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Exchange Traded Options Johnston Investment Management Pty Ltd does not give investment advice and we are not recommending the trading of options. The product/s you trade should be your personal choice after you have investigated every aspect of trading it. Our objective is to educate our clients and provide an effective futures brokerage service, as we believe that you are the best person to manage your investments and future. It's our goal to give people an unbiased view of all the trading vehicles available, including options. The options market is marketed to be a limited risk and unlimited profit potential trading vehicle. This concerns me as this may be true in theory when buying options, the reality is often different as most options end up worthless. For the knowledgeable trader with good trading skills, the options market can be very profitable. Our clients who have made the highest percentage profits are options traders. For inexperienced traders the trading of options can be very difficult because of the particular trading skills needed to capture profits in this volatile market before the asset wastes away. An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock (equity). In the case of an index option, its value is based on the underlying index. Both the purchase and sale of options involve a degree of risk and are not suitable for all investors. Options transactions should be entered into only by investors who understand the nature and extent of their rights and obligations, and are aware of the risks involved. An investor should not purchase an option unless they are able to afford a total loss of premium and transaction costs, and should not sell an option unless they either own the underlying security or are able to sustain substantial financial losses. Buyers (Takers) The buyer has the right, not the obligation, to purchase the underlying security at a specific price within a specific time period. Theoretically, the profit potential is unlimited, while the risk is limited to the amount paid for the option. Sellers (Writers) The Seller has the obligation to deliver the underlying security at a specific price within a specific time period if exercised against. Theoretically, the profit is limited to the premium paid and the risk is unlimited. Option Clearing House The Options Clearing House is the central organisation through which all options are traded. The rules of the Australian Options Market requires that an investor have an account approved by a clearing member of The Australian Options Market before being permitted to take (buy) or write (sell) options. The client's broker is required by the Exchange to obtain information as to the client's investment objectives and financial situation, so that their suitability for trading in options can be assessed. Some Clearing Members may impose their own additional requirements, such as a minimum amount in a client's account, before approving clients for options trading. Clients are required by the Exchange to agree that they will abide by the Rules of the OCH. Expiry Dates The expiry date is usually the last Thursday before the last Friday of the expiry month unless the OCH determines another date. Puts And Calls Options come in two primary forms. They are calls and puts. A call option gives the holder the right, not the obligation, to buy 1000 shares of the underlying stock at a fixed price and for a fixed period of time. Traders buy calls to profit in a rising market. A put option gives the holder the right, not the obligation, to sell 1000 shares of the underlying stock for a fixed price and for a fixed period of time. Traders buy put options to profit in a falling market. This is why an option is considered to be a 'wasting' asset. Since the option only has value for a fixed period of time, its value decreases, or 'wastes' away with the passage of time. In the case of an index option, the holder can participate in the movement of the index. However, these options are cash settled and therefore, the holder of the option will never wind up with a position in the underlying securities. The Four Components To An Option Once the Security is selected, there are four components to an option. Three Fixed and one variable: Fixed : The number of shares, the strike price, and the expiration date. Variable : The premium (Price)
There are two different types of options with respect to expiration. There is a European style option and an American style option. The European style option cannot be exercised until the expiration date. Once an investor has purchased the option, it must be held until expiration. An American style option can be exercised at any time after it is purchased. Today, most stock options which are traded are American style options. And many index options are American style. However, there are many index options which are European style options. An investor should be aware of this when considering the purchase of an index option. At-The-Money, In-The-Money, Out-Of-The-Money There are three different terms for describing where an option is trading in relation to the price of the underlying security. These terms are 'at-the-money', 'in-the-money', and 'out-of-the money'. Knowing which one of the above to trade is important, as it will affect the volume, volatility, percentage price movement and your trading style. In short 'in-the- money' are less volatile and more expensive, and ' out-of-the-money' are more volatile and less expensive. Intrinsic Value The price difference between the underlying security and the option's strike price is the intrinsic value. Time Value Time value is the amount by which the price of the option exceeds its intrinsic value. Intrinsic Value + Time Value = Option Price What is Influencing the Price of an Option There are four major factors which determine the price of an option. They are:
An options price decays each day it is in existence. Further, the closer the option gets to expiration, the faster it decays Volatility The volatility part of the pricing model is a measure of the range the underlying security is expected to fluctuate over a given period of time. The measurement of volatility is the standard deviation of the daily price changes in the security. The more volatile the underlying security, the greater the price of the option. Delta Delta is the rate of change of an option premium relative to the price of the underlying security. There are many different option pricing models in practice. However, the original breakthrough was in the Black-Scholes model. It was a model for pricing options before options were widely traded. The original Black Scholes model worked primarily for European style options. However, it has been modified to work with American style expiration. There are several option pricing models around today, but the fact remains, that an option is only worth what a buyer and seller agree to trade at. It doesn't matter what someone thinks it is worth. Understanding how to manage your trade entry and exit in options is a vital part of your option trading skills.
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