How do Options Trade?

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Over the last month, I’ve written about the various parts that make up an option. This included the two basic types of options — calls and puts. I also showed you how an option is valued. That is, how an option price is made up of both intrinsic and time value and the way things like volatility and interest rates affect option prices.

Today, I’m going to wrap up this series of articles by writing about the actual mechanics of an option trade. While it might seem a bit daunting at first, it really isn’t that different to any of the share trades that you might have done already.

The role of the ASX

The options market is run and regulated by ASX Clear — a wholly owned subsidiary of the ASX. ASX Clear has very clear responsibilities. These include managing the daily operations of the options markets, listing new option series and setting the contract specifications for each option contract.

As the name implies, ASX Clear also clears all trades in the option market, ensuring that all option trades are settled. It also has a much more basic goal than this. That is, to facilitate a continually tradeable market that enables buyers and sellers to readily enter and exit the market.

From a risk management perspective, ASX Clear also performs a vital function. It sets the margin requirements for open option positions. I’ll cover more on this in a moment.

Counterparty

If you’ve ever entered a share trade online, you’ll see a list of buyers and sellers. This will usually show how many buyers and sellers are at each price level. When you enter your order, you’ll see that your order is matched against another’s.

However, when it comes to settlement you are actually settling with the ASX. Through its clearing facility, the ASX stands between the buyer and seller to ensure that all trades are settled on a T + 3 basis. That is, shares are exchanged for funds three business days after the transaction takes place.

They do this to manage what they call ‘counterparty risk’. This is the risk that your counterparty in the trade mightn’t be able to fulfil their obligations. For a seller, there is a risk that the buyer won’t have sufficient funds to pay for the shares they’ve bought. For a buyer, there is the risk that the seller won’t be able to deliver the shares.

Just as this ensures a smooth and reliable settlement process for share trading, the same applies with ASX Clear and option trades. However, there’s one big difference between shares and option trades, and that is the time from the trade until settlement.

T + 1 settlement

Under the CHESS system, shares are currently settled on a T + 3 basis, although the ASX plans to introduce a T + 2 cycle in March 2016. With option trades, settlement takes place on a T + 1 basis. Meaning that you’ll need to have the required funds available in your account the same day you do your trade, so that you can settle the trade the next business day.

Margins

When you buy an option, whether it’s a call or a put, you pay a premium to the seller. By paying this premium, you gain a ‘right’. That is, the right to exercise the option if you choose. By receiving a premium, the option seller takes on obligations.

The most an option buyer can lose is the premium they pay. If it’s not in their interest to exercise the option before it expires, they’ll let it lapse, worthless. However, if an option is exercised, the option seller will need to buy shares (in the case of a put option), or deliver shares (in the case of a call option) at the option strike price.

Because of this obligation, the option seller carries more risk than the option buyer. To cater for this risk, ASX Clear require option sellers to provide collateral in the form of ‘margin’.

What are margins? The ASX describes them this way:

A margin is the amount calculated by ASX Clear as necessary to cover the risk of financial loss on an options contract due to an adverse market movement.

There is one basic rule to remember here — only option sellers are required to lodge margins. Option buyers are not required to lodge any margin.

Your option broker is responsible for lodging any required margins on your behalf with ASX Clear. These margins are re-calculated throughout the day (and at the end of the day) to ensure that you always have enough margin to cover your position.

If your required option margin increases, they will debit your account. Likewise, if your obligation decreases, they will credit your account. Once the option seller closes out their position, any lodged margin is returned to their account.

There is another key point to note — your broker might require more margin than the minimum amount stipulated by ASX Clear. So, before placing a trade, you need to check what your broker’s requirements are.

As per the option settlement of T + 1, you’ll be required to lodge any additional margins within one day of notification (if you don’t already have sufficient funds in your trading account). In extremely volatile markets, you might be required to lodge additional funds the same day.

Calculating the margin requirement

There are two components used to determine how much margin you are required to lodge. The first of these is ‘premium’ margin, and the second is called ‘initial’ (or ‘SPAN’) margin.

Premium margin is the actual market value of the option at the close of business each day. If you sold an option for 30 cents, then your premium margin that day would be 30 cents times 100 (the standard number of shares in an option contract) equals $30 per contract.

If the next day, the option is worth 40 cents, then your premium margin requirement would be $40 per contract.

Initial margin, or SPAN margin, refers to market risk. That is, it considers what could happen under a worst case scenario in the market. Using factors such as the share price history and volatility, the ASX uses probability calculations to establish the potential maximum price moves under different market scenarios over any given day.

Option trading process

An option buyer has three different ways to close out a trade. First, they can sell the same option as the one they bought. The important thing is to make sure that the option codes are the same. Each option has its own unique code, so you need to check that you’re selling the same option as the one you bought.

Second is exercise. The option buyer can exercise their option at any time until expiry (with an American option) and at expiry (with a European option). With a call option, an option is in-the- money if the strike price is below the market price. A put option is in-the-money if the market price is below the strike price.

Third, by allowing it to lapse without exercising it. There would be no point exercising an option that is out-of-the-money at expiry. It would be cheaper to buy the shares (in the case of a call option), or, they would get more money by selling their shares in the market (in the case of a put option).

There are a number of reasons you might close out a position. Firstly, the trade might be going against you and you want to cut your losses on the trade. Or, the trade might be going in your favour and you want to lock in your profit.

The other reason might be that you want to avoid the possibility of being exercised. For example, if you think a call option buyer might want to exercise to take delivery of shares prior to it going ex-dividend.

An option seller has two ways to close out a trade. First, they can buy back the same option as the one they initially sold. Again, they need to make sure that they’re buying back the same option as per its unique code.

The second way is simply to let the option expire. One of the more common reasons for selling options is to generate income. If this is your strategy, then the aim is not to be exercised before expiry. You want to keep the premium you’ve received without having to close out your position.

If the option you sold expires worthless, then you’ve made the most possible profit out of your trade. You’ve kept all the premium, and can then look at repeating the process.

Having now read about the mechanics of an options trade, you can see that it isn’t that different to a share trade. Buyers are matched with sellers, the same as if you are buying shares on the ASX. Once you’ve done a couple of trades, you’ll find you’ll quickly get an understanding for how the option market works.

Matt Hibbard,

Editor, Options Trader

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Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.
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