As options are a type of derivative, which is a complex financial product, it’s a good idea to talk to a financial planner or check guidelines on the Australian Taxation Office (ATO) website before investing in options.
An option is a contract between two parties that gives the buyer the right, but not the obligation, to buy or sell an asset at a set price (the strike price) at a specified future date (the expiry date).
The investor pays for the option and the seller gets to keep that payment whether the buyer uses, or exercises, the option or not.
Exchange Traded Options (ETOs) are options traded on an exchange, such as the Australian Securities Exchange (ASX), so they have a standardised contract and they can be traded through an online broker, such as CommSec.1
Options can be bought and sold at any time and the price will depend on the value of the underlying asset and the amount of time left before the option expires.
What are the risks
ETOs can offer investors leverage, so a move in the value of the underlying asset will typically give a greater move in the value of the ETO. But this could be a gain or a loss, so investors have to understand the risks involved. An ETO can magnify your gain or your loss.
Using ETOs might help you to enhance the return, or increase your income, on your portfolio while also potentially protecting against any adverse move.
But any adverse move could be greater than you expect, so it is important to consider the risks involved, match that with what you are trying to achieve financially and ensure you are comfortable with this type of investment.
Two strategies that an SMSF might consider are:
1. Buy Write strategy - also known as a Covered Call
2. Buying a Protective Put
Covered Call/Buy Write Strategy
The Covered Call/Buy Write strategy is when an investor holds a long position2 in a security or single stock and writes (sells) call options over that security in an attempt to generate increased income from that particular asset.
You would usually hold a long position if you expected the price of a stock might increase.
But this Covered Call/Buy Write strategy is often used when the investor has a short-term view that the security will make minimal gains or remain flat and hence the writing of the call option is used to generate income, while also providing a limited downside protection to the underlying security given any unexpected fall.
The premium received for writing the option is the maximum profit using this strategy if writing an at-the-money call option - where the strike price is identical to the price of the stock, or where the underlying share price remains fairly stagnant.
The protection received is also the premium received and is limited in the event of any adverse move in the underlying security.
This is explained by the diagram:
Some considerations that should be taken into account with this strategy are:
- Strike price: The investor needs to balance the amount of premium received against the probability of being exercised and hence selling the stock at the strike price
- Exercise: The seller of a call option must be aware that a call can be exercised at any time if it is an American style, as opposed to a European style, and therefore you must be prepared to sell the stock at the strike price. (European style can only be exercised at the expiry date of the option.)
Protective Put Strategy
The other strategy that might be used by SMSFs is the Protective Put strategy. This can be implemented by purchasing put options (puts) against individual underlying securities or against your domestic equities portfolio by purchasing puts in the S&P/ASX 200 (ASX: XJO).
The reasons for considering this strategy include:
- The investor is positive overall but has concerns about a possible short-term adverse move and wants some insurance against this possibility
- The investor is concerned about the outlook on either a respective single security or the market overall
- Protection of unrealised gains
- Imminent news announcement with possible negative implications
If the stock or index stays strong, the investor still benefits from upside gains minus the premium paid for the respective put.
If the opposite happens, the investor has several choices.
One option is to ‘exercise the put’ which triggers the sale of the stock. The strike price sets the sale levels and if the outlook remains negative on a stock, it might turn out to have been prudent to do this.
If the investor still remains positive on the security, they can sell the put and recoup part of the premium paid, or ‘take profit’. This would depend on the strike price the investor originally selected when purchasing the put for protection.
See the diagram below:
The investor needs to balance the amount of premium paid against the level of protection required. Higher strike prices are more expensive, while lower strike prices provide less protection.
ETOs are a more complex form of investing and beginners should always seek advice. CommSec has a dedicated team that can discuss option strategies.