Once upon a time there was an intelligent guy with movie-star good looks. With only one year of option trading experience, at the age of 42, he left his job to become a full-time trader. In between tennis matches and golf games, he traded and traded. In his first 6 months, he made twice his usual salary as a brain surgeon. He laughed heartily, his golden hair glistening in the sun. Next, he took an extended 2-year holiday on his fabulous shiny yacht in the Mediterranean, with a harem of beautiful, scantily clad girls half his age. By day they would bask in the sun and swim in the ocean. By night they would drink cocktails and admire the perfect sunset before retiring to their cabins. Trading options was so much easier than he had ever expected…
Quick reality check … this is a fairytale. To trade options effectively will take a little more effort than that. However, once you’ve got the swing of these fabulous leveraged tools, you may just surprise yourself with how much you can make!
What the heck is an option?
Exchange traded options (ETOs) are generally the first form of derivative that traders are exposed to, and much to our dismay it has become the practice of spruikers of ETO trading schemes to suggest to people that they move straight into option trading without any prior exposure to the markets.
Before we begin talking about exchange traded options, it is necessary to be able to distinguish between ETOs and company issued options. Most traders are familiar with company issued options. These are options issued by companies as a means of raising capital and are traded on the Australian Stock Exchange (ASX). They are generally European in nature, which means they may only be exercised on the day of expiry. Upon exercise the number of shares on issue will rise as the options are converted to ordinary shares. It is this conversion to ordinary shares that enables companies to raise equity.
ETOs are not issued by the company and are traded on the Australian Securities Market. ETOs are known as American options they can be exercised at any time. And their exercise does not result in any change to the capital structure of the underlying company.
ETOs fall into that class of securities known as a derivative, their existence and price is derived from an underlying security, in this case an ordinary share.
What You Don’t Know Will Hurt You!
It’s important to note that if you cannot successfully trade shares then it will be impossible for you to trade any form of derivative. All derivatives trading will allow you to do is to be more successful and more flamboyant in your failure.
As a share trader you should be able to answer the following questions with ease.
- What is your entry trigger?
- Do you believe this to be the secret of successful trading?
- What is your position sizing methodology?
- What is your exit strategy?
- What is the expectancy of your trading system?
If you cannot answer these questions then your chances of succeeding at options trading will be quite small. You will need to set yourself the task of learning about these facets of trading. If you know the answer to these questions and you’ve had a chance to gain a bit of trading experience, then yippee! You’re ready to take the next step and investigate leverage with options.
Even though this definition sounds a bit confusing, it’s important that you spend some time considering it. An ETO is the right but not the obligation to buy or sell a given security at a certain price within a given time. So if I purchase a BHP call option I have bought the right but not the obligation to buy BHP at a set price by a given time. As an example if I have bought the BHP July 3000 call I have bought the right to buy BHP at $30.00 on or before the expiry date in July. You will notice that when I write $30.00 I write it as 3000. This is a form of shorthand that is used to describe the strike or exercise price of an option. So an AMP June 825 call is an AMP $8.25 call option.
Conversely, a put option is the right but not the obligation to sell a given security at a certain price within a given time. So if I purchase an ANZ 3100 June put I have bought the right but not the obligation to sell ANZ at $31.00 on or before the end of June.
Notice how when an option is described, there are four components that make up the description. The stock being traded, this is referred to as the underlying stock, the expiry date, the strike or exercise price and whether it is a put or a call option. All option description contains these four basic elements and this is how an order is conveyed to the broker.
When an option is purchased it has to be purchased from someone. It is important to note that there are two sides to an options transaction and it is here that we run into our first piece of jargon. If I buy an option as an opening position I am said to be an option taker or buyer. So if my instruction to my broker is to buy 10 NAB July 5000 calls to open I am an option taker. In performing this trade I am said to be long that particular option. The maximum potential loss for an option buyer is limited to the amount they paid for their option. Option buyers are also said to have undertaken a debit transaction. It has cost money to initiate the position.
