The Basics

In Australia we talk about Exchange Traded Options (ETO's) that are settled via the OCH (Options Clearing House). However, Options are used across the globe in almost every type of industry and although the exact details are different, the concept remains the same; When Options are traded there is an agreement between the buyer and a seller of an asset - they agree on a premium paid for the right to transfer the asset.

For our purposes we will talk about ETO's. They are used in a variety of different ways. The main ways of using ETO’s are:

• Acting as insurance for shares;
• Profiting on Share price movement by Option trading, and;
• Fixing a purchase price.

There are two different types of options; Call option contracts and Put option contracts. You pay a premium for the right, but not the obligation, to buy shares of the Stock at the specified strike price on or before the specified expiration date. After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell the shares to you at the specified price when you request. A Put option is the opposite, if you believe the price of the stock is going to fall you would buy puts, they give you the right, but not the obligation, to sell the shares at the specified price. Puts are an excellent way of providing insurance if you hold shares in a stock and want to protect the downside without selling your position, if for example you wanted to retain the stock for dividend or capital gains purposes.

The difference between 'right' and 'obligation' is very important. It means that you are able to limit your losses to the amount that you originally spent to purchase the options. Compare this to other forms of leveraged products such as Contracts for difference (CFDs) or margin lending where your exposure is continuous and unlimited until you exit the contract. With an option, if you are in a losing position the worst case scenario is that you can simply let the option expire 'worthless'.

It is also important to note that you do not need to own, nor intend to own, the underlying stock to trade Options. As the options are traded on the exchange there is always a buyer or seller available for the option series. Therefore you can realise gains or losses as long as the market is open.

Options contracts are sold in lots of 1,000 shares (for most of the listed companies) and each contract has a specific strike price (series). For example BHP Billiton Limited’s (BHP) option series are at 50c intervals. For each Call option there is a corresponding Put option. There are also different series for different months. BHP has an option series that expires every month whereas a stock such as Rinker Limited (RIN) may only have options every 3 months. If a Stock becomes popular then a new series can be introduced if there is demand. You will also see that on the last Friday of the month there is a spike in the volume of traded shares for those stocks with options series that expired the day before as the contracts are settled.