Options trading can seem daunting at first glance, especially for novice traders. While trading options does come with risk, it can also bring plenty of opportunities to traders as well. In this article, we take a look at what are options, and how to get started with options trading in Australia. Feel free to keep reading below to get a better understanding of this topic.

What are options?

Options are a type of derivative contract that gives holders the right but not the obligation to sell or buy the underlying asset at a predetermined price sometime in the future. Options buyers are charged what is called a premium by the sellers in order to exercise this right. If market prices end up being unfavourable to option holders, they can simply let the option expire worthlessly and not exercise the right. On the other hand, if the market moves in a favourable direction and makes the option more valuable, the option holder can choose to exercise the right.

Options trading jargon

When it comes to trading options, most traders use some specific terminology when it comes to talking about them. Here are a few popular terminologies traders use and their meanings:

• Holders and writers: The buyer of an options contract is called the holder, while the seller is sometimes called the writer. For a call option, the holder has the right to buy the underlying asset from the writer. For a put option, the holder has the right to sell the underlying asset to the writer.
• Strike price: This is the price at which the holder can buy or sell the underlying asset when the option expires.
• Premium: This is the fee that the holder must pay to the writer for the option.
• Expiration date: This is the date on which the option contract terminates
• In the money: When the underlying asset’s price is above the strike price (for a call option) or below the strike (for a put option) the option contract is said to be in the money. This means if the option holder exercises the contract, they can trade at a better price than the current market price.
• Out of the money: When the underlying asset’s price is below the strike (for a call option) or above the strike (for a put option), the option is said to be out of the money. If an option is out of the money when it expires, then exercising the option will incur a loss.
• All the money: This is when the underlying asset’s price is equal or very close to being equal to the strike price.
• Break-even point: This is when the underlying asset’s price is equal to an option’s strike, plus the premium (for a call option) or minus the premium (for a put option). This means the contract is not making a profit or a loss.

How to start options trading in Australia

Here, we take a look at a few steps on how traders can start options trading in Australia. Keep reading below to learn more:

Find what makes up an option’s price

There are three major factors that affect the premium, or what traders pay when they trade an option. All of these elements work using the same principle – the more likely it is that the underlying asset will move in a favourable direction at its expiry, the higher its value will be.

There are three major factors that affect the premium, or what traders pay when they trade an option. All of these elements work using the same principle – the more likely it is that the underlying asset will move in a favourable direction at its expiry, the higher its value will be.

Time to expiry: The longer an option has before its time to expiry, the more time the underlying asset has to pass the strike price. Conversely, having less time before expiry means there is less time for the underlying asset to move in a favourable direction. As such, an out-of-the-money option tends to lose value as it nears its expiration date, as there is less chance of it expiring in a profitable manner.

Level of the underlying market: For a call option – the further below the underlying asset is to the strike price, or for a put option – the higher above the underlying asset strike price is, this means the options are in the money. More specifically, there is more chance of these options expiring with value.

Volatility of the underlying market: The more volatile an option’s underlying asset is, the more likely that it will pass the strike price. This volatility therefore tends to increase the premium of an option.

Learn about the Greeks

The Greeks are typically measurements of the trader’s risk that comes with trading options. They are each named after a Greek symbol. Understanding how this works can help traders to better calculate their risks.

Gamma: Gamma is a derivative of Delta, and it measures how much an option’s delta moves for every point of movement in the underlying asset.

Delta: Delta is specifically a measurement of how sensitive an option’s price is to the movement of the underlying asset. If all variables do stay the same, traders can use Delta to work out how much impact the market movement will have on their option’s value.

Theta: Theta measures how much an option’s price decays over time. So, a high theta tends to indicate that the option is close to the expiration date. The closer an option gets to its expiration date, the faster the time value decays.

Vega: An option’s Vega tends to measure its sensitivity to volatility in the underlying market. More specifically, this is how much the option’s value will move for every 1% change in volatility.

Rho: Rho indicates how much changes in the interest rate will move an option’s price. So, if the option’s price rises as a result of interest rate changes, then its Rho is considered positive. Conversely, if the option’s price falls, then its rho is considered negative.

Bottom line

Options can offer alternative ways for traders to take advantage of the price movements of underlying assets. While trading options can be slightly complicated in the beginning, as traders become more familiar with trading terms and factors that impact an option’s price, it does become more familiar as time goes on. As always, if a trader still has questions about options, it is always best to seek advice from a financial advisor or professional, just in case.

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