Options trading allows you to earn income in down markets, add leverage to your trading, protect your portfolio and even speculate on price movements of various asset classes.
But they're also not to be taken lightly. Options are complex trading instruments that come with unique risks. If you're ready to get started trading options, follow the steps below. Otherwise you can learn more about how options trading works first.
You'll need to sign up to a stock broker that offers options trading. You can compare popular brokers that offer options trading in the table below. To open an options trading account, you'll need:
Before signing up you'll need to decide whether you want to trade Australian-listed stock options or options from overseas markets such as the United States as many platforms only offer one or the other.
It's also possible to trade options on other types of securities, such as commodities, indices, futures and forex.
Once you know what you want to trade, you can more easily compare the fees, features and trading tools to find the best broker for you.
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To trade options successfully, it's crucial to have clear investment objectives and a plan in place. Consider what options you want to trade, how much you want to invest, which strategies to use, and your risk tolerance.
Remember that options trading is riskier than passive investing, so it may not be suitable for more conservative investors. Despite the potential for large returns, statistically speaking, trading options is more likely to result in losses.
Knowing your end goal will help to inform which options trading strategy you use, including your entry and exit strategies and the assets you select. For instance, are you hoping to make a profit by speculating on asset price volatility? Or are you intending to use options to hedge against falling prices of shares you already own? Perhaps you're trying to build up a passive income? These goals require very different strategies and planning.
Once you know all this, you can start to decide which assets to focus on and how you'll be trading them.
Once you've decided which company share or other asset you want to trade (called the underlying asset), you'll need to select your contract.
Every contract has a different expiration date, strike price and option type, so you'll need to decide all of these factors when choosing.
The expiration date is the date on which the options contract expires. After this date, the contract is no longer valid and the option either becomes worthless or is exercised by the holder, meaning the underlying asset is bought or sold.
The strike price is the price at which the underlying security can be bought or sold when the option is exercised. This price is predetermined and is stated in the options contract. For example, if you buy a call option with a strike price of $200 on Apple shares, you have the right to buy Apple shares at $200 per share before the expiration date.
Finally, the option type refers to whether you want to buy or sell a call option or a put option. A call option gives you the right (but not the obligation) to buy the underlying security at the strike price, while a put option gives you the right to sell the underlying security at the strike price.
Which contract type you pair with your chosen asset depends on how you think that asset will perform.
Generally speaking, if you think the asset's price will rise, you should buy a call option or sell a put. Alternatively, if you predict the stock or market price will fall, you should buy a put option (also called shorting) or sell a call option.
Before placing your trade, you'll need to top up your account with enough funds.
Depending on who you sign up with, there's usually a few ways to fund your account, including direct deposit, via a credit card, PayPal or even BPAY.
You can usually fund your account by following the prompts in your broker's account.
If you're using leverage, keep in mind that you'll need enough funds to cover potential losses, which may be greater than your initial trade amount.
There's also usually a minimum amount required when trading options. This will vary from broker to broker but generally speaking, you'll need to start with at least $1,000.
After you've chosen your contract and funded your account, it's time to execute your buy or sell trade.
First, you need to decide on the price at which you want to enter the trade, known as the premium. This is the price you're willing to pay the seller for the contract or the price you're willing to accept if selling. It's influenced by factors such as the current market price of the underlying security, implied volatility, the expiration date and other market factors.
You also need to consider the premium that the market is currently offering for the options contract. This market premium is set by the bid-ask spread, which is the difference between the highest price a buyer is willing to pay for the option (the bid price) and the lowest price a seller is willing to accept (the ask price).
The strike price of an option is the price you can buy or sell the underlying security, at the time when the option is exercised. It does not change. Meanwhile, the spot price is the current market price of the underlying asset.
Then there's the time frame. In traditional trading of assets, you're looking to buy and hold over the long-term. In options, it's the opposite – the shorter the time, the better. This is because the closer an option gets to its expiry date, the less it is worth. As such, you're looking for sharp movements of the underlying asset in a short period.
Once you have determined the price, it's time to place your order. You can choose between a market order or a limit order.
A limit order allows you to set the maximum price you are willing to pay (if buying) or the minimum price you are willing to receive (if selling) for the option. A market order will execute at the current market price, which may result in paying a higher premium than you initially intended due to the bid-ask spread.
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An option is an agreement between 2 parties to enter into a contract that gives the owner the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon strike price before an unspecified date.