If my instruction to the broker had been to sell 10 NAB July 5000 calls to open then I have initiated a short options position and I am referred to as an options writer. A trader who sells an option as an opening transaction is said to be an option writer. The option writer receives a premium from the option buyer short that particular option. A call option writer can be either covered or naked. A covered option writer will own the underlying shares against which the call option has been written. For example a trader who owned 5000 ANZ and then wrote 5 ANZ calls against this position would be referred to as a covered writer.
A trader who simply writes options without the underlying security is said to have taken on a naked position. All sounds rather glamorous, doesn’t it! Naked option writers are liable for margins to be levied against their account by the ASX. Option writers are said to have undertaken a credit transaction since they receive an option premium when the position is initiated. In some instances, option writers can face theoretically unlimited losses. Option writers and buyers can make great money, if they are consistent, know the ins and outs of the market, and focus on their money management.
Your financial future is in your hands
It is very important that traders understand the distinction between being an option buyer/taker and an option seller/writer. Each has a differing set of obligations and a different risk profile.
Option buyers have the right but not the obligation to exercise their option; for this they pay a premium, this premium is the maximum amount they can lose. For example if I had paid $0.35 for a given option then the most I can lose per option contract is $0.35, I cannot lose any more than that.
Option writers/sellers are under a potential obligation to either deliver stock if they are a call option writer or buy stock if they are a put option writer. For this obligation they receive a premium from the option buyer. It is possible for an option writer to face a potentially catastrophic loss. It is for this reason that option writers must not only be aware of their obligations but should also have a firm exit strategy. I might add that hoping and praying are not acceptable as strategies.
It is very important for option writers to understand their obligations and the potential for loss that such positions carry. To illustrate this, consider the following. If I write a RIO June 8000 put I am obligated to purchase RIO at $80.00 if the option buyer chooses to exercise their part of the contract. Remember there are two parts to the contract, there is the option writer and there is the option buyer, the buyer has the right but not the obligation to sell RIO at $80.00 on or before the expiry date of the option.
My view in writing this put is that I believe RIO will go up, the aim of being an options writer is to buy the option back at a price that is lower than what it was sold for. Option writers have the opposite view to option buyers so if I write a put option I am bullish, if I write a call option I am bearish.
Let’s assume that my view of RIO is incorrect and RIO falls precipitously to $60.00 and the put option buyer exercised their right to sell RIO at $80.00 and I have the stock put to me. Irrespective of the price RIO is trading at in the market I have to pay $80.00, I now face a loss of $20.00 per share since I will be forced to buy the stock at $80.00 yet I can only sell it at the market price of $60.00. This loss will be somewhat offset by the premium I received when I sold the option but in reality this would only just cover the brokerage costs in such a transaction.
Difference between options and CFDs
Both ETOs and CFDs are derivatives – their existence and pricing is derived from an underlying security. ETOs like CFDs can be used to trade trends they are also highly leveraged instruments favoured by speculators.
However ETOs have a slight advantage over CFDs in terms of the range of market conditions they can be applied to, a CFD like a share and a futures contract requires the price to be trending. If price stops trending they lose their utility. This is not the case with ETOs since strategies can be generated that actually take advantage of a hesitation in price. ETOs can also be used to trade both time and volatility since these are both components of an ETOs price they also form variables that traders can generate strategies to trade. Whilst such strategies are slightly more complicated than simply buying a call, they nonetheless give the trader the opportunity to trade all market conditions.
Take the guesswork out of Options
If you’re keen to learn more about options, you need to turn to experienced traders who have the knowledge, experience and cutting edge techniques to help drive your account into profit. Chris Tate and Louise Bedfordare among the best in the business, and have several products focussed on options.
Chris and Louise Can Help You!
The Art of Options Trading in Australia
The Secret of Writing Options
This book by Louise Bedford is written in easy-to-understand language, is highly recommended for newcomers to options trading in Australia, and those already trading the options market. Click here to read more
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