount by which the option is in the money. Put another way, it is the difference between the strike price of the option and the market price of the underlying share. This number cannot be negative. Therefore, an out of the money option cannot have any intrinsic value.

To give you an example, if BHP Billiton (BHP) is trading at $36 and we consider a BHP $35 call option trading at $1.60, the intrinsic value is $1. i.e. $36 - $35 = $1

2) EXTRINSIC (OR TIME) VALUE

Otherwise known as time value, this is the price that is being paid for the option's advantages. It represents the amount the buyer is prepared to pay for the possibility that the market may move in their favour during the life of the option. Equally, it is the price that the writer is willing to accept to offset the risk that they have taken on.

The extrinsic value is calculated by subtracting the intrinsic value from the option premium. To use the call option example above, the extrinsic (or time) value is $1.60 (premium) - $1 (intrinsic value) = 60c.

BUY AND WRITE

There is an options strategy called 'buy and write' (or a 'covered call') that we have recommended in The Rivkin Report many times, and those interested in options may well find it useful.

A buy and write strategy involves combining a position in the underlying shares and a corresponding one in options. The strategy involves buying a number of shares and selling (writing) call options against the shares at the same time… hence the name buy and write (sometimes simply referred to as 'buy write').

Let's say David Jones (DJS) has fallen and is trading at $4 in February. And let's assume that our view is that the potential downside from $4 is not great, but the stock may not go up quickly either.

So our strategy involves buying, let's say, 10,000 DJS shares at $4 ($40,000). Then we sell 10 March $4 call options at 15c (an estimate). So we buy shares and we write (or sell) call options against the holding. The outcome is that we put the $1500 (10 contracts x 1000 shares x 15c premium) from selling the call options in our pocket immediately (which we get to keep regardless… our compensation for the flexibility we have sold to the buyer of the options).

Now let's look at the three possible outcomes come expiry in March:

1. DJS rises above $4. The buyer of the call options we sold will exercise those call options, thus exercising their right to buy 10,000 DJS at $4. The buyer will obviously do this as they can buy DJS at $4 via these call options and then sell the shares higher in the market. So we will be exercised and we must therefore sell 10,000 DJS shares to the buyer of the call options at $4. We originally bought 10,000 DJS shares at $4, which must now be sold to the buyer of the call options at $4… so we end up selling our DJS shares at the same price we bought them. So our final result is a profit of $1500, which is simply the call options premium we got to keep.
2. DJS doesn't move. We will probably not be exercised and therefore, we will still own the stock after expiry and our net position is that we are $1500 ahead, which once again is the premium we got to keep. We then have a choice of simply holding the shares, holding and writing more calls or selling the holding at $4.
3. DJS falls below $4. The options will not be exercised and we will still own our DJS shares after expiry and we will still have the $1500 premium, but depending on how far DJS has fallen, we may not be ahead. If DJS is trading at $3.80, we are down $2000 on our shareholding, whilst being up $1500 from the premium. Hence, our net position is a $500 loss (at $3.80). We then have a choice of simply holding the shares, holding and writing more calls or selling the shares.

So have a think about the outcome of these three scenarios. If the stock rises, we have made some money but missed out on some upside (could have made more money had we not sold calls, but not the end of the world); if the stock stays steady, we have made money; and if the stock falls, we may or may not be ahead, but we are certainly better off for having sold the call options (as we made the premium). Remember that we cannot sell our DJS shares during the life of the options without creating a high-risk exposure for ourselves. The reason for this?

Imagine the following occurs… DJS goes up to $4.20 shortly after we buy the stock and we sell our 10,000 shares at this price (locking in a $2000 profit), but the stock then keeps going higher, ending up at $4.50 at expiry. We then find ourselves unprotected (also known as 'naked' in options terminology, the opposite of 'covered'). This is because the buyer of the calls will exercise their right to buy the shares at $4 and we will have to sell 10,000 DJS shares at $4 to this buyer. But we don't have the stock anymore, because we sold it at $4.20. So we must buy 10,000 DJS shares in the market at $4.50 and then on-sell to that buyer at $4! This results in a $5000 loss, which is greater than the $2000 we made from selling our shares at $4.20 and the $1500 premium we got, combined.

Summary

The price at which we start making money is lowered by the sale of the options, from $4 to $3.85 ($4 - 15c premium). We have basically bought the shares at this price, as we paid $4 per share but received 15c in premium per share. The cost of this bonus 15c is that we give away any upside above $4.15 ($4 + 15c). So if the stock went to $5 by expiry, we still only get the $4.15 (we sell the shares at $4 and keep the 15c premium).

This is a low-risk strategy as you can see. If you want to own the stock anyway, there is no real downside. If the stock goes down, selling those calls has softened the blow on those shares you own; if the stock doesn't move, the premium is money for jam; and if the stock rises, you still make money, being the premium. As mentioned, the only negative to this strategy is if the stock goes up a lot, you miss out on some upside and you only end up making a small profit, as opposed to what would have been a larger profit had you only owned the shares (not great, but not quite the same thing as a loss!).It's a good strategy when the worst case scenario is that you only make a little instead of a lot! Some might argue that if the stock goes down a lot, you are losing money so the strategy is no good. But this is wrong… assuming you wanted to own the stock anyway, all that's occurred by selling those calls is that you've lost less than you would have had you not sold the calls.

OTHER OPTIONS STRATEGIES

Beyond the buy write strategy, there are a multitude of other options strategies, some simple and some very complex. It is beyond the scope of this article to outline other strategies in detail, but a brief explanation of a few basic strategies is warranted.

Spreads

Spreads involve the simultaneous purchase and sale of options within the same class. This strategy can employ calls or puts, and whichever direction the stock moves, one leg of the strategy will result in a profit and the other leg will obviously result in a loss. The investor hopes that the loss on one leg is outweighed by the profit on the other.

Straddles

Straddles involve the investor holding a position in both a call and a put option with the same strike price and expiry date. This is a good strategy to employ if an investor believes that a stock will move strongly in one direction, but the investor is unsure as to which direction. The stock price must move significantly for the investor to profit.

Strangles

Strangles are a strategy whereby the investor holds a position in both a call and a put option with different strike prices but the same expiry date and underlying asset. It's only profitable if there are large movements in the price of the underlying asset. The strategy involves buying an out of the money call and an out of the money put.