Exchange-traded options (ETOs) allow investors to manage risk and protect their portfolios against capital loss for a relatively small cost. Writing options also enables investors to earn income, though this also entails risk, especially in a rising market.

An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a security at a predetermined price on or before a predetermined date. To buy this right, the taker pays a premium to the writer (seller) of the options contract.

Call options give the buyer the right to buy a stock at a predetermined exercise price, or strike price. Put options, meanwhile, give the holder the right to sell a stock at that price. An ETO locks in the sale price of your shares for the life of the option, no matter how low the share price falls. An options contract typically covers 100 shares.

Some investors use options to defer the decision to buy or sell shares, a strategy that allows you to see how the shares behave before making a commitment. If you buy an option and decide not to exercise it, the most you can lose is the initial premium--normally only a fraction of the total share price.

The ASX's senior manager of equity derivatives, Graham O'Brien, says the most common reason investors use options is for "protecting against market falls (buy puts) or earning income in flat markets (selling calls over stock owned)".

Shaw and Partners' options manager, Nick Biven, says options trading can produce a good income, especially when the market is flat, but caution is warranted. "Most of our clients are sophisticated or professional investors, who have experience in derivatives trading, and financial advisers," he says.

For retail investors, it's crucial to get financial advice first so they understand what they're doing.

The most popular options on the ASX are those taken over the ASX/S&P 200 index, which enable investors to take a view on which way the stock market overall is going, without taking on any specific company risk.

Unlike put or call options, shares don't change hands with options index trading, just cash. As per the underlying index, the strike price and premium of an index option are expressed in points.

"Clients with well-diversified portfolios can use index options rather than a combination of various single stock options to help reduce the cost--protect or earn income in one trade as opposed to many," says O'Brien.

"Speculators often prefer the index as it can be easier to predict through technical analysis as opposed to single stocks.

"Calls have more (net) writing than puts, meaning clients selling calls are expecting the market to move sideways or slightly up," says O'Brien. "Many clients buy [put] index options to protect their portfolios against market falls while the sellers are expecting the market to move sideways or slightly down."

The tables below highlight the most popular ETOs traded on the ASX.

Top 10 call and put option contracts

Income generation is a big reason to buy and sell options. By selling a put option, you can create income from writing the put, as well as committing to buy stock at a lower level. By selling a call option, you have the obligation to sell the shares if the taker exercises.

"In a flat market, clients who write options to generate income, including selling calls to hedge against a stock fall, will be the most profitable. Speculators are the least likely to make money," says Biven.

"But in a market that rises sharply, as we've had in recent weeks, it gets harder to make money. We have seen writers of index calls start to make losses after making strong profits the previous year.

"Writers of calls over stock, although having received small premiums from selling the calls, are getting exercised, having to sell their stock and miss out on potential capital gains.

"The biggest risk of using options is selling something which you don't own. The risk is that you can't fund the margin and you need to close out the position at a loss."

If the seller of a call option doesn't own the underlying shares and a call option is exercised, the seller would be forced to buy the underlying shares at a market price higher than the strike price to deliver them to the options buyer.

For those that already own the underlying shares you may lose out on potential capital gains if the market price rises above the strike price.

Another factor to be aware of is that the cost of an ETO is variable, depending on market conditions and the volatility of a particular share. The premium rises in more volatile share markets so you pay more for the insurance offered by a put options contract.

Brokerage fees average from a minimum of around $50 per options trade or up to 1 per cent of the premium paid or received on the options contract, whichever is higher.

The ASX charges additional fees for options contracts, 45 cents plus GST for index options and 13 cents for an option contract over shares. It may not sound like much, "but it can add up," says Shaw's Biven.

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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