If you are looking for a security to invest in, options are one choice available to you. But what are “options”, and what are the benefits, or the cons, of investing in options? Are there alternatives? Here’s an Investor Buddy guide to options.
What is an option?
An option is a contract between the buyer and seller that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a set price before a certain date. Just like stocks or bonds, an option is essentially a security, but it is also a binding contract between the parties. Exchange Traded Options (ETOs) are broken down into Equity Options and Index Options. The Australian Stock Exchange has a load of information for about options and other investing alternatives such as derivatives, warrants, bonds and shares. This includes handy diagrams, tools, and even online classes.
Why use options?
There are several reasons why people choose to invest in options:
- Using leverage to increase returns. A principal reason for the popularity of options is the ‘leverage’ that options offer. Although they usually cost not more than 5 per cent of the purchase price of the shares that underlie them, investors can be exposed to more shares than if they were to buy the actual stock.
- Share price protection. You can be protected from a fall in the value of a share with options, as the selling price is secured for the underlying shares.
- Diversification. As well as costing less if compared ‘dollar to dollar’, options allow the diversification of shares. In other words, more can be purchased for the same money.
- The possibility of earning income against shares you hold or are looking to buy. “Writing” (selling) options against stocks can generate income.
Using brokers for options plus more
The needs of the option trader are different to those of investors who only invest on a buy-and-hold basis as option trading requires more frequent monitoring than share trading, due to the leveraged risks. As such, it is compulsory your broker is accredited to advise on options specifically. Brokers are divided into full-service brokers (including research and advice), discount brokers (simply carrying out your buy and sell orders), and those that combine the two to a certain level.
