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Option Market Basics

Why do some market participants trade options?

The answer to this is quite easy: the Australian exchange-traded options market is one of the most dynamic, innovative and exciting of markets available and options themselves are one of the most profitable tools available to traders. Options are used by both large and small traders because of their leverage, risk management capability and capacity to greatly enhance the return on assets.

By the end of this chapter you should be able to:

• Distinguish between company-issued and exchange-traded options.
• Define the basic types of options.
• Define which options are bullish and which are bearish.
• Understand the components of an option.
• Understand basic option terminology.
• Understand the presentation of option quotes.
• Understand the six basic strategies and their payoff diagrams.

Exchange-Traded Options

Before we begin talking about exchange-traded options (ETOs) 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 they 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, they are traded on the Australian Options Market (AOM), a subsidiary of the ASX. ETOs are known as ‘American’-style options—they can be exercised at any time. The exercise of such options does not result in any change to the capital structure of the underlying company. ETOs fall into the class of securities known as ‘derivatives’; their existence and price is derived from an underlying security, in this case an ordinary share.

It is here that I must issue my first warning about trading ETOs. If you cannot successfully trade shares then it will be almost impossible for you to trade any form of derivative. All derivatives trading will allow you to do is be 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 before you even consider a move into derivatives.

Options Basics

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-Billiton call option I have bought the right but not the obligation to buy BHP-Billiton shares at a set price by a given time. As an example, if I have bought a BHP-Billiton July 1100 call, I have bought the right to buy BHP-Billiton shares at $11.00 on or before the expiry date in July. (You will notice that when I write $11.00, I write it as 1100; this is a form of shorthand that is used to describe the strike or exercise price of an option. So an NAB June 3650 call is an NAB $36.50 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 NCP June 1000 put I have bought the right but not the obligation to sell News Corp at $10.00 on or before the end of June.

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
• whether it is a put or a call option.

All option descriptions contain these four basic elements. This is how an order is conveyed to a broker. The components of an options contract are looked at later in this chapter.

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 buyer or option taker. So if my instruction to my broker is to buy ten NAB July 3500 calls to open I am an option buyer. 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 paid for the option. Option buyers are also said to have undertaken a debit transaction. It has cost this person money to initiate the position. This concept is extended when we look at spreads. Any spread that costs money to initiate is a debit spread.

If my instruction to my broker had been to sell ten NAB July 3500 calls to open then I have initiated a short options position and I am referred to as an option writer or an option seller. A trader who sells an option as an opening transaction is an option writer. The option writer receives a premium from the option buyer for that particular option. In the case of spreads, any spread that generates a credit is referred to as a credit spread.

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 5,000 ANZ shares and then wrote five ANZ calls against this position would be referred to as a covered writer (an option contract generally gives the trader leverage over 1,000 shares). A trader who simply writes options without owning the underlying security is said to have taken on a naked position. Naked call option writers are liable for margins to be levied against their account by the ASX, and they will have to buy the shares on the market if the option is exercised.

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.

It is very important that traders understand the differences between being an option buyer/taker and an option writer/seller. Each has a differing set of obligations and a different risk profile.

Option buyers/takers 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 35¢ for a given option then the most I can lose is 35¢ per share. I cannot lose any more than that.

Option writers/sellers are under a potential obligation to either deliver stock if they are call option writers or buy stock if they are put option writers. For this obligation they receive a premium from the option buyer. It is possible for an option writer to face a theoretically unlimited loss. This loss is only theoretically unlimited because a stock will eventually stop going up or down, but this is a rather moot point when you are faced with a position that is moving rapidly against you.

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 an NCP June 1200 put I am obligated to purchase NCP at $12.00 if the option buyer chooses to exercise the contract. (Remember there are two parts to the contract; there is the option writer and there is the option buyer.) The put option buyer has the right but not the obligation to sell NCP at $12.00 on or before the expiry date of the option.

