What is options trading?

Options trading refers to buying and selling derivative contracts called options. Although it may seem confusing initially, anyone can learn how to use options to their advantage.

Let's take a look.

Introduction to options trading

An options trader buys and sells a type of financial instrument called an option. An option is a derivative contract, which means it derives its value from an underlying asset or benchmark. In the case of an option, the underlying asset is usually a company share. But, as we'll soon find out, it can also be an exchange-traded fund (ETF) or even an index.

Options contracts give the holder the right – but not the obligation – to buy or sell a particular company's stock for a predetermined price (called the 'exercise price') on or before a specific date (the 'expiry date'). As the price of the underlying share changes, it will affect the option's value. This allows investors to make a profit by trading it.

However, options trading isn't always just about turning a profit. You can also use options to hedge against potential losses in your portfolio. This means that strategic options can help minimise your portfolio's risk.

Put and call options

There are two types of options: puts and calls. 

Buying a put option gives you the right to sell the underlying security for a given price within a specific timeframe. Buying a call option, on the other hand, gives you the right to buy the underlying asset for a given price within a specific timeframe.

Options allow investors to make strategic bets on how they think the underlying asset will perform in the future. For example, if you think a share's price will rise, you could buy a call option with an exercise price at or below the stock's current price. If the stock price goes up, the value of your option will increase. 

This is because it gives you the right to buy the share from the option seller at a lower price than its current market price. If you exercise the option, you can lock in an instant profit by buying the shares for the price specified in the option contract from the option seller – and then selling them straight away on the open market.

The above example also highlights another crucial part of any option. It is a contract between two parties: a buyer and a seller. If the option buyer chooses to exercise their option, it forces the seller to enter into a transaction with them – to either buy or sell the underlying asset. 

This means that an option contract is always a zero-sum game: one party to the contract wins while the other party loses.

What are the four types of options trading?

You can trade put and call options on three different underlying assets: shares (also called equities), ETFs, and market indices such as the S&P/ASX 200 Index (ASX: XJO). A fourth option type is a low exercise price option (LEPO). This can give you exposure to certain shares at little to no upfront cost.

Equity options 

Equity, or stock options, are options on shares of individual companies. Traders who buy and sell stock options speculate on the future price performance of a specific company's shares.

If you are options trading in Australia, you are only permitted to trade equity options on ASX-approved companies. And remember, holding a call option does not mean you receive dividends or have any of the voting rights of ordinary shareholders. Only once you exercise your option and take ownership of the underlying shares will you get any of those benefits.

ETF options

These trade just like equity options but allow you to speculate on the price performance of certain exchange-traded funds. 

ETFs are funds set up to mirror the returns of specific indices or market sectors. Trading ETF options can be an excellent way to bet for or against specific sectors in the market or certain investment strategies that individual ETFs may represent. 

For example, you might think the market value of tech stocks might fall in an inflationary environment when interest rates rise. In that case, you could buy put options on a tech stock ETF to profit from a potential decline in the fund's value.

Index options 

While similar to equity and ETF options, index options allow you to speculate on the performance of a particular index, like the ASX 200.

However, index options and ETF and equity options have a few key differences. Firstly, they can only be exercised on the option's expiry date, as opposed to equity and ETF options, which can be exercised at any point up to expiry. 

Secondly, index options are only settled in cash, whereas equity and ETF options result in a transaction between the option holder and issuer involving shares of a company or units in an ETF.

Low exercise price options

LEPOs work differently from equity, ETF, or index options. Firstly, LEPOs are only available as call options on stocks or indices. Secondly, they are designed to closely track the underlying asset's price.

LEPOs typically have a very low exercise price (think as little as one cent per share). Because the exercise price is so low, the 'premium' (the price you must pay) for LEPO options is high. However, you aren't required to pay the LEPO premium upfront. Instead, you make margin payments throughout the life of the LEPO.

Because LEPOs trade close to the underlying asset price but don't require an upfront payment to buy, they can offer investors a cost-effective alternative to margin trading.

Benefits of options trading

Some of the benefits of options trading are listed below.

Low cost: It is usually much cheaper to buy options than it is to buy the underlying shares. For example, buying 100 shares of CSL Limited (ASX: CSL) at $280 a pop would set you back $28,000. Rather than forking out that much for shares in CSL, you could buy in-the-money call options instead. 

'In-the-money' simply means you can exercise the options for a profit. So in the case of a call option, the strike price is less than the market price of the underlying share. The strike price is the price paid to buy or sell the underlying asset if the option is exercised. 

A deep-in-the-money call option will often perform similarly to the underlying asset. But it will usually only cost a fraction of the price. This can make options more cost-effective for gaining exposure to specific companies, ETFs, or even whole market indices.

