There are two types of options, calls and puts. A call option gives you the right to buy, say, 1000 Telecom shares at a fixed ("exercise") price on or before an expiry date.
Let's say you pay 40c a share, or $400, for the option; the exercise price is $6.25, and the expiry date is June 23 next year.
If, before that date, Telecom shares rise above $6.25, you can exercise your option to buy at the then-cheap price.
You can then sell the shares whenever you wish - hopefully at a profit that will more than cover the price of the option and all transaction costs.
But if June 23 comes and goes and the shares have never reached $6.25, you throw away your option. The $400 is wasted. Obviously, when you bought the option, you were expecting the share price to rise.
What about the person who sold the option to you? At the time of the sale, they get the $400.
After that, if the Telecom share price rises enough for you to exercise the option, the seller loses. They have to sell the shares to you at below market price.
If they don't already own the shares, they will have to buy high and sell lower (or they may minimise their loss by buying as soon as the share price hits $6.25).
On the other hand, if the price never tops $6.25 by June 23, they've gained by $400. And as long as it doesn't top $6.65, they've made at least some gain.
The person who sells a call, then, is expecting that the share price won't rise much or will fall.
They, too, may be a risk taker. There's another possibility, though. The seller might already own Telecom shares, and be worrying that the price will fall.
For them, selling the option has given them at least some gain - what they got for the option - if the price does, in fact, go down.
People or institutions in that situation use options to reduce rather than take risk and are prepared to give up some of their potential return to do that.
A put gives you the right to sell - as opposed to buy - say, 1000 Telecom shares at an exercise price on or before an expiry date.
You can follow through the examples above in reverse. But the basic idea is that if you sell a put, you are expecting the share price to rise.
If you buy a put, you might be expecting that the share price will fall. Or you might own Telecom shares and be worried that their price will fall. With the option, you can limit your loss by guaranteeing you won't get less than the exercise price.
There are three main points about options:
* They're quite tricky to get your head around. Don't trade them if you don't fully understand them.
* If you own the underlying shares, you can use options to reduce the risk of holding those shares, as described above.
But there's no free lunch. If you sell a call, you get the proceeds from the sale. But if the price of your shares rises, you could end up losing part of the share price gain.
And if you buy a put, you limit your potential losses. But to do that, you pay the price of the option.
In some cases, it will end up worth the hassle and the transaction costs, in other cases, it will not.
* If you're trading options as a risk taker - without owning the underlying shares - note the following: options trading is what is called a zero sum game. For every dollar one person gains, another person loses a dollar.
The average options trader, then, makes zero, before transaction costs.
After fees, commissions, brokerages, taxes and so on, the average person suffers a loss.
You might think you'll do better than average. But I wouldn't count on it.
Consumers Institute surveyed people who attended a three-day course on options trading run by a man who said he made a 4900 per cent return on options.
Of the 31 people who responded and had been actively trading options, one had made a profit, one had broken even, and four had made money using a related technique.
The others reported losses ranging from about $2000 to $6000. Add course costs of $3000 to $5000, plus more for software and advanced courses. "It's an expensive process," says Consumer magazine.
What about taxes?
New Zealand doesn't have a capital gains tax. But if you trade any financial instrument that doesn't pay interest or dividends, the only reason to buy it is to sell at a profit. So that profit will be subject to income tax.
I don't like the chances of any options trader convincing the IRD that their gains should not be taxed.
What's more, if you are paying tax on your options profits, "there's a higher chance that the IRD may ask questions about your other investments