Equity options are contracts between two parties, giving the buyer the right – but not an obligation - to buy or sell an underlying security at a ‘locked-in’ price at some point in the future.
Options are often used by investors to protect against falls in the value of a share portfolio, and to generate income. The ability to use options regardless of the market climate make them popular with many investors.
Options are issued by and traded on ASX. They are similar to futures, in that they enable you to ‘lock in’ a future buy or sell price for an underlying security – usually shares in individual companies or a market index like the S&P/ASX 200. The difference with options is that there is no obligation to buy or sell the security.
Options traded on ASX have standardised contracts and are settled through ASX. This is unlike ‘over-the-counter’ options which are traded directly between parties, involve counterparty risk and have varying contract terms.
Acquiring an option involves the buyer (usually known as the ‘taker’ or ‘holder’) paying a premium to the seller (usually known as the ‘writer’). The seller generates income upfront from the premium but must also deliver the underlying securities if the option is exercised. Depending on the style of option, the taker can exercise at any time prior to expiry (American style) or only at expiry (European style).
Call and put options
There are two types of options. 1. Call options - these give the buyer the right to purchase the underlying security. 2. Put options - these give the buyer the right to sell the underlying security. This allows investors to potentially benefit from both rising and falling markets. Find out more about option strategies.
No obligation to exercise
While options give you the right to buy or sell an underlying security, there is no obligation to do so. If the security does not perform as expected, you can simply let the option expire. The most you can lose is the initial premium paid to the option writer.
Earn income from your shares
You can earn additional income from the shares you already own by writing options against them as you can generate income upfront from the premium. However, you will be obliged to deliver the shares if the option is exercised.
Hedge against share price falls
Options can be used to offset potential falls in share prices, by taking put options to guarantee the sale price of your shares for the life of the option, no matter how low the share price may drop.
You can end an options contract early without exercising the option by ‘closing out’. This typically involves taking what is known as an offsetting position. For example, if you had taken a call option, you would write an equivalent call option to close out the position. Both takers and writers can close out their positions at any time.