Understanding options trading westpac

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Understanding Options Trading

Disclaimer of Liability

Information provided is for educational purposes and does not constitute financial product advice. You should obtain independent advice from an Australian financial services licensee before making any financial decisions. Although ASX Limited ABN 98 008 624 691 and its related bodies corporate (`ASX') has made every effort to ensure the accuracy of the information as at the date of publication, ASX does not give any warranty or representation as to the accuracy, reliability or completeness of the information. To the extent permitted by law, ASX and its employees, officers and contractors shall not be liable for any loss or damage arising in any way (including by way of negligence) from or in connection with any information provided or omitted or from any one acting or refraining to act in reliance on this information.

No part of this Booklet may be copied, reproduced, published, stored in a retrieval system or transmitted in any form or by any means in whole or in part without the prior written permission of the ASX Group.

For these product/s the market is operated by ASX Limited ACN 008 624 691.

All Ordinaries?, All Ords?, ASX?, ASX100?*, ASX200TM*, CHESS?, and ITS? are trade marks of ASX Operations Pty Limited, a member of the ASX Group. For those trade marks indicated with an asterisk, ASXO has entered into an arrangement with Standard & Poor's (S&PTM). Those trade marks must be prefaced by the mark S&P when used to describe indices. S&PTM is a trade mark of Standard & Poor's, a division of The McGraw-Hill Companies, Inc.

Edition 10 printed July 2007.

? Copyright 2007 ASX Limited ABN 98 008 624 691. All rights reserved 2007.

Exchange Centre, 20 Bridge Street, Sydney NSW 2000 Telephone: 131 279 .au

Contents

Before you begin

2 Taxation

16

What is an option?

3 Tradeability

17

Call options

3

Put options

4 How can options

Advantages of option trading

5 work for you?

18

Risk management

5

Time to decide Speculation

5

5 Trading index options

20

Leverage Diversification Income generation

5 How are index options different?

20

5 Settlement method

20

5 Some key advantages of

Option features

trading index options

21

6 Examples of how trading index

The 5 components of an option contract 6 options can work for you

21

1. Underlying securities/approved indices 6 Differences between equity

2. Contract size

6 options and index options

23

3. Expiry day

6

4. Exercise (or strike) price

7 Pay-off diagrams

24

5. Premium

7 Call option taker

24

1

Call option writer

24

Adjustments to option

Put option taker

25

contracts

8 Put option writer

25

Summary

26

Option pricing fundamentals

9

Intrinsic value

9 Risks of options trading

27

Call options

9

Put options Time value

9 You and your broker

28

10

Your relationship with your broker

28

Parties to an option contract 11

The option taker

11

The option writer

13

The paperwork: Client Agreement forms 28

Instructing a broker to trade options

29

Role of market makers

30

Australian Clearing House

31

Tracking positions and costs 14

Glossary of terms

33

How to track options positions

14

Costs

14

Option contract specifications 35

Margins

15

Further information

36

Before you begin

The ASX exchange traded options market has been operating since 1976. Since the market started, volumes have increased significantly. There are now over 100 different companies and several indices to choose from. A list of companies and indices over which Exchange Traded Options (options) are traded can be found on the ASX website, .au/ options (under Option Stocks in the "Trading Information" section).

This booklet explains the concepts of options, how they work and what they can be used for. It should be noted that this booklet deals exclusively with Exchange Traded Options over listed shares and indices, and not company issued options. Information on other ASX products is available by calling 1300 300 279 or visiting .au. To assist in your understanding there is a glossary of terms on page 33.

Option sellers are referred to as `writers' because they underwrite (or willingly accept) the obligation to deliver or accept the shares covered by an option. Similarly, buyers are referred to as the `takers' of an option as they take up the right to buy or sell a parcel of shares.

Every option contract has both a taker (buyer) and a writer (seller). Options can provide protection for a share portfolio, additional income or trading profits. Both the purchase and sale of options, however, involve risk. Transactions should only be entered into by investors who understand the nature and extent of their rights, obligations and risks.

2

What is an option?

An option is a contract between two parties

There are two types of options available:

giving the taker (buyer) the right, but not

call options and put options.

the obligation, to buy or sell a security

at a predetermined price on or before a

Call options

predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract.

Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a

For illustrative purposes, the term shares is

predetermined date.

used throughout this booklet when referring to the underlying securities. When considering options over an index, the same concepts generally apply. From time to time options may be available over other types of securities such as instalment receipts or preference shares.

Call option example

Assume Santos Ltd (STO) shares have a last sale price of $14.00. An available 3 month option would be a STO 3 month $14.00 call. A taker of this contract has the right, but not the obligation, to buy 1,000 STO shares for

The standard number of shares covered by one $14.00 per share at any time until the expiry*.

option contract on ASX is 1,000. However, this For this right, the taker pays a premium (or

may change due to adjustment events such as purchase price) to the writer of the option.

a new issue or a reorganisation of capital in the In order to take up this right to buy the STO

underlying share.

shares at the specified price, the taker must

All of the examples in this booklet assume

exercise the option on or before expiry.

1,000 shares per contract and ignore brokerage On the other hand, the writer of this call

and ASX fees. You will most definitely need to consider these when evaluating an option

option is obliged to deliver 1,000 STO shares at $14.00 per share if the taker exercises

3

transaction. For options over an index, the

the option. For accepting this obligation the

contract value is based on a dollar value

writer receives and keeps the option premium

point. Details can be checked in the contract

whether the option is exercised or not.

specifications.

TAKER (BUYER)

BROKER

ASX

BROKER

WRITER (SELLER)

It is important to note that the taker is not obligated to exercise the option.

*The expiry day for stock options is usually the Thursday before the last Friday in the expiry month unless ACH determines another day. This may change for various reasons (eg. for public holidays), so please check with your broker. For index options, refer to the contract specifications.

Put options

Put options give the taker the right but not the obligation to sell the underlying shares at a predetermined price on or before a predetermined date. The taker of a put is only required to deliver the underlying shares if they exercise the option.

Once again it is important to note that the taker is not obligated to exercise the option.

Put option example

An available option would be a STO 3 month $14.00 put. This gives the taker the right, but not the obligation, to sell 1,000 STO shares for $14.00 per share at any time until expiry. For this right, the taker pays a premium (or purchase price) to the writer of the put option. In order to take up this right to sell the STO shares at a specified price the taker must exercise the option on or before expiry. The writer of the put option is obliged to buy the STO shares for $14.00 per share if the option is exercised. As with call options, the writer of a put option receives and keeps the option premium whether the option is exercised or not.

If the call or put option is exercised, the shares are traded at the specified price. This price is called the exercise or strike price. The last date when an option can be exercised is called expiry day.

There are two different exercise styles: American style, which means the option can be exercised at any time prior to the expiry; and European style, which means the option can only be exercised on the expiry day. Most stock options traded on ASX are American style.

RIGHTS AND OBLIGATIONS

4 CALL OPTION

TAKER (BUYER)

Taker receives the right to buy shares at the exercise price in return for paying the premium to the writer.

Writer receives and keeps premium but now has the obligation to deliver shares

if the taker exercises.

WRITER * (SELLER)

*TAKER (BUYER)

PUT OPTION

Taker receives the right to sell shares at the exercise price in return for paying the premium to the writer.

Writer receives and keeps premium but now has the obligation to buy the underlying shares

if the taker exercises.

WRITER (SELLER)

* The taker of a put and writer of a call option do not have to own the underlying shares.