What Exactly Are Options?
An option is a contract, between two parties, a buyer and a seller, that gives the buyer the right, but not the obligation, to buy or sell an underlying asset—like a stock or an ETF—at a predetermined price, on or before a specific date.
The buyer pays a 'premium' for this right, which the seller collects. This simple mechanism unlocks a world of strategic possibilities, from protecting your investments to speculating on market direction with leverage.
Who Uses Options?
While once the domain of professionals, options are now used by a diverse range of participants for sophisticated financial operations.
Institutional Investors
Investment banks, hedge funds, and asset managers use options to execute complex strategies, hedge portfolios, and generate returns (alpha) in ways not possible with stocks alone. Everything from reducing market risk to capitalising on price movements.
Corporations & Businesses
Companies use options to manage real-world financial risk. An exporter might use currency options to lock in a favorable exchange rate, while a mining company could use them to hedge against a fall in commodity prices.
Retail & Private Investors
Thanks to exchange-traded options, sophisticated tools are now accessible to everyone. Private investors use options for the exact reasons we'll cover: to generate income, hedge their own portfolios, and speculate on market moves.
What are Options Used For?
Options are the most diverse financial instruments and have a purpose for many portfolios. Whether you want to speculate on price, reduce risk or increase yield, there is a solution available.
Generating Income
Earn income by selling Options. Investors receive a premium up-front when the strategy is opened.
Hedging and Managing Risk
Assist investors in protecting their portfolio from a drop in value of a share or the market.
Speculation & Leverage
Profit from your view of market movements. Navigate the rise and fall of the markets using a range of Options strategies.
The Two Types of Options: Calls & Puts
Call Options (A Bet on the Rise)
A Call Option gives the holder the right to buy an asset at a specific price (the strike price). You buy calls when you are bullish and expect the underlying stock price to go UP.
Put Options (A Bet on the Fall)
A Put Option gives the holder the right to sell an asset at a specific price. You buy puts when you are bearish and expect the underlying stock price to go DOWN.
The Language of Options
Get familiar with the core concepts that form the building blocks of every options strategy.
Strike Price
Moneyness (ITM, ATM, OTM)
'Moneyness' describes the option's strike price relative to the current price of the underlying stock. It tells you if exercising the option would be profitable right now (ignoring the premium paid).
- In-the-Money (ITM): The option has intrinsic value. A call is ITM if the stock price is above the strike. A put is ITM if the stock price is below the strike.
- At-the-Money (ATM): The strike price is (very close to) the current stock price.
- Out-of-the-Money (OTM): The option has no intrinsic value. A call is OTM if the stock price is below the strike. A put is OTM if the stock price is above the strike.
Intrinsic & Extrinsic Value
An option's premium (its price) is made up of two components:
- Intrinsic Value: The amount by which an option is In-the-Money. It's the real, tangible value you'd get if you exercised it immediately. OTM options have zero intrinsic value.
- Extrinsic Value (or Time Value): This is the portion of the premium above the intrinsic value. It represents the 'hope' or probability that the option will become more profitable before it expires. It's influenced by Time to Expiration and Implied Volatility.
Formula: Option Premium = Intrinsic Value + Extrinsic Value
The Greeks (Risk Metrics)
"The Greeks" are a set of calculations used to measure different factors that affect the price of an option. They are essential for risk management.
- Delta: Measures how much an option's price is expected to change for every $1 move in the underlying stock.
- Gamma: Measures the rate of change of Delta. It shows how much Delta will change for a $1 move in the stock.
- Theta: Measures the rate of time decay. It shows how much value an option loses each day as it approaches expiration.
- Vega: Measures sensitivity to Implied Volatility. It shows how much an option's price changes for every 1% change in IV.
Open Interest
Volatility Skew
American vs. European Options
- American Style: Can be exercised at any time up to and including the expiration date. Most single-stock options on the ASX are American style.
- European Style: Can only be exercised on the expiration date itself. Index options, like those on the XJO, are typically European style.
The Two Sides of a Trade: Buyer vs. Seller
Every options contract has a buyer and a seller. Many market participants have a different purpose for their buys/sells, which creates liquidity in the market. One Investor might buy a put to protect their stock investment, whilst another sells a put to collect premium
The Option Buyer (Taker)
Pays a premium to acquire the rights of the options contract. They are betting on a significant price move.
- Goal:
- Profit from a large move in the stock price (up for calls, down for puts).
- Max Profit:
- Unlimited for a call buyer. Substantial for a put buyer (stock price to zero).
- Max Risk:
- Limited to the premium paid for the option. You can't lose more than your initial investment.
- Probability:
- Generally has a lower probability of success, as time is against you and need to cover the premium to break-even.
The Option Seller (Writer)
Collects the premium up up-front from the buyer in exchange for taking on the obligation of the contract.
- Goal:
- Profit from the option premium decaying. This happens over time, with IV crush and the further OTM the contract becomes.
- Max Profit:
- Limited to the premium received when the option was sold.
- Max Risk:
- Substantial or unlimited.
(Note: This risk is generally managed with other positions to limit losses.) - Probability:
- Generally has a higher probability of success due to time decay (Theta) favouring option sellers.
Implied Volatility
Implied Volatility (IV) is one of the most critical concepts in options pricing. It's not a measure of past price movement; it's the market's forecast of how much a stock's price is likely to move in the future.
Think of it as the "fear gauge" or "expected movement" for a stock. High IV means the market expects big price swings (leading to expensive options), while low IV suggests less velocity of movement (leading to cheaper options prices).
How traders assess IV: To determine if IV is high or low, traders don't just look at the absolute number. They compare it to its own past behaviour using metrics like IV Rank and IV Percentile, and also compare it to the stock's actual price movement (Historical Volatility).
Reading the Option Chain
The option chain is the menu where all available contracts are listed. Learning to read it is essential for finding and placing your trades.
| CALLS | STRIKE | PUTS | ||||||
|---|---|---|---|---|---|---|---|---|
| LAST | BID | ASK | VOLUME | PRICE | LAST | BID | ASK | VOLUME |
| 2.55 | 2.50 | 2.56 | 120 | 48.00 | 0.04 | 0.03 | 0.04 | 540 |
| 1.60 | 1.58 | 1.62 | 350 | 49.00 | 0.10 | 0.09 | 0.11 | 890 |
| 0.80 | 0.78 | 0.81 | 1,500 | 50.00 | 0.30 | 0.29 | 0.31 | 1,250 |
| 0.35 | 0.33 | 0.36 | 980 | 51.00 | 0.82 | 0.80 | 0.83 | 410 |
| 0.12 | 0.11 | 0.13 | 650 | 52.00 | 1.55 | 1.53 | 1.57 | 220 |
This is a simplified example for a stock trading at $50.25 with a specific expiry date.
Typically, Calls are on the left and Puts are on the right, with the Strike Prices running down the middle. You can see the bid/ask prices to know what you can buy or sell an option for, and the volume shows how many contracts have traded that day.
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