Free Investment Advice

If you’re trading stocks or bonds, there are a whole range of strategies you can follow, which range from the long term buy and hold, right through to day trading using technical analysis. Options trading is very similar.

Understanding exactly what an option is one of the trickiest things to understand when you’re starting out. Here’s a 101 to bring you up to speed.

Basically, an option is a contract that gives you the right to buy (a call option) or sell (a put option) a stock or bond at a set price (the strike price) on or prior to a set date (the expiration date). You might need to read that a few times to get the hang of it!

There are different types of options available in the marketplace, with ‘American’ options able to be exercised anytime between purchase and expiration, and ‘European’ options only able to be exercised on the expiry date. Although the terms are geographical, nowadays the location where you buy options doesn’t automatically mean you’ve bought one type or the other. As a general rule of them, American-style options are mostly used for stocks and bonds, whereas European-style options are for indexes.

Officially, options expire on the Saturday after the third Friday of the expiry month of the contract.

However as US markets are shut on Saturdays, that makes the Friday the effective expiry day. Talk about confusing!

Now that you have a basic understanding of what an option is and how it works, let’s take a look at some basic strategies. I’ll just focus on American-style options for stocks.

When you buy or sell an option, you basically have two choices - you can hold it to maturity, or you can choose to exercise it prior to expiry. A large proportion of investors do hold their options until maturity before exercising it to trade the underlying asset. Let’s look at an example.

You’ve purchased a call option for $1, with a strike price of $25. As options contracts are generally for 100 share lots, your purchase (ignoring commissions) would cost you $100, and you’d have the right to purchase $2500 of stock through the option. Now, if the expiry date arrives and the stock is worth $27, it makes sense to go ahead of buy the stock, because you only have to pay $25. That means you’ve made an immediate profit of $2 per share if you sell them again immediately on the stock market. However you still have to factor in what you paid to buy the option, which was $1 a share. So after your purchase costs are deducted, your overall profit is $1 a share. Well done!

But what happens if the share price doesn’t hit $27 - or even $26, which is your breakeven point for this option. Well, if there is still time to expiry and the share price is above $26 but appears to be dropping, it may be a good idea to exercise the option immediately so you can get out of the contract without loss. If the share price is under $26, you might still be able to sell the options for a smaller amount than you paid, for example 20c a share, and recoup some of your losses. If the option is now worthless, you basically just let the contract run in the hope that the price might jump up again, but accept that you’ve lost your $100. One of the good things about options is that you’ve only bought the option to purchase or sell - you’re not under any obligation to do either upon expiry. So your risk is limited to the amount you spend buying the option in the beginning.

One thing to be aware of is that option prices aren’t just influenced by the price movements of the underlying assets - they’re also affected by their time to expiry. As the expiry date approaches, option prices tend to drop rapidly. So if you have an option that you don’t want to hold until expiry, it may be worth selling out early to avoid being too badly hurt by the price dropping as expiry approaches.