Over the last couple of weeks, we’ve taken a look at the two main types of options. These are call options and put options.
If you recall, a call option gives the buyer the right to buy shares in a company for a specified price (called the exercise or strike price) at any time until the option expires.
The person who sells this call option to them, the option ‘writer’, takes on an obligation. They must hand over the shares at the strike price if the call option buyer exercises their option. For taking on this obligation, the option writer receives a premium.
A put option gives the buyer the right to sell shares in a company for a specified price (also called the exercise or strike price) at any time until the option expires. As with a call option, the put option writer receives a premium for taking on this obligation.
If the put option buyer exercises their option, the put option writer must buy the shares at the exercise price, even if the shares are trading much lower.
Irrespective of whether the option is a call or a put, the rights are with the option buyer. The obligation is always with the option writer/seller.
An option is a contract. To enable an option contract to readily trade on an exchange, it needs to be standardised. This way, both the option buyer and seller understand their rights and obligations. This is where it can get a little confusing.
However, by breaking an option contract down into its basic components, you’ll soon become familiar with option market jargon. Before you know it, you’ll be using these option phrases yourself.
There are a handful of specific features that make up a share option. Let’s now look at their key components:
- Underlying security — this is the share over which the option is being traded. It could be AMP [ASX:AMP], CBA [ASX:CBA] or Origin [ASX:ORG].
- Type of option — can be either a call option or a put option. You know the difference between these two already.
- Exercise price — also referred to as the ‘strike’ price. This is the price at which the option buyer can exercise their option if they choose.A call option with a strike price of $10 enables the call option buyer to purchase the underlying shares at $10 until the option expires. A put option with a strike price of $20 enables the put option buyer to sell the underlying shares at $20 until the option expires.
There are normally multiple exercise prices available on options contracts. Most of the volume will typically take place on options with prices closer to the current share price.
Using AMP as an example, with the current share price around $5.75, strike prices would typically be set at 25 cent intervals, although this may vary. These strike prices in near dated options will be set at $5.00. $5.25, $5.50, $5.75, $6.00, $6.25, $6.50 and beyond. The further the strike price is way from the current share price, the less liquid it will be.
- Contract size — on the ASX, a standard share option is for 100 shares per contract. So, one contract equals 100 shares; 10 contracts equal 1,000 shares of the underlying security.This can vary though if the company has undertaken a rights issue for example. The ASX needs to ensure that any adjustments to a company’s share structure doesn’t adversely affect either the option buyer or seller.
For example, Origin recently undertook a capital raising which affected both the strike price levels and the number of shares in an Origin options contract. Origin option contracts expiring in January have 115 shares in each contract.
- Expiry date — all options have an expiry date. This is simply the date at which the option expires, which is fixed by the ASX. With share options, this is the Thursday before the last business Friday of the expiry month. Sounds a bit long winded doesn’t it?But whenever you place your options trade on your platform it should tell you the exact day of expiry. You can also readily find this information on the ASX website.
- Premium — this is the price that the option trades at. That is, the price at which the buyer and seller are matched. You’ll see this quoted on a cents per share basis. For example, an option might trade at a premium of say 20 cents. That means that if you bought one contract it would cost you $20. That’s 100 shares per contract times 20 cents per contract.
That covers the components that make up an option. By breaking an option contract into these individual parts, you won’t find the jargon confusing. In the coming weeks, I’ll go into more detail on the mechanics of an options trade and what drives option pricing.
Editor, Options Trader