Options contracts are derivatives investments, which means you're exchanging contracts rather than buying and selling physical assets. There's always an underlying asset attached to the contract, such as shares or commodities, which is how a price is determined.
You can trade different financial products through options, including the following:
Similar to trading shares, you'll profit based on the difference in the contract's price from the day you enter the contract to its future price.
In Australia, you'll come across ETOs which are attached to shares listed on the ASX. These work in the same way as regular options and allow you to trade ASX-listed shares.
Options listed on overseas markets, such as the United States, are also possible to trade from Australia, depending on the platform you use.
At this point, you might be asking yourself, why not just buy shares or commodities? While there are various reasons to trade options over buying shares, most investors trade options for the following reasons:
On the downside, trading options is usually much riskier than directly buying or selling shares. While buying shares is a relatively simple process, options trading can be complicated and has a greater chance of miscalculation leading to loss.
Options traders also typically use leverage which means they can enter a large trade with a small amount of initial capital. While this can amplify profits, it will also amplify losses if the trade goes against the trader.
While investing in the share market directly is suitable for investors of any level of experience, options trading is best suited to more experienced traders.
The 2 main participants in an options contract are the "buyer", who is the person that purchases the contract, and the seller of the contract, dubbed the "writer".
There are 2 types of options that you can either buy or write. A call option gives its buyer the choice to purchase shares from its writer at a specific price (the "strike price") before a set time (the "expiry date"). A put option is the opposite, where the buyer enters a contract to sell the shares to the writer at a set price within a specific time frame.
The buyer of a call option is hoping that the underlying shares will rise in price, while the put option buyer is betting that prices will fall. The writers of the contract are hoping for the opposite.
Remember that the buyer of the contract has the right to buy or sell the underlying share as laid out in the contract (called exercising) but is not actually required to do so.
If the option is not exercised, it will expire worthless on the expiration date. If the option is exercised, the buyer of the option will either buy or sell the underlying asset at the agreed-upon price. If the trader is holding a short option position that is exercised, they will need to fulfill the obligation to buy or sell the underlying asset.
Example: If a trader buys a call option on a share with a strike price of $50 and the share price rises to $60, the trader can exercise the option and buy the share at $50, then sell it at the market price of $60, realising a profit of $10 per share.
The 2 main types of options contracts are call options and put options.
Buying call options gives you the right to buy an asset at a predetermined price within a specific time frame. Selling call options obligates you to sell your assets to the buyer of the option if they exercise their option.
Day traders often use call options to control multiple shares with a low amount of money.
Example: How it works if you buy call options:
Company X stocks currently trade at $100 per stock. That's expensive for you, but you believe the stock price will move higher and you can turn a profit.
You buy 1 call option, which is the right to buy 100 stocks of the company at an agreed upon price ($100 per stock). To buy this options contract, you pay a premium of $500 ($5 x 100 stocks). With a $500 investment, you control 100 stocks worth $10,000.
A week later, the stock price climbs to $120 per stock. To exercise the option, you would need to have $10,000 in your account to buy the 100 stocks at the agreed-upon price of $100 each.
Instead of buying the stocks, you sell the options contract to another trader for a higher price than what you paid and pocket the difference between the premium you paid for the option and the price for which you sold it on the market.
Buying put options gives you the right to sell an asset at a predetermined price within a specific time frame. These are the opposite of call options.
Put options are often used to insure your investment.
Example: How it works if you buy put options:
There are 2 main styles of options contracts: American style and European style options. While American style options are more common around the world, both types of contracts tend to exist in any one market.
There are also other less common styles of options contracts, including:
In Australia, American style options are most common, although ASX-listed ETOs can be either American or European.
It's important to understand the different styles of options contracts because the style can impact the price and the timing of when the option can be exercised, which can affect the potential profitability of the trade.
If you trade options, you'll face a number of different fees, depending on what you trade and where you trade them.
Keep an eye out for:
Many of these fees are a fraction of a cent, but given you will be charged them, it is best to take note of what you're paying to the broker.
In Australia, the biggest fee you'll pay is the broker commission fee which can range from $5 to $50 depending on the assets you're trading.
Options trading isn't suitable for everyone and has the following drawbacks to keep in mind.
Options trading comes with rewards and opportunities, but it also has increasing risks and it can be difficult for newer investors to grasp the concepts behind them.
While options trading gives you the right but not the obligation to own the underlying asset, you are trading with leverage, which should be left to sophisticated investors.
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