Options: basics
What are options?
An option is a contract giving you the right to buy or sell an underlying asset at an agreed price before or when the contract expires. Underlying asset refers to the asset to be bought or sold if the option is exercised. It can be a stock, a commodity (eg gold), a bond, a currency or an index (eg Hang Seng Index).
As a buyer of an option contract, you pay a premium for the right to buy or sell the underlying asset. On the other hand, if you are a seller of an option contract, you receive a premium from the buyer, and you have the obligation to buy or sell the underlying asset to the buyer.
Options can be traded in the exchange as a standard contract or over-the-counter, ie only traded via a dealer network as a tailored contract.
Know the key terms in option trading
Before understanding more about the mechanics of options trading, it is important for you to know the following key terms in an option contract:
- Exercise price / Strike price: The pre-determined price at which the underlying asset can be bought or sold.
- Expiry date: The last day on which a buyer of an option contract can exercise the right to buy or sell the underlying asset.
- Exercise style: It refers to when an option can be exercised. There are two exercise styles: American and European. The American-style option can be exercised during any trading day on or before the expiry date. The European-style option can only be exercised on the expiry date.
- Contract size: The amount of the underlying asset that an option contract represents. For example if the underlying asset of an option contract is a certain stock, the contract size will be the number of shares (eg 1,000 shares).
- Settlement method: It refers to how the buy/sell of the underlying asset will be settled when the option is exercised. There are two ways of settlement - either by physical delivery of the underlying asset or in cash.
Types of options
There are two types of options - call vs put
Call option (ie Call): A call option gives the buyer the right to buy the underlying asset. The buyer of a call option can determine whether to exercise the right when the market price of the underlying asset is higher than the exercise price.
Put option (ie Put): A put option gives the buyer the right to sell the underlying asset. The buyer of a put option can determine whether to exercise the right when the market price of the underlying asset is lower than the exercise price.
How are options traded?
When you buy an option, you pay a premium. In general, your maximum loss will be limited to the premium that you paid, under the circumstances that the option is not exercised.
On the other hand, when you sell an option, you receive the premium, but at the same time as you have the obligation to buy or sell the underlying asset, you will have to make a deposit (ie the so-called margin) in your trading account. In case the price movement of the underlying asset goes against your expectation, you may be required to pay up additional deposit. Similar to margin trading of stocks, your broker may issue a margin call that request you to make up the margin shortfall. Your potential loss for selling an option can be much more than the premium that you receive.
Normally, for exchange-traded options, the exchange sets the margin required for exchange participants (ie the brokers), but the broker may set a higher margin level than that required by the exchange. You must understand and check from your broker the margin levels before you start trading options in the exchange. You may refer to the “Margin data search” in HKEx website to find out the estimated margin requirement for selling an option.
Liquidity risk of option trading
Options traded in the Hong Kong exchange are operated under a market-making system to provide market liquidity. That means option traders who are brokers/dealers are appointed as a market maker by the exchange. These market makers are obliged to quote both bid and offer prices for the option contracts. You may know more about the market maker obligations from HKEx website.
However, investors should bear in mind that the quotes provided by a market maker are not always at your desired level. Moreover, options can become illiquid in certain circumstances like unusual market volatility, during which a market maker is not available or cannot meet its obligation. In such case, you may find it difficult to trade options. Investors should be aware of this liquidity risk.
“List of Market Makers or Liquidity Providers in Futures Exchange Products and Stock Options” on the HKEx website.
What are the transaction costs for trading options?
If an option is traded in the Hong Kong exchange, transaction costs include brokerage commission, an SFC levy, an investor compensation levy*, exchange fee or trading tariff, depending on the type of option. You also have to pay a fee to exercise an option.
*The investor compensation levy has been exempted since 19 December 2005.
For trading fees and commission of transacting options traded in Hong Kong exchanges, please refer to the “Trading Fees and Commission Table” on the HKEx website.
To learn more about options, you may visit the HKEx stock options corner which provides information about the Hong Kong stock options market, how to make use of options and frequently asked questions about option trading.
