Back to basics: what is an option?

Just when you’d thought you knew it all about trading, we’re throwing another term at you. 

You’ve read up on shares, you know the difference between trading and investing, and you certainly know how the stock market works – you even understand the Stonk meme now for real. 

So what the hell is an option? 

Understanding options trading

An option is a contract between two parties, that allows an investor to buy or sell a security at a predetermined price over a certain period of time. For the investor (or the ‘taker’) to cash in on the deal, they pay a premium to the writer (or the ‘seller) of the contract. Think of a premium like a down-payment you might place on a house or a car. Or, if you’re a Gen Z, maybe your first AfterPay payment, because Gen Z can’t afford houses. 

(Go ahead and read more about that here). 

Don’t get it twisted though – options are not the same thing as shares, given they don’t represent ownership in a company. There are two types of options to choose from: call options and put options. 

Call options 

Call options give the investor/taker the right (but certainly not the obligation) to buy said shares at a predetermined price. 

Example: The ASX has put it (relatively) simply for us. Here’s their take. “Assume Santos Ltd (STO) shares have a last sale price of $14.00. An available 3 month option would be a STO 3 month $14.00 call. A taker of this contract has the right, but not the obligation, to buy 1,000 STO shares for $14.00 per share at any time until the expiry*. For this right, the taker pays a premium (or purchase price) to the writer of the option. In order to take up this right to buy the STO shares at the specified price, the taker must exercise the option on or before expiry.”

Put options 

A put option is basically a 180 switch. 

An investor gains the right to to sell a certain amount of shares of a certain security, at a (you guessed it), predetermined price at a predetermined time. 

(Take a shot every time we say ‘certain’. General advice only.) 

Example: Coming back at you with the ASX examples here. “An available option would be a STO 3 month $14.00 put. This gives the taker the right, but not the obligation, to sell 1,000 STO shares for $14.00 per share at any time until expiry. For this right, the taker pays a premium (or purchase price) to the writer of the put option. In order to take up this right to sell the STO shares at a specified price the taker must exercise the option on or before expiry.”

What are the advantages of options trading?

Managing risk 

We’ll cover risk management soon in the OMG Blogosphere, don’t you worry. But for now, we’ll say this: put options allow you to essentially take out an insurance against a fall in share price.  There will always be risks, however – an expensive options contract, for example, is an option with a high level of uncertainty, meaning the market is volatile for that particular asset and therefore more risky. But we’ll get to volatility, too. 

Options are more resilient 

Options (generally) are more resilient to changes in market prices, meaning you can capitalise on equity rising or dropping over time without investing in it directly. With a call option, you’ve got time until the contract expiry date to decide whether or not you exercise that option and buy the shares. The same goes for the taker of a put option. 

Diversification

Options trading can help you build a diversified portfolio for a lower initial outlay, rather than purchasing shares directly. What a win. 

We’ve thrown a lot of terms at you today. We hope you’re okay. 

If you’re feeling ready to throw your hat in the ring, how about saving some dollar dollar bills with a free 2 months of OpenTrader? Signing up out of principle is still a reason to sign up. Probably.