Options, or Exchange Traded Options (ETOs) more specifically, are a derivative security in that their value is directly derived from an asset such as an equity, or from an index. An option is a contract between two parties which conveys a right, but not an obligation to buy or sell an underlying equity or index at a set price.
There are two types of ETOs:
Call option: the right to buy a specific asset at a specific price within a specific time frame – as the underlying asset increases in value, the value of the option will increase
Put option: the right to sell a specific asset at a specific price within a specific time frame – as the underlying asset decreases in value, the value of the option will increase
Thus, the buyer of a call option is hoping that the underlying asset will rise in price, while the put option buyer is hoping that prices will drop. The writers of the contract are hoping for the opposite of either scenario.
ETOs enable investors to benefit from asset price movements without the need for holding the underlying asset. Investors may profit from both
The strike price is the specific price that the asset is agreed to be bought or sold at before a set period of time or ‘expiry date’.
The price paid by the buyer to the writer of the contract, determined on a per-share basis. For example, if you buy a call option for 100 shares in Wesfarmers (WES) with a stock price of $50 and a premium of $0.40, you are essentially agreeing to pay the stock price of $80 x 100 shares + the premium price per share ($50.40 x 100) = $5,040. In this situation, the share price of WES must increase past $50.4 before the end of the term. Brokerage fees must also be considered, with options trading fees generally starting at $34.95.
upward and downward movements in the underlying assets over which the options are traded.
When the transaction occurs, the option buyer pays a premium price, which is the cost of the option. The taker of the option is not obligated to exercise the option. If they choose to let the contract lapse, the option will not be exercised and they will forego the option premium.
Anatomy of a stock option
Underlying securities: options may be listed over shares traded on the ASX, ETFs, bonds and over a share price index.
Contract size: a standard option contract will cover 1000 underlying securities unless there have been amendments to the terms of the contract.
Exercise price: price at which the underlying securities are sold or bought if the option is exercised. i.e., TYR:ASX $3.4.
Expiry date: the date in which the option expires.