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The world of options trading

Options trading can be a tricky investment process and that’s why it is important to read as much as you can about them as possible before you risk your hard earned savings. According to Peter Switzer, founder of Switzer Financial Services, an option is “a contract to buy or sell a specific stock, exchange-traded fund (ETF) or similar product”. They are otherwise known as Exchange Traded Options (ETO).

1. The different types of options available

The three different types of options available on the Australian Securities Exchange (ASX) are:

  • Equity options
  • Index options
  • Low exercise price options.

An option contract has a price when it may be exercised or acted on in the future, called the strike price, Switzer explains. There is also an expiration date for the contract after which it will cease to exist. Basically, investors can lock in a price to buy or sell a share and index.

2. Put options and call options

There are ‘call options’ and ‘put options’ both of which can be bought and sold.

“The purchase of a call gives the owner the right, but not the obligation, to buy the underlying security at the strike price on or before the expiration date,” Switzer explains. “In turn the seller of the call is required to sell the security at the strike price at the buyer's request.”

A ‘put option’ on the other hand gives the owner of the contract the right, but not the obligation to sell the underlying security at the strike price at the buyer’s request.

“The type of option utilised, and whether it’s purchased or sold, depends upon what the investor hopes to achieve,” he says. 

3. The use of options

Options can be used to generate income, protect portfolio gains, hedge a position or add diversity to a portfolio.

“They’re not a straightforward play for the inexperienced and I recommend a lot of homework before you dabble with options trading,” says Switzer.

According to the Australian Securities Exchange (ASX), options allow investors to “gain protection from falls, earn extra income if the market is flat or generate leveraged returns if the market rallies”.

4. Do your research and get advice on options

The ASX says there are five main components of an option.

They are:

  1. The underlying security
  2. Contract size
  3. Exercise or strike price
  4. Expiry date
  5. Premium. 
Doing the research before using options is important. You may also consider visiting a trusted financial adviser who can give you further information about whether such an investment would be suitable for you. Also check out www.asx.com.au for further information about options trading.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Published on: Thursday, November 25, 2010

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