Stephen Karpin, CommSec

Question:

What’s the difference between being a buyer or seller of an option? And what are the advantages and disadvantages of each?

Response:

An option is either the right to buy (a ‘call' option) or the right to sell (a ‘put’ option) an underlying asset for an agreed price on or before the predetermined date. Each transaction has a seller (the ‘writer’) and a buyer (the ‘taker’).

The buyer has the right, but not an obligation, to exercise the option while the seller of the option has an obligation to sell or buy the underlying asset at the agreed price if called upon by the buyer of the option. For this obligation, the seller of the option receives the premium (which is the agreed price at which the option trades).

For example, it is now early July and NAB last traded price was $ 24.50. An investor, Kelvin, has a short term bullish view on NAB however currently does not have enough funds to buy NAB shares. Kelvin decides to buy NAB 24.50 August Call for $0.95 per share to gain exposure to NAB’s share price.  On the other side of the transaction, the seller receives the premium of $0.95 per share for taking the obligation of delivering NAB shares at $ 24.50 if Kelvin decides to exercise his option on or before the expiry date of the option.

If NAB’s price increases, Kelvin as a buyer of the call option can realise profit by either exercising the option or selling it back in market (as most premiums have a time value or extrinsic component, most shares are sold before expiry). One advantage of buying an option is therefore time to decide. For a much smaller capital outlay than buying the stock outright the investor is able to gain exposure in NAB shares, and has until expiry date in August to decide whether to exercise the option to buy NAB shares. Conversely, if NAB price decreases, the risk (ie cost) is limited to the amount of premium paid for the option.

The advantage of selling an option is the certainty of the premium received. From the example above, the seller will receive $ 0.95 per share (or $ 950 per contract – which is normally 1000 shares) for selling the call option. As well as the premium received, the seller has also increased the effective selling price to $ 25.45 (the strike price $ 24.50 plus $0.95 premium received) if the option was to be exercised. The disadvantage of selling the option in this example is that the seller has most likely foregone any upward movement in NAB beyond $ 25.45 as the option buyer will most likely exercise the option. Where the writer of the call option does not hold the underlying asset to deliver the shares upon exercise, they are selling the option naked or uncovered.  A writer of uncovered call options faces unlimited risk of upward movement in the asset price.

A put option works similar to the case above, except the taker of the option has a right to sell the underlying asset and therefore, all other things being equal, the taker will profit from a falling stock price. The risk is limited to the amount of premium paid. In contrast, the seller receives the premium for accepting the obligation to buy the shares if the option was to be exercised. The writer of an option thus faces downside risk of being forced to purchase stock at a price higher than the current market price should the stock price fall.  

There is an initial margin requirement involved in naked selling in the form of providing collateral. Should the market move against the position, additional margin must also be met promptly. These margins can be substantial depending on the positions and the market condition. They can be satisfied by lodging cash or eligible shares as collateral through your broker, which then lodges collateral to ASX Clear (the ASX’s Clearing House.

By Stephen Karpin, General Manager, CommSec

Trading options involves risks, please consult your financial planner or adviser.  A Product Disclosure Statement for Exchange Traded Options issued by Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814 is available from www.commsec.com.au and should be considered before making any decision about the product. Fees and charges apply. The information in this article is general in nature and does not take into account any investor's particular objectives, financial situation or needs. In considering its appropriateness, investors should read the relevant product disclosure statement and consult a financial adviser before making an investment decision.

Important Information

The views expressed in this article are those of Stephen Karpin, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814.  Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 and a Participant of the ASX Group.

This article was produced by CommSec. Except to the extent that any liability under any law cannot be excluded, no liability for any loss or damage which may be suffered by any person, directly or indirectly, through relying upon any information or statement in this document is accepted by the Commonwealth Bank or CommSec or any of their directors, employees or agents, whether that loss or damage is caused by any fault or negligence on their part or otherwise. Commonwealth Bank and its subsidiaries do not guarantee the obligations or performance of CommSec or the products or services offered.  

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