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Exchange-traded options can be complex and high risk. Before investing, understand how they work, the risks involved and whether they suit your investment goals.
What is an exchange-traded option?
An exchange-traded option (ETO) is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at an agreed price on or before a set date. Most ETOs in Australia are linked to shares or share market indices. For ETO share options, each contract typically represents 100 shares.
There are two main types of options:
Call options - A call option gives the buyer the right to buy an asset at an agreed price before the option expires. Investors may use call options if they believe the price of the asset will rise.
Put options - A put option gives the buyer the right to sell an asset at an agreed price before the option expires. Investors may use put options if they believe the price of the asset will fall or want to protect an investment from losses.
Unlike buying or selling shares directly, buying or selling an option is simply buying or selling a contract whose value is linked to the underlying asset. This makes options a type of derivative.
There are very different potential risks and benefits between buying an option and selling an option.
Buying an exchange-traded option
When you buy an option, you're paying a premium for the right (but not the obligation) to buy or sell an asset at an agreed price before the option expires.
Importantly, if the market doesn't move the way you expected, the most you can lose is the premium you paid for the option, plus any fees.
Buying a call option can be useful if you're keen to buy a particular investment and know the maximum price you want to pay for it.
Example: Buying a call option
Jen wanted to buy 10,000 shares in XYZ company. The shares were trading at $5 per share, so buying them would cost $50,000.
As she was borrowing money to buy them she couldn't trade until her loan approval came through - but she felt sure the share price was going to increase soon.
To lock in the current price, she bought 100 call options with a $5 strike price at $30 per contract, for a total cost of $3,000. The option gave her the right to buy 10,000 XYZ shares at $5 per share at any time during the next 6 months.
That way, Jen knew the maximum price she would have to pay for the shares if her loan was approved.
Ending 1: The share price falls - Jen doesn’t exercise the option, costing her $3,000
By the time Jen's loan was approved, the XYZ share price had fallen to $3 per share. Because she could now buy the shares on the market for less than the option price, she chose not to exercise the option.
Jen lost the $3,000 premium she paid for the option.
Ending 2: The share price rises - Jen makes a $17,000 profit
By the time Jen's loan was approved, the XYZ share price had increased to $7 per share.
Jen exercised her options and bought 10,000 shares for $5 per share, paying $50,000.
Because the shares were now worth $7 per share, the market value of her shares was $70,000. She decided to sell quickly and lock in the profit.
Want to see the workings?
- Shares covered by the options: 10,000 (100 contracts each representing 100 shares)
- Strike price: $5 per share
- Market price at expiry: $7 per share
- Premium paid: $3,000
Outcome
- Cost to acquire shares using the options: $50,000
- Market value of shares: $70,000
- Gain from exercising the options: $20,000
- Less premium paid: $3,000
- Profit if shares sold immediately: $17,000
Buying a put option can be useful if know you want to sell a particular investment in the future and know the minimum price you’re happy to sell it for.
Example: Buying a put option
Michael owned 10,000 shares in XYZ company. The shares were trading at $5 per share, giving his investment a value of $50,000.
He was planning to sell the shares in 6 months to help pay for a house deposit. While he hoped the share price would increase, he was concerned it might fall before he was ready to sell.
To protect himself, Michael bought 100 put options with a $5 strike price at $30 per contract, for a total cost of $3,000. The option gave him the right to sell 10,000 XYZ shares for $5 per share at any time during the next 6 months.
That way, Michael knew the minimum price he could receive for his shares, while still benefiting if the share price increased.
Ending 1: The share price falls – Michael’s home deposit is protected
By the time Michael was ready to sell, the XYZ share price had fallen to $3 per share.
Michael exercised his option and sold his shares for $5 per share, rather than the market price of $3 per share, keeping his $50,000 home deposit protected.
Want to see the workings?
- Shares owned: 10,000
- Strike price: $5 per share
- Market price when sold: $3 per share
- Premium paid: $3,000
Outcome
- Sale proceeds using the options: 10,000 × $5 = $50,000
- Market value of shares without the options: 10,000 × $3 = $30,000
- Benefit from exercising the options: $20,000
- Less premium paid: $3,000
- Net benefit: $17,000
Ending 2: The share price rises – Michael doesn’t need to exercise the option
By the time Michael was ready to sell, the XYZ share price had increased to $7 per share.
Because he could sell his shares on the market for more than the options price, he chose not to exercise the options.
He was able to sell his shares for $70,000, which was a net amount of $67,000 after the $3,000 cost of the options was taken into account.
Benefits and risks of buying an exchange-traded option
Possible benefits
- A call option lets you benefit if the price of the underlying asset rises.
- A call option gives you exposure to an investment for a smaller upfront cost than buying the asset outright.
- A put option lets you benefit if the price of the underlying asset falls.
