Options are contracts that provide the right, but not the obligation, to buy or sell an asset at a specified price. For example, you could be buying an option to buy Microsoft shares in December for $30 each.
When you write this type of options contract, you are being ‘given’ the right to do so by someone else who owns an options contract giving them the right to buy Microsoft shares from you for $30 in December.
This person is the holder of that contract, and your counterpart is the writer of that contract. If at any point up until December, Microsoft shares are selling for less than $30, then no one will exercise their rights to buy or sell (depending on which side of the contract you’re on) from you. Conversely, if Microsoft shares are selling for more than $30, then the holder of that options contract will exercise their rights to buy from you.
Set up an account with a brokerage
The first step is to find a brokerage house that offers trade options. It may be an online service or several physical brokerages available around Australia. You can register on this site.
Find an option you want to buy/sell
If you plan to buy an option contract, this step will be easy – search for options with stocks you’d like to trade with. However, if you want to sell contracts, try searching for ‘options’ and select one of the search results. Often, the top result will provide some detail about what options are, which can help give you direction as far as possible option types go.
Decide what you want to trade
You will need to determine what you want to buy or sell. For this example, let’s say that a client wants to buy put options on Westpac Banking Corp for a total sum of $500,000 at the end of the year.
Decide who you’re going to trade with
Determine if there are any restrictions based on whose company it is and how much they have invested in their own company. In this case, no one can write an option contract for more than $5 million worth of shares from Westpac Banking Corporation because from time to time, these contracts require detailed price information from the companies themselves. So it would be a conflict of interest if an organisation had this type of access to its data.
Decide what you want your options contract to be ‘worth’
Decide on the price that one option contract will cost, known as the premium. In terms of shares, it may be $20 per share for Microsoft or $4 per share for Westpac Banking Corporation.
If the holder wants to utilise their rights, then they must pay $20 per share, but if they don’t want to exercise those rights (or can’t because it has already expired), then they wouldn’t have to do anything except let the contract expire which would mean you as a writer wouldn’t lose any money. You, as a writer, would still make money if the price of Westpac shares went up, but not as much since you could have written more contracts for a higher premium cost.
Decide when you want your options contract to end
The above examples are European options, which means you can only exercise them on the expiry date (this is usually shown in the ‘text’ section of an option contract). However, an American option allows the holder to exercise their rights at any time up until expiry. It may have advantages depending on whether shares are trending upwards or downwards, so it’s essential to know which one suits your strategy best.
Buy or sell your options contract with someone who has already created one
Many organisations specialise in creating these contracts, but ultimately they are sold to other investors known as the ‘holders’. The holder is then free to sell it in the secondary market if they desire.
Sit back and wait for your options contract to expire or exercise your rights
When your contract expires, you either have nothing left to do, or you will have received a payment from someone exercising their rights over what they purchased from you.