Options can be a great tool to put in your box. But you need to know how to use them. Although there are just two types of options — a call option and a put option — they can be used individually, or combined to create dozens and dozens of investment strategies.
For example, if you thought a share price (or an index) was about to rise, you could buy a call option. A call option gives the buyer the right to buy the underlying shares at a fixed price at any time until the option expires. For gaining this right, the option buyer pays the option seller a fee, known as the premium.
A put option is the opposite of a call option. The put option buyer gains the right to sell the underlying shares to the option seller, at any time until expiry. As with a call option, the put option buyer pays a premium to the put option seller, to compensate them for taking on this obligation.
An investor might buy a put option if they though the underlying shares might be headed for a fall. For example, if an investor held shares in a company trading at $10, they might look to lock in a price by buying a put option. This fixed price is called the strike (or exercise) price.
Continuing with this example, the same investor might buy a put option with a strike price of $9.50. Meaning, that if the share price was to fall below this level before the option expires, they have the right to hand the shares over to the put option seller. The transaction is carried out at the strike price.
Buying options allows investors to potentially gain in both market directions. Selling options, also known as ‘writing’ options, can be a useful strategy to generate income. Every time a trader or investor writes an option, they receive a premium. However, with options, you always need to understand your obligations — every premium received comes with an obligation which must be fulfilled if the option is exercised.
Buying put options over existing shares is like a form of insurance. You’re paying a premium in exchange for the right to exit your shares at a pre-determined price — the strike price. It’s similar to how you might insure your house or car. You pay a premium, which obligates your insurance company to replace or repair the underlying asset to its original or agreed condition.
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All options have expiries, just like an insurance premium. And all options have a fixed strike price. The ASX lists all the different strike prices available for each option series. So, for example, an option expiring in three months’ time will have a range of strike prices for the option buyer to choose from.
This range of strike prices helps determine the value the writer puts on these options. Let’s continue with the example of an investor holding shares trading at $10. If the put option writer had to ‘insure’ these shares at a $10 strike price, the shares only have to fall one cent or more before expiry for the option to be exercised.
If you were writing this put option at $10, you’d likely want a fair bit of premium. In this example, you’re taking on an obligation to buy the underlying shares at the same price as it’s currently trading at. What happens if the shares fell to $8 or $9 before the option expires? You’d still have to buy them at $10, as per the option strike price, so you’re taking on an obligation you want to be duly compensated for.
But how about writing a put option at $9.50 or $9.00? You can see that the further away the put option strike price moves below the current share price, the further the share has to move before the option will get exercised.
So, if a share is trading at $10, a put option with a $9 strike price is less likely to be exercised than a put option with a $10 strike price. The further away the strike price moves from the current share price, the less premium the option writer will seek to be compensated, as there’s less chance of being exercised.
One of the great things about options is their flexibility. In this put option example, the buyer could lock in a strike price higher than the current share price. This could be $10.50 or $11 for example. But as you’d expect, the option writer is taking on a bigger obligation (agreeing to buy shares higher than the current share price), so will expect a much higher premium.
The relationship between the strike price and the current share price is called the intrinsic value. A $10.50 put option on a $10 share price has 50 cents intrinsic value. By exercising the option, the buyer can sell their shares for 50 cents higher than the current market price.
A $10 or $9.50 strike price (when the shares are trading at $10) has no intrinsic value. The put option buyer wouldn’t gain anything by exercising the option early, as they could get more for selling the shares in the market.
Using a call option example, a $5 strike price when shares are trading at $6 has $1 of intrinsic value. The call option buyer could buy the shares for $1 cheaper if they exercised the option than if they bought them in the market. But a $7.50 call option has no intrinsic value if the shares are trading at $6. The call option buyer could buy the shares cheaper in the market than by exercising the option.
This intrinsic value is one of two parts that combine to determine the value of an option. The second part is time value. Time value reflects the amount of premium the option writer wants to receive (on top of the intrinsic value) for the risk that the option will be exercised before expiry.
If an option is trading at $1 and has no intrinsic value, the time value equals $1. Or if an option is trading at 50 cents and has 20 cents intrinsic value, then it has 30 cents of time value.
Another way to look at it is that time value reflects the maximum amount an option buyer is prepared to pay, on top of intrinsic value, for the trade to have the best chance of success before expiry. Or from the option writer’s perspective, the minimum amount of premium they’re prepared to receive for taking on the risk of being exercised.
These two parts — intrinsic and time value — combine to determine the value of an option. This value reflects the perceived chance of the option being exercised prior to expiry. The more time the option buyer has to be right, the more the option seller will want to be compensated.
Editor, Total Income