My view in writing this put is that I believe NCP will go up. Option writers have the opposite view to option buyers. If I write a put option I am bullish, and the person buying it is bearish. It is always the buyer who has the right to exercise the contract.

Let’s assume that my view of NCP is incorrect and NCP falls precipitously to $5.00 and the put option buyer exercises the right to sell NCP at $12.00, and I have the stock put to me. Irrespective of the price NCP is trading at in the market I have to pay $12.00. I now face a loss of $7.00 per share since I will be forced to buy the stock at $12.00 yet it is now only worth $5.00. 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.

We will now look at the possible option positions and their implications.

Call Options

A call option provides the right but not the obligation to buy the underlying security at a fixed price on or before a set date. An NAB July 3500 call is the right but not the obligation to buy NAB at $35.00 on or before the expiry date in July. To obtain this right a premium is paid.

If a trader buys or takes a call option then this person’s market view reflects the two following conditions:

A call option buyer can lose no more than the premium paid to purchase the option.

The call option buyer may either exercise the option and take delivery of the underlying stock or choose to sell the option.

A trader who has bought a call option is said to be long the option and also long the underlying stock.

If a trader sells or writes a call option, this person’s market view reflects the two following conditions:

The call option writer is required to sell the underlying stock at a set price if called upon to do so.

The writer wants to avoid having the shares called away.

A naked option writer faces potentially unlimited loss and the potential profit is limited to the amount of premium received when the option was sold.

The option may expire worthless or the writer can buy the option back for a profit.

A trader who has written a call option is said to be short the option and also short the underlying stock.

Put Options

A put option gives the right but not the obligation to sell the underlying security at a set price on or before the expiry date. A WMC June 800 put is the right but not the obligation to sell WMC at $8.00 on or before the expiry date in June.

If a trader buys or takes a put option this person’s market view reflects the following two market conditions:

A put option buyer can lose no more than the premium paid for the option.

The trader can either sell the put option or exercise it and sell the underlying shares.

A trader who has bought a put option is said to be long the put option but short the underlying stock.

If a trader writes or sells a put option, then this person’s market view reflects the two following conditions:

A put option writer’s profit is limited to the premium received in selling the option. A put option writer faces potentially unlimited risk. All put option writers are naked.

The option may expire worthless or the trader can buy it back at a profit.

A trader who has written a put option is said to be short the option but long the underlying stock.

The Components of an Options Contract

It will be apparent that options are standard contracts. The functioning of the options market is dependent upon this. It enables communication between options traders and a clear understanding of the rights and obligations specified in the contracts that are being traded.

The components of an options contract require closer examination.

Date of Expiry

Options move through a set calendar cycle that is fixed according to the underlying share. In addition to this quarterly cycle some stocks also have ‘spot months’. These options are listed ten business days before the expiry of the nearest month. Some stocks have a rolling three-month spot expiry. These are all listed in the Appendix.

The Options Clearing House (OCH) stipulates that trading in options ceases at the close of trading on the Thursday preceding the last working Friday of the maturity month. If the Thursday falls on a public holiday, trading will cease on the last business day preceding the last Friday of the expiry month.

The OCH produces a calendar that lists each expiry date. This can be downloaded from: www.asx.com.au/markets/l4/OptionExpiryCalendar_AM4.shtm

Exercise Price (Strike Price)

This is the price at which an option buyer may exercise the right to buy or sell shares covered by a given options contract. Each exercise price is generally fixed throughout the life of the option, with exercise prices being set at the following intervals:

Stocks selling at:

Whilst these are generally fixed for the life of the option, they may be altered if the company whose shares are covered by the options makes a cash issue.

It is important to highlight the difference between the effects of cash issues and those of a bonus issue. A well-known practical example of this was the bid for Optus by SingTel. In the event of the bid being successful the following formula would be used to adjust the exercise or strike price for CWO:

As highlighted below a bonus issue results in both a change in strike price and the number of shares covered by the option. A cash issue does not alter the number of shares covered by an option contract since these shares do not accrue to the option contract unless the option is exercised on a cum-issue basis.

