guide to options trading new - nzx to options... · a guide to options trading 3 of 9 what are...

Guide to Options Trading NZX Derivatives Market

A GUIDE TO OPTIONS TRADING 2 of 9

CONTENTS

WHAT ARE OPTIONS? 3

COMPONENTS OF AN OPTION 4

ADVANTAGES OF TRADING OPTIONS 5

PAYOFF DIAGRAMS 7

GLOSSARY 9

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WHAT ARE OPTIONS? An option is simply the right of the buyer, and obligation of the seller, to buy or sell an asset at a specific price (the exercise or strike price) at any time within a specified time period (American style). NZX equity options relate to an underlying equity security and contain the right to buy or sell that particular security.

There are two types of options traded - call options and put options. Call options give the buyer the right but not the obligation to purchase the underlying asset at a set date in the future at a price set today. Put options give the buyer the right but not the obligation to sell the underlying asset at a set date in the future at a price set today.

For example, one October call option over Telecom Corporation of New Zealand Limited (“Telecom”) ordinary shares with an exercise price of $2.50 gives the buyer the right, on or before the expiry date of October, to buy

shares in Telecom for $2.50 each. If this option is exercised the writer or seller of the option must sell Telecom shares to the option buyer for $2.50.

On purchasing an option, the purchaser pays the seller a premium, which is the cost of the option. The purchaser of the option is not obligated to exercise the option, and may even decide to sell it before it expires, or let it lapse.

Buying a call option allows you to lock in a purchase price for the shares. Purchasing a put option will enable you to lock in a selling price for your shares.

Call Option Put Option Buy Right to buy Right to sell Sell Obligation to sell Obligation to buy

COMPONENTS OF AN OPTION • Underlying Asset: The underlying asset

of an option is what is delivered if the option is exercised. This could be shares or commodities. For example, options traded on the NZX Derivatives Market are issued over shares such as Telecom Corporation of New Zealand Limited, Fletcher Building Limited, Trade Me Group Limited and the Whole Milk Powder futures contract.

• Exercise Price (Strike Price): This is the price you receive, or pay for the underlying asset (i.e. the shares) when you exercise your option. As the underlying asset’s price moves, new exercise prices may be listed. For example, if you are the buyer of a $2.50 TEL call option, when you exercise that option you are entitled to purchase those shares from the option seller at a price of $2.50.

• Premium Option buyers pay a price for the rights

contained in the option known as the premium, which includes the intrinsic and time value of the option. The intrinsic value of an option will reflect the difference between the price of the underlying asset and the option’s strike price, whilst the time value will decrease as the option nears expiration. The premium is quoted per share so a premium of $0.05 on one contract representing 100 shares would equal $5.00.

• Contract Size: One option contract represents a unit size of the underlying, for example 100 shares, one tonne of Whole Milk Powder, or 10 futures contracts. In the case of NZX equity options each option relates to 100 shares.

• Expiry Date: This is the date at which all unexercised options expire. Each option has a range of different expiry months to choose from. As one month expires a new option with a later expiry date is created.


ADVANTAGES OF TRADING OPTIONS Income: By writing (selling) call options (covered calls) investors can earn income on the underlying asset that they hold. This is a popular strategy for those who hold shares, especially when investors expect the price of their shares to remain flat.

Example: Assume you own 10,000 shares in Telecom, which is trading at $2.50 in early January. You expect the current price to remain stable over the coming months and decide to write a call option to generate some extra income.

In this example; you write (sell) 100 July expiry $3.00 Call Options for a premium of $0.05/share. Remember one option contract equals 100 shares, so 100 options is equivalent to $10,000 shares.

As the writer or seller of the July $3.00 Call Options, this means you accept the obligation to sell your Telecom shares for $3.00 if the option is exercised. For this you receive the premium of $0.05 per share (10,000 shares * $0.05 = $500).

If at expiry, the share price is below $3.00 the option will expire worthless and you have earned $500 in extra income by selling the call.

If the share price rises above $3.00, the option will be exercised and you will have to sell your shares. Effectively you have sold your shares for $3.05 as this is the exercise price and the premium received. Whilst this strategy still returns a profit, you will not realize any further gains if the share price continues to rise.

$2.50*10,000 ($25,000) Cost Price of TEL Shares $0.05*10,000 $500 Call Premium Received $3 *10,000 $30,000 Sale Price of TEL Shares (($30,000-$25,000)+$500)

$5,500 Total Profit Received

Note that the above examples do not take into account brokerage and transaction costs, which will also be incurred when trading option contracts.

Protecting the value of your shares Put options allow you to protect your shares against a fall in value. By purchasing a put option you are able to guarantee the sale price of your shares for the life of the option, no matter how low the stock price may be.

Example: If in April you think the share price of Fletcher Building Limited (“FBU”) is going to fall from its current price of $6.50, you could purchase a FBU September $6.50 Put Option. In this example the put option premium is priced at $0.37/share. This option gives you the right to sell your FBU shares at the exercise price of $6.50 any time until the options expiry.

An advantage of this strategy is that you are not obliged to exercise the option. If the value of your shares increases, you will benefit from the price rise, and have only lost the put option premium.