- You can use a put option like insurance against a fall in the value of an investment.
Risks
- Asset price movements can be very unpredictable over a short time period, making it difficult to work out the value of an option.
- If the market doesn’t move the way you expect, the option may expire and be worthless, meaning you’ll lose all the money you paid for it.
- The cost of the option reduces your overall return on investment.
Selling an exchange-traded option
When you sell an option, you're being paid money for someone else to have the right to buy an asset from you or sell an asset to you at an agreed price before the option expires. If they decide to exercise their right, you have to fulfil the contract.
Selling exchange-traded options is significantly riskier than buying them, because the right to execute the option sits with the other person, not with you.
Example: Selling a call option when you own the asset (a covered call)
Sarah owned 10,000 shares in ABC company, which she'd bought for $5 per share. She decided she was happy to sell her shares if the price rose to $7, so she sold 100 call options with a $7 strike price at $30 per contract, for a total cost of $3,000.
The buyer of the options then had the right to buy her shares for $7 per share at any time during the next 6 months.
In return for selling the options, Sarah received a premium of $3,000.
Ending 1: Share price falls - Sarah makes $3,000
ABC company’s shares didn’t hit $7 over the 6 months, so the buyer of the call options didn’t exercise the right to buy the shares. This meant that Sarah made $3,000.
Ending 2: Share price rises - Sarah makes $23,000, but misses out on an extra $17,000
A few months later, ABC company's share price had risen to $9 per share. The buyer of the call options exercised their right to buy the shares for $7 per share.
Because Sarah already owned the shares, she simply sold her 10,000 shares to the option holder for $7 per share, receiving $70,000.
Sarah originally paid $50,000 for the shares, so she made a profit of $20,000 on the shares. When the $3,000 premium is added, her total profit was $23,000.
However, because she had sold the call options, Sarah could not sell her shares on the market for $9 per share. Had she not sold the options, she could have sold her shares for $90,000, making a profit of $40,000 on the shares.
Want to see the workings?
- Shares purchased: 10,000 at $5 per share
- Total cost of shares: $50,000
- Strike price: $7 per share
- Premium received: $3,000
- Market price when option exercised: $9 per share
Outcome
- Proceeds from sale of shares: 10,000 × $7 = $70,000
- Profit on shares: $70,000 − $50,000 = $20,000
- Plus premium received: +$3,000
- Total profit: $23,000
Opportunity cost
- Value of shares at market price: 10,000 × $9 = $90,000
- Profit if shares had been sold at market price: $40,000
- Actual profit received: $23,000
- Missed gain: $17,000
Unless you own the asset outright, it’s important to know that selling exchange-traded options is a very high-risk activity. You could lose a lot more money than you were expecting, potentially putting you into significant debt.
Example: Selling a call option when you don’t own the asset (an uncovered call)
Cal believed XYZ company's shares, which were trading at $5 per share, were unlikely to rise much over the next 6 months.
To earn some extra income, he sold 100 call options with a $5 strike price at $30 per contract, for a total cost of $3,000.
The buyer of the options then had the right to buy the shares for $5 per share at any time during the next 6 months. In return, Cal received a premium of $3,000.
However, Cal did not own any XYZ shares.
Ending 1: Share price falls - Cal makes $3,000
A few months later, XYZ company's share price had fallen to $3 per share. The buyer of the call options didn’t exercise the right to buy the shares, which meant that Cal made $3,000.
Ending 2: Share price rises - Cal loses $17,000
A few months later, XYZ company's share price had risen to $7 per share. The buyer of the call options exercised their right to buy the shares for $5 per share.
Because Cal didn't own the shares, he had to buy 10,000 shares on the market for $7 per share, costing $70,000. He then had to sell them to the option holder for $5 per share, receiving $50,000.
Overall, selling a call option for $3,000 cost Cal $17,000.
Want to see the workings?
- Share price when Cal sold the call options: $5 per share
- Number of shares covered by the options: 10,000
- Strike price (agreed sale price): $5 per share
- Premium received for selling the options: $3,000
When the options are exercised
- Market price of shares: $7 per share
- Cost to buy 10,000 shares on the market: 10,000 × $7 = $70,000
- Amount received from selling shares to the options holder: 10,000 × $5 = $50,000
Loss on the share transaction
- Loss on sale of shares: $20,000
- Less premium received: $3,000
- Net loss: $17,000
These types of losses can be amplified if you sell uncovered call options on volatile, speculative stocks.
Selling a put option is also risky. It gives the buyer the right to sell an asset to you at an agreed price before the option expires. Selling a put option can generate income through the premium received, but if the share price falls significantly, you can be forced to buy shares for more than they're worth. The loss on the shares can be much greater than the premium received.
