When you buy shares, you’re buying a tiny part of a company that you hope will be more successful, so you’ll see your shares grow in value. Hopefully you’ll also earn money that’s paid out to you as dividends.

But beyond shares, you’ll find ‘derivatives’, called that because their value is derived from the value of the underlying shares.

One type of derivative is an equity option, which is traded on an options market. When you buy an option, you’re buying the right to buy or sell shares at a set price (the strike price). Your option is valid for a fixed period of time, until an expiry date.

At the expiry, you have the right to buy or sell the shares at the set price, but you don’t have to, and in fact might choose not to.

There are two types of equity options, ‘calls’ or ‘puts’.

A call is the right to buy shares and a put is the right to sell shares.

Like a deposit on a house

A call option is a bit like putting in an offer on a house and giving the owner a deposit.

That deposit allows you to buy the house at the price you agreed, say NZ$600,000.

You have a month to get your finance and decide it’s the right place for you.

If you change your mind – it turns out to be leaky – you could pull out. You’d lose your deposit, and the house deal would be called off.

But say a new CV came out while you were waiting to settle, and it said the house was now worth NZ$800,000, you’d probably go through with the deal. You could sell the house tomorrow and make NZ$200,000. You’d be silly not to.

You can see an opportunity (speculating)

In the case of shares, you might think that Apple has put out some cool phones that are selling well, so you expect their shares to go up in price. Apple is currently trading at around US$200.

You could buy a call option on Apple shares by paying a premium (the cost of the option) if you thought the price of Apple was going to go up.

You may decide to buy a US$210 call (US$210 being the strike price) if you think the price is likely to rise above US$210. This gives you the right to buy Apple shares at US$210.

You choose a timeframe. If you think the price will rise during the next month, you’d choose an expiry date one month away.

At the expiry date, if the price of Apple is trading above US$210, your option would be ‘in the money’ and you’d automatically buy the shares, or be ‘exercised’ on that option.

This means if you’re the buyer of the option, you’d buy 100 Apple shares at US$210. (1 option = 100 shares for US shares like Apple.)

If you were right, you might find that the price has gone well past your strike price of US$210, trading at, say, US$240. You can make a nice profit by selling your 100 shares at US$240.

Banking the profit

You could bank that profit, the difference between the US$210 and the US$240 on 100 shares, minus the cost of your option premium.

If Apple was trading below the US$210 strike price at the expiry date, your option would be ‘out of the money’ and would expire, worthless. All you’ve lost is the premium you paid for the option.

If Apple soared to US$400 instead of US$240, you’d bank a much larger profit.

Speculators will buy calls if they think prices will rise and puts if they think prices will fall.

While your risk is limited to the premium paid with bought options, there’s a lot more risk with selling options. If you’ve sold an option, you have an obligation to buy or sell shares if the option is ‘in the money’
at expiry.

If you had instead sold a US$210 call on Apple, you’d have given someone else the right to buy Apple shares at US$210. This means you’d have to sell Apple shares at US$210 when the market might be at US$240, or even higher.

To buy those shares back, you’d have to pay US$240 and you’d be cementing that loss.

Alternatively, if Apple was trading below US$210 at expiry, that sold call would be ‘out of the money’, and you would take no further action but get to keep the premium you received for selling it.

Uses for options

Aside from speculating, options may also be used for hedging or adding value to your portfolio. The idea of hedging is to manage the risk on your share portfolio.

Many fund managers use options to hedge their portfolios when they’re worried about a downturn in prices.

Put options can be very useful in this scenario.

You can buy put options if you think the price of a share is likely to fall. If it does fall, you offset the losses on your shares against gains on the value of your put options.

Put options

A put option is the right to sell shares at a given price, the strike price.

If you see a downturn coming in the market, you may want to keep holding your Apple shares, but you might buy a US$190 put, so if the share price did drop below US$190, you have the right to sell Apple at US$190. It’s like an insurance policy.

If the market plummets and the price drops to US$150, you make a profit between the US$190 strike and US$150, less the premium paid.

So, you’re losing on the value of your shares, but offsetting that by gaining on the option.

In this case, you’d close the option out at a profit before expiry. If you held onto your put option and it was exercised, you’d be selling out of your shares at US$190.

You can also use options to generate extra income on the shares you own.

This works well when you own shares that you don’t think will rise in price much in the short term.

Covered calls

As a shareholder, you can sell ‘covered calls’, labelled as such because you’re selling call options which are covered by your shareholding, thus limiting your risk.

Assuming the sold calls are out of the money at expiry, you keep the premium received (and take no further action) which supplements the income on your shareholding.

When you learn about options and understand them, you’ll find they can be useful. But options are a leveraged product, so they can come with a high level of risk. You need to have a good understanding of them before investing. Choose a broker with a good knowledge of them to assist with your trading.

First published 29 May 2019

This article does not contain any financial advice and has not taken into account any particular person’s circumstances. Before relying on it, we recommend you speak with a financial adviser. This story reflects the views of the contributor only. Content comes from sources that we consider are accurate, but we do not guarantee that the content is accurate.