If the price decreased from $6.50 to $6.00, a put option could have minimized this loss:

• April – FBU price is $6.50 • August – FBU price is $6.00 • Exercise September Put option in

August and receive $6.50 per FBU share

• Realised selling price – $6.50 - $0.37 = $6.13

In this example you receive an effective selling price of $6.13 for a FBU share. If you had not purchased an August put option you would have received an effective selling price of $6.00 per share, meaning the purchaser of the put option is $0.13 per share better off from purchasing a put option.


If the price of the price of FBU shares rose above $6.50 the put option would expire worthless and the total loss would be the cost of the put premium.

Directional Trading Options are an ideal way to profit from volatility in the market. Options allow you to capture price movements in the underlying asset without trading the asset itself.

Options over equity securities expose you to movements in the share price for a fraction of the cost of purchasing the shares themselves. As options require minimal initial outlay, you can gain leveraged exposure to share price movements and increase your returns.

An increase in the price of the underlying share may mean a greater percentage gain on the call option than the increase in price of the underlying share. Similarly, if the price of the underlying shares fall, the percentage loss may be greater on the call option than the percentage change in the value of the shares.

Example: Assume it is August and you believe the price of Trade Me Group Limited (“TME”) shares will appreciate over the next month. The following table provides an example of the returns from buying TME shares at $4.50 compared to buying a TME November $4.50 Call Option at $0.22. This comparison assumes the TME share price has risen to $4.80 and the price of a TME Call Option increases to $0.40.

SHARES NOVEMBER $4.50 CALL 15 August $4.50 $0.22 15 October $4.80 $0.40 Profit $0.30 $0.18 Percentage return 6.67% 81.82%

In this example the percentage return from buying the call option is greater than the return from buying the shares by 75.15% if selling the option. Buying the call option rather than the underlying shares also requires 4.9% of the initial capital outlay needed to buy the shares ($0.22 / $4.50 = 4.89%).


PAYOFF DIAGRAMS

Buy Call (Bullish) Suppose that ABC shares are trading at $10 and a 1 month call option with a strike price of $10 is trading at $1.50. You have a view that the price of ABC shares will rise in the next few weeks so you purchase a 1 month ABC $10 call option representing 100 underlying shares, costing you $150. If your view is correct and the price of ABC shares rallies to $14 per share you would profit $250. To achieve this profit you would exercise your right to purchase 100 ABC shares at $10 and then sell them on the market for $14 meaning you receive $400 in total. Your net profit from this transaction will be $250 after the initial cost of the option ($150) is subtracted from the $400 you receive. The return on investment (“ROI”) from the option is considerably higher at 167% compared to the ROI from selling the shares of 40%. The maximum total loss when buying a call is the cost of your premium i.e. $150.

Buy Put (Bearish) Suppose that ABC shares are trading at $10 and a 1 month put option with a strike price of $10 is trading at $1.50. You have a view that the price of ABC shares will fall in the next few weeks so you purchase a 1 month ABC $10 put option representing 100 underlying shares, costing you $150. If your view is correct and the price of ABC shares falls to $6 per share you would profit $250. To achieve this profit you would exercise your right to sell 100 ABC shares at $10 and then purchase them on the market for $6 meaning you receive $400 in total. Your net profit from this transaction will be $250 after the initial cost of the option ($150) is subtracted from the $400 you receive. The maximum total loss when buying a put is the cost of your premium i.e $150.

Profit/loss

-$150

$0

Underlying stock price

6 8 10 12 14

Profit/loss

-$150

$0


6 8 10 12 14


Write Call (Mildly Bearish) Suppose that ABC shares are trading at $10 and a 1 month call option with a strike price of $10 is trading at $1.50. You have a view that the price of ABC shares will fall slightly in the next few weeks so you write a 1 month ABC $10 call option representing 100 underlying shares, generating you $150. If your view is correct and the price of ABC shares falls to $9 per share the option would not be exercised, and you would profit $150, or the premium received for the sale of the call. This is a particularly risky strategy to undertake if you do not own the underlying shares, as losses can be unlimited if the stock price rises dramatically and you are obligated to sell at the agreed strike price.

Write Put (Mildly Bullish) Suppose that ABC shares are trading at $10 and a 1 month call option with a strike price of $10 is trading at $1.50. You have a view that the price of ABC shares will rise slightly in the next few weeks so you write a 1 month ABC $10 put option representing 100 underlying shares, generating you $150. If your view is correct and the price of ABC shares rallies to $11 per share the option would not be exercised, and you would profit $150, or the premium received for the sale of the put. This is a particularly risky strategy to undertake especially if you have not short sold the underlying stock, as losses can be significant if the stock falls dramatically and you are obligated to purchase it at the agreed strike price.


Profit/loss

$150

$0


6 8 10 12 14

Profit/loss

$150

$0

6 8 10 12 14


GLOSSARY

American style option: American style option contracts may be exercised at any time before the expiration date.

Call option: the right without obligation to purchase the underlying asset at the strike price.

Covered call: writing calls to generate revenue when an investor owns the underlying asset.

European style option: European style option contracts may only be exercised at the expiration date of the option.

Exercise/strike price: The price at which the underlying security can be purchased (call option) or sold (put option).

Intrinsic Value: The difference between the underlying stock’s price and the strike price of the option.

Put option: the right without obligation to sell the underlying asset at the strike price.

Time Value: The portion of the options premium that is attributable to the amount of time remaining before the expiration of the option.

Writing an option: selling the right to buy/sell an underlying asset at the strike price.

guide to options trading new - nzx to options... · a guide to options trading 3 of 9 what are...

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