Number of Shares

An option contract generally gives the trader leverage over 1,000 shares of the underlying stock. However, this may change during the life of the option if the underlying stock is involved in a bonus issue. If for example a company declares a 1 : 1 bonus then there will be an additional 1,000 shares created with an exercise price half that of the original exercise price.

Premium

The quoted price of an option is more often known as the premium. Option prices are quoted on a per share basis, thus to obtain the full contract price a trader has to multiply the quoted price by 1,000. Hence, if BHP-Billiton July 1000 calls were trading at 10¢, the price of one contract would be 10¢ × 1,000 = $100.

An option premium splits naturally into two parts: intrinsic value and time value. Intrinsic value may be defined as the difference between the market value of an underlying security and the exercise price of a given option.

For example, if BHP-Billiton is trading at $10.10, then a BHP-Billiton July 1000 call option is said to have an intrinsic value of 10¢, this being the difference between the option strike price and the current price of the underlying stock. If this call is trading at 20¢, 10¢ of this is the intrinsic value. The remaining 10¢ represents the time value left in the option. If our option price had remained the same whilst BHP-Billiton was trading at $10.15 then our intrinsic value would have been 15¢ and our time value would 5¢.

The formula for determining the intrinsic value of a call option is as follows:

The formula for determining a put option’s intrinsic value is as follows:

As an option moves towards expiry the amount of time value contained within the premium will decrease at an accelerating rate until an option has no time value left. In such situations an option will only trade at its intrinsic value.

A further refinement to our description can be added by the introduction of the terms in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM).

A call option is said to be in-the-money if the stock price is above the strike price of the option, and it is out-of-the-money if the stock price is below the option strike price. If a call option is out-of-the-money, it naturally has no intrinsic value and its premium merely represents its time value.

Put options work in reverse. A put option is said to be in-the-money if the stock price is below the option strike price and out-of-the-money if the stock price is above the strike price.

Both put and call options have their greatest amount of time value when the stock price is equal to the exercise price. In such a situation an option is said to be at-the-money. As an option becomes either deeply in-the-money or out-of-the-money, its time value will shrink rapidly. This tends to be more evident in put options, which decrease in time value at a greater rate once they go in-the-money compared to an equivalent call option. As we will see later, this feature is of some importance. At-the-money options are composed of only time value. Only in-the-money options have any intrinsic value at expiry.

The relationship between share price, strike price and the concepts of in-the-money, at-the-money and out-of-the-money can be seen in the following table.

Table 1.1 Price Relationship

Reading Option Quotes

The reading of option quotes is only slightly different from reading equity quotes. Call option quote tables are given in all major daily newspapers and the Australian Financial Review. A fictitious example is shown below.

Table 1.2 Option Quote Table

These tables are largely self-explanatory, however there are a few important features that traders need to be aware of.

When reading from left to right the option exercise month and then the strike price are shown. There are then two columns showing the current buyer and seller quotes. It is here that traders will need to be a little careful. If we examine the first quote series the XYZ March 930 call is bid $2.46, offered $2.64, yet the last sale was $2.93. This last sale is referred to as being stale in that it was obviously some time ago, and is not reflective of current price action. There is a simple way to see whether a last sale is stale and that is to look in the column marked T.O. (turnover). This column is the number of option contracts traded that day—if there is no number in this column then the last sale price is irrelevant.

The next column is called Open Int., or Open Interest to give it its full name. Open interest refers to the number of option contracts currently open for that particular series. From the earlier section you will remember that options are a contract, they have two parties. When those two parties come together open interest goes up by one contract. As we will see later open interest is an important feature when deciding which option to trade.

At this point I need to introduce another warning. If you are relying on yesterday’s paper for your information you are doomed to failure. The trading of options requires access to real-time information. As we will see later, this real-time information will also need to include a great deal more than simply price.

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