Getting Started with the Basics

For those getting started in options, one of the first things they learn about are call options.

It is not surprising really. To most who come to options trading via the share market, buying a call option is something that seems familiar.

The aim of buying shares and call options is similar. Essentially, the buyer of either wants to profit from an increase in the share price.

There are, however, important differences. Unless the call option buyer exercises their option, they never take delivery of the underlying shares.

Meaning, that they miss out on any dividends (and associated franking credits) if the company pays them during the lifetime of the option.

There are also other differences. Although, they probably matter less to a private trader than an institution. For example, the buyer of a call option doesn’t have any voting rights over the underlying shares.

The biggest difference, though, is the financial commitment. The moment you buy shares, you must settle the trade two days later. That is when you have to hand over the full value of the shares.

When you buy a call option, however, you don’t have any such obligations. It is up to you if you want to exercise your call option and take delivery of the shares. Only then do you have to hand your money over.

If you decide not to exercise your call option, all you lose is the premium you paid. In essence, the call option gives the buyer exposure to a move without risking the full amount of buying the shares.

And if the share price rallies, they can sell the option for a profit. In doing so, they never have to own the underlying shares.

Always a tradeoff

Of course, if buying a call option was superior to buying the shares outright, everyone would buy call options instead.

But buying a call option comes with its own limitations. Because all options have a finite life, time is constantly ticking against them. Once an option expires (without being exercised), it ceases to have any value.

The other thing is the breakeven price. If you buy shares at $5, they only need to increase one cent for you to be in profit.

If instead you buy a $5 call option for 15 cents, the share price needs to rally above $5.15 before you make any money. That’s because you need to recoup the cost of the option.

When you buy a call option, not only does the share price have to move higher before you break-even, it also has to happen before the option expires. Something much easier said than done — particularly if the market takes a tumble in the meantime. 

With time continually ticking away, the time value of an option decreases every day. This time decay does not erode evenly.

Getting your timing right

Time decay accelerates the closer you get to expiry. Roughly, an option loses two-thirds of its time value in the last half of its life.

Because of that, option buyers often close out their positions well before expiry. That is, before this time decay starts accelerating against them.

Those that write options — that is, those whose initial position is to sell an option (not closing a previous bought option) — want to capture as much of this time decay as possible.

That’s why they look to write options in the latter part of its life. Even if the share price trades sideways, or even increases slightly, the eroding time value reduces the value of the option.

And that is what an option writer is trying to capture. They want to write (sell) an option at a higher price, and watch its value decrease every day. If the option runs into expiry without exercise, all the premium generated from the option is theirs to keep.

Spruce up your income

By writing call options over their shares, an investor can effectively double their income stream. That is, the regular dividends they receive…plus the premium from writing options. If they get it right, they can generate more income from writing options than they do from dividends.

With options, though, you always need to understand your obligations. When you buy an option, you are gaining a right to do something. You don’t have to do it — the choice is always yours.

However, when you write an option, you are taking on an obligation. That is why you receive a premium.

Writing a put option means that you have to take delivery of the shares (if exercised). And if you write a call option, that means you have to hand over the shares if the call option buyer exercises their option.

The call option writer is obligated to hand over the shares at a fixed price (the option strike price), even if the share price rallies in the meantime. While they might generate income form writing the call option, they are potentially missing out on further gains in the share price.

Sometimes options can all sound a bit confusing. But if you work your way through the basics, you can see how options are one of the most useful tools in the market.

All the best,

Matt Hibbard
Editor, Options Trader

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years. Matt researches income investments. You can find more of Matt’s work over at Total Income, where he is hunting down the next generation of dividend-paying companies for the future. He is also the editor of Options Trader, where he uses basic options strategies to generate additional streams of income beyond the regular dividend payments. Having worked for himself and with global firms for almost three decades, Matt has traded nearly every asset in existence. But now he is on a very different mission — to help investors generate income irrespective of what the market is doing. It’s about getting companies to pay you a steady, stable income, with minimal stress and the least risk possible. Matt doesn’t believe you have the luxury of being a bull or a bear in the market right now. You have to earn an income from it, regardless of whether stocks are going up or down. By getting the financial markets to pay you an income, you can get to focus on more important things than just money.

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