What are Exchange Traded Options (ETOs) and how do they work?

The rundown

  • ETOs are contracts between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a security or index at a predetermined price on or before a predetermined date. They’re traded on the ASX and regulated by the Australian Securities and Investments Commission (ASIC).
  • The two main types are call options (the right to buy) and put options (the right to sell).
  • Like insurance, buying a put option can protect against a fall in the share price of a stock an investor owns. While selling a covered call can generate income while holding a stock, offsetting potential downside. 
  • To generate income, selling options (especially covered calls) allows investors to collect premiums, which can supplement returns in flat or mildly bullish markets. 
  • ETOs allow investors to gain exposure to a stock or index with less capital than buying the underlying asset outright. This magnifies potential gains but also increases risk. 

What is an Exchange Traded Option (ETO)?

ETOs are contracts between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a security or index at a predetermined price on or before a predetermined date. To acquire this right, the taker (also known as the buyer) pays a premium to the writer (also known as the seller) of the contract. They’re traded on the ASX and regulated by ASIC. 

ETOs could help investors profit from movements in the price of an underlying security like a share or index. So, it’s like buying or selling a stock, with a few extra steps, let’s explore how they work.

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What is a call option?

A call option is the right to buy a stock or an index at a predetermined price before a set expiry date; this includes a premium paid for the opportunity. So, the ‘extra steps’ here are the premium and set expiry date. 

For example, paying the premium to buy a call option on a stock gives the investor the right to buy that stock, but not the obligation to buy, on the expiration date. The investor could make money if the stock rises above the exercise price by selling or exercising the call option.

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What is a put option?

A put option is the right to sell a stock or an index at a predetermined price before a set expiry date; this includes a premium paid for the opportunity. So, as with the call option, the ‘extra steps’ here are the premium and set expiry date. 

For example, paying the premium to buy a put option on a stock gives the investor the right to sell that stock, but not the obligation to sell on or before the expiration date. The investor could make money if the stock falls below the exercise price by selling or exercising the put option.

How to use ETOs: an example1

Suppose you own 1,000 shares of XYZ Ltd at $10 each. You sell a covered call with a strike price of $11, expiring in one month, and receive a premium of $0.30 per share. If the share price stays below $11, you keep the premium and your shares. If they rise above $11, your shares may be sold at that price, locking in a gain plus the premium. 

Explore six ETO strategies and how they can impact your investing strategy.

Can I generate income using ETOs?

Yes, investors can generate income from the premium.

For example, if an investor owns a stock and sells a  ‘covered call’ (which is selling the right for someone to buy this same stock), this allows them to collect the premium and gives the buyer the right to purchase the stock at the specified price on or before the specified expiration date, if the option is exercised. This could allow the investor to make an income from the premium, however this works best where the market is flat.

Can I manage risk with ETOs?

Investors could use options to reduce the risk of their portfolio.

For example, if an investor has $100,000 invested in one stock and believes it will rise in value over time, however, they worry it may fall in the short term, they could mitigate the possible fall in value by buying a put option. This allows the investor to sell this stock (but does not oblige them to sell the stock) on or before the expiration date. Investors can make money if the stock falls below the exercise price by selling or exercising the put option.

Risks to consider

Trading ETOs comes with some risks. Key risks include:

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Time decay

Options lose value as expiry approaches.

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Volatility

Sudden market moves can impact option pricing.

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Leverage risk

ETOs increase exposure to risk.

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Liquidity risk

Some stocks have few buyers and sellers, which could make a fast sell a problem.

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Potential for loss

Especially when writing (selling) options, losses can be significant. 

ETOs allow investors to gain exposure to a stock or index with less capital than buying the underlying asset outright. This magnifies potential gains, however, ETOs also increase a portfolio’s exposure to risk.

 Advanced investors may use ETOs to manage the timing of capital gains or losses. However, tax treatments can be complex and may depend on the strategy used. Always refer to the ATO or speak to a licensed tax adviser. 

Ready to get started?

Discover how you could open a CommSec Options Account today. During your application, you’ll complete a Target Market Questionnaire (based on the Options Target Market Determination) and a knowledge assessment2 to make sure an Options Account is right for you.

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1 Assumptions: The above “Example”, is a hypothetical example isand for illustrative purposes only. No warranty is provided regarding the results shown and different assumptions will lead to different outcomes which could vary significantly from the “Example”. No tax implications have been considered in this example and you should seek your own professional tax advice before investing.

2 Trading Exchange Traded Options (ETOs) can involve considerable risk. For that reason, you should only trade ETOs if you understand the nature of the product (especially your rights and obligations) and the extent of the risks you are exposed to.

The target market for this product can be found within the product’s Target Market Determination, available here.  
 
A Product Disclosure Statement for Exchange Traded Options (Options) issued by Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814 is available from www.commsec.com.au. 

You can view the Exchange Traded Options Product Disclosure Statement and Terms and Conditions, CommSec Best Execution Statement and CommSec Financial Services Guide, and should consider them before making any decision about these products and services. There can be high levels of risk associated with trading in Options; only investors familiar with the risks of Options trading should consider these products.

The Academy is intended to provide general information of an educational nature only. Any securities or prices used in the examples given are for illustrative purposes only and should not be considered as a recommendation to buy, sell or hold. Past performance is not indicative of future performance. Investing carries risk.

© Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814 (CommSec) is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945. CommSec is a Market Participant of ASX Limited and Cboe Australia Pty Limited, a Clearing Participant of ASX Clear Pty Limited and a Settlement Participant of ASX Settlement Pty Limited.

The information on this page has been prepared without taking into account your objectives, financial situation or needs. For this reason, any individual should, before acting on this information, consider the appropriateness of the information, having regards to their objectives, financial situation or needs, and, if necessary, seek appropriate professional advice.

CommSec does not give any representation or warranty as to the accuracy, reliability or completeness of any content on this page, including any third party sourced data, nor does it accept liability for any errors or omissions.
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