Options can reduce your portfolio risk: You'll often hear options trading described as high risk. However, used strategically, options can also help to reduce your portfolio risk by operating as a hedge against potential losses.

For example, if you hold a particular share and are worried about a near-term fall in value (perhaps a contentious company report is set to be released this week), you could buy a put option on that stock. If the report contains bad news and the company's share price falls significantly, you can exercise your option and still sell your stock at the higher strike price. 

If the report contains good news and the company's share price rises, you can simply let your put option expire, thereby only losing the premium you paid for the contract. 

Higher (potential) returns: Because options cost less than buying the underlying asset directly, they can potentially magnify your returns. The payoff from a call option can be similar to what you'd receive by owning the underlying stock directly but at only a fraction of the outlay.

And the risks?

You can lose all your money: While options might offer a good way to supercharge your returns, they also come with some added risks. For example, it is possible that your option can quickly lose its value and even expire worthless (or 'out of the money'). In that case, you wouldn't choose to exercise your option, and you'd lose your entire premium.

This makes options riskier to own than the underlying shares. A company's stock price can recover over time, whereas an option is only valid until the contract's expiry date – which may only be a matter of months. And if you make a bad bet, that's all your money gone.

You can lose more than all your money: We've only really spoken about buying options so far in this article. Selling (or' writing') your option contracts on stocks is also possible. In this case, you are the party in the agreement required to act if the buyer exercises their option.

If you write a call option, and the stock price moves up instead of down, your losses are theoretically unlimited (and can put you in some severe financial strife!). This is because you are required to deliver the stock to the option holder at the end of the contract – and there is no limit to how high a company's share price could climb. 

The options market can be complicated: Although options trading is open to all investors, there's no doubt it can be confusing, particularly at first. Options can sometimes be challenging to get your head around, and you should be aware of your rights and responsibilities before becoming party to a contract.

How to start options trading in 3 easy steps

Apply for an options trading account with a broker: The first thing you'll need to do is open an options trading account with a brokerage. 

This differs from a share trading account and will often require extra documentation to ensure you fully understand the risks involved. Despite having to jump through a few extra hoops in the application process, it's never been easier to trade options, with many popular online brokers now offering options trading accounts.

Come up with a trading strategy: Before starting options trading, you should have a clearly defined strategy to help you achieve your investing goals. This is important as it will keep you focused as you execute your trades (and help limit your losses). Always do plenty of research before you begin trading.

Make your trades: Once you have an options account and have developed your trading strategy, you can start executing your trades. Always trade according to your plan, and only risk small amounts on safer bets – especially when you're just starting out.

What's the best strategy…

The right strategy for you will depend on your goals, objectives, investing experience, and risk appetite. Some popular approaches are listed below. However, there are many others out there, and you should tailor one to your own personal situation.

For beginners

A good way to generate income from options trading is by following a 'covered call' strategy. This is when you write (or sell) a call option on a stock you already own. If the stock price rises, you will be obligated to sell the option holder your stock, but if the price falls, the option will expire worthless.

In this case, you hope the share price will stay relatively stable (or decline slightly). This means the option holder won't exercise their option (and you won't be required to sell any of your shares), and you'll pocket the option premium.

This can be an excellent strategy for a beginner if you have a portfolio of blue-chip or less risky stocks. The share prices of these shares are likely to be less volatile. This allows you to generate income from collecting the premiums without much risk of severe losses.

For safety

A 'protective put' strategy is one of the best strategies for options traders seeking safety. This hedging strategy can help protect your portfolio from significant losses. 

We described a protective put earlier in this article. It's when you own the underlying share but are concerned about a possible near-term loss in its value. In this case, you could buy a put option, which can help to hedge away some of that risk. If the share price falls, you get paid out on the option. If the share price rises, you'll still participate in that upside and only lose the premium you paid to buy the option.

For mega returns

Often, simply buying call options will be the highest-returning strategy. The gains are potentially unlimited, as there is (theoretically) no cap on how high a company's share price could rise.

In volatile markets where a company's share price may move dramatically, but you're unsure in which direction, you can follow a 'long straddle' strategy. This involves simultaneously buying a call and a put option on the same stock with the same exercise price and expiry date. The gains on this are also theoretically unlimited. The most you have to lose is the premiums paid for both contracts.  

Options trading versus share dealing

As we've explored in this article, there are plenty of benefits to options trading that share trading simply can't offer. Options trading can be more cost-effective, it can limit your portfolio losses, and it may even magnify your potential returns. However, there are also drawbacks, including additional risks.

Before starting out in options trading, carefully consider whether it is right for you. Learning about options can take significant time and often requires you to be able to closely monitor the markets. Make sure you have the free time available to commit to this strategy.

And remember, you don't have to choose one or the other. Options can always be combined with a share trading strategy to deliver higher returns and better manage your risk.