Share options are financial instruments that provide the right (but not the obligation) to buy or sell a certain number of shares at a predetermined price on or before a future date.
Share options are a type of derivative — their value is derived from the value of another asset (the underlying shares). Let's see how investors can use share options to speculate on share price movements and hedge existing positions.
What is a call option?
A call option gives its holder the right to buy a certain number of shares for the 'exercise' or 'strike' price on or before a future date. For example, a call option on Xero Limited (ASX: XRO) with an exercise price of $100 would allow the holder to buy shares in Xero for $100 before its expiry.
It is profitable to exercise a call option where the share's market price is greater than the exercise price. The more the market price increases above the exercise price, the more profitable the call option will be. If the option is not exercised before its expiry, it simply expires and is no longer of value.
And a put option?
A put option gives its holder the right to sell a certain number of shares for a specific price on or before a future date. For example, a put option on REA Group Limited (ASX: REA) with an exercise price of $150 would allow the holder to sell shares in REA Group for $150 before its expiry.
It will only be profitable for the put option holder to sell REA Group shares for $150 if the market price is below this. As the profit on a call option increases when the share price rises, the gain on a put option increases when the share price falls.
How are options different to shares?
Options differ from shares because if someone holds shares, they own part of the company. If someone holds options, they have the right to buy or sell shares in the future.
A call option holder would become a shareholder when they exercise the option and use it to buy shares at the exercise price. Conversely, a put option holder will no longer be a shareholder if they use the option to sell all of their shares in the company.
How are they different to futures?
Options are different to futures because options give the holder the right, but not the obligation, to buy or sell the shares at the exercise price.
Futures, however, obligate the parties to buy or sell the underlying assets at a predetermined future date and price. Like options, futures are derivatives because their value is derived from the value of the underlying assets. Unlike options, futures require the holder to buy or sell the underlying assets. This means they may miss out on favourable price movements.
Why do investors use share options?
Investors may use share options for a range of reasons, including:
- Speculation: Investors who expect share prices to rise might buy call options. If they expect share prices to fall, they might buy put options. Investors may do so with no intention of ever exercising the options. Investors can also trade the options themselves before expiry, allowing them to take a profit or limit a loss on their position.
- Risk management: Put options can be used to hedge against a possible adverse movement in the price of shares that an investor already owns.
- Time to decide: An investor may be interested in buying shares in a company but wants time to consider their decision. Buying a call option allows them to lock in the price of the shares and gives them until the expiry date to decide whether to invest. Likewise, a put option locks in a sale price, giving the investor time to consider whether they want to sell their shares.
- Leverage: Trading in options allows investors to benefit from changes in share prices without having to pay the total price of shares. This is a form of leverage. Leverage provides the potential to make a higher return from a smaller initial outlay compared to investing directly. Using leverage, however, usually also involves more significant risk.
- Income generation: Shareholders can write options against their shares, allowing them to generate extra income above dividends. They receive the option premium from their buyer upfront, but if the option is exercised, they must deliver the shares at the exercise price.
What are the risks of trading share options?
Trading in options is generally considered riskier than trading in shares directly. Investors should only use them if they are confident they understand how options work and the associated risks, which include:
- Market risks: The price of options is impacted by various factors, including the value of the underlying shares and the time remaining on the option. Options can fall in price or become worthless before expiry.
- Value erosion: An option is a wasting asset whose value erodes as it nears its expiry date. Investors need to ensure the options they have selected have sufficient time left before expiry for the investor's view to be realised.
- Unlimited losses: Investors who choose to write options face potentially unlimited losses if they do not own the underlying shares or have offsetting positions in place.
- Liquidity risks: The market's liquidity for share options can depend on the presence of market makers. A lack of liquidity may increase the risk of loss by making it difficult to transact.
Should you invest in them?
Options can provide a valuable means of risk management and speculation. But options also carry risks. This means it is important to understand how they work and their role in your investment strategy.
Owning shares directly is a more common way to invest in the share market. However, investors can use options to limit downside exposure and provide a benefit from share price movements, using relatively little capital upfront.