Example – Selling a put option
Ben believed XYZ company's shares, which were trading at $5 per share, were going to increase in value over the next 6 months.
To earn some extra income, he sold 100 put options with a $5 strike price a4 $30 per contract, for a total cost of $3,000.
The buyer of the options then had the right to sell the shares to him for $5 per share at any time during the next 6 months. In return, Ben received a premium of $3,000.
Ending 1: Share price rises - Ben makes $3,000
A few months later, XYZ company's share price had risen to $7 per share.
The holder of the put options didn't exercise their right to sell shares for $5 because they could sell them on the market for the higher price of $7 per share instead.
As a result, the options expired worthless and Ben kept the $3,000 premium.
Ending 2: Share price falls - Ben loses $17,000
A few months later, XYZ company's share price had fallen to $3 per share and the holder of the put options exercised their right to sell 10,000 shares to Ben for $5 per share.
Ben had to buy the shares for $50,000, even though they were only worth $30,000 on the market.
Overall, selling the put options for $3,000 cost Ben $17,000.
Want to see the workings?
- Share price when Ben sold the put options: $5 per share
- Number of shares covered by the options: 10,000
- Strike price (agreed purchase price): $5 per share
- Premium received for selling the options: $3,000
When the options are exercised
- Market price of shares: $3 per share
- Amount Ben must pay to buy 10,000 shares: 10,000 × $5 = $50,000
- Amount he receives from sale: 10,000 × $3 = $30,000
Loss on the share transaction
- Loss on share transaction: $20,000
- Less premium received: $3,000
- Net loss: $17,000
Some online brokers market short-dated exchange-traded options as a way to make quick gains. They may offer fee-free or discounted trading, or incentives such as cash vouchers or airline reward points to encourage retail investors to start trading on their platforms. It’s important to know that short-dated ETOs are very high-risk products and you could end up losing a lot more than you invested.
Benefits and risks of selling exchange-traded options
Possible benefits
- You receive a premium upfront when you sell the options and if the options expire without being exercised, you keep the premium.
- Selling a call option over shares you already own can generate additional income from your investment, as long as the market moves the way you think it will.
- Selling a put option can generate income while you wait to buy shares at a price you're prepared to pay, as long as the market moves the way you think it will.
Risks
- Your potential losses can be multiples greater than the premium you receive.
- If you sell a call option and the asset price rises significantly, you may miss out on gains or suffer large losses if you don't own the underlying asset.
- If you sell a put option and the asset price falls significantly, you may be forced to buy the asset for more than it's worth.
- Asset price movements can be very unpredictable over a short time period, making it difficult to manage the risks.
- In some circumstances, losses can be substantial and may exceed your initial investment.
Options are complex. Learning how they work before risking real money can help you build your knowledge and confidence.
The ASX offers a 10-module, self-paced online learning course.
You can also try the ASX Options Trading game. This lets you practise trading options in a simulated environment using virtual money. It's a way to explore how options work and understand the risks, without using your own money.Your options investing checklist
Use this checklist before you invest in exchange-traded options. If you answer “no” to any of these, stop and do more research.
1. Do I understand how options work?
crop_square I understand the difference between a call option and a put option.
crop_square I understand the difference between buying an option and selling (writing) an option.
crop_square I know when I can make money and when I can lose money.
2. Do I understand the risks?
crop_square I understand that options can lose value quickly and may become worthless before they expire.
crop_square I understand that if I buy an option, I could lose all of the money I pay for it.
crop_square I understand that if I sell an option, I may lose more than my initial investment.
crop_square I understand that some option strategies can result in very large losses.
3. Am I comfortable with leverage?
crop_square I understand that options use leverage, which can magnify both gains and losses.
crop_square I understand that a small movement in the market can have a large impact on my investment.
crop_square I understand that using borrowed money can increase my losses.
crop_square I understand that I may have to provide additional money at short notice if I receive a margin call.
4. Can I afford to lose this money?
crop_square If I lose money on this investment, can I still pay my rent, mortgage and/ or bills?
crop_square Am I using savings I need soon?
crop_square Am I borrowing to invest?
5. Have I done my research?
crop_square I've read the product disclosure and risk information.
crop_square I understand the fees, costs and tax implications.
crop_square I've practised or learned how options work before investing real money.
crop_square I've considered getting financial advice if I'm unsure whether options are suitable for me.
Stop, consider the risks, and seek advice
This page covers the basics of exchange-traded options. But there are many other added complexities to some products on offer in the market that can increase the risks even further.
There are also specific options trading strategies or options with different duration or expiries - such as short-dated ETOs – that can magnify risks and potential losses.
Options are complex investments. If you don’t fully understand how an option works, how it generates returns, and how you could lose money, it may not be suitable for you.
Consider seeking independent financial advice before you invest, and learn more about how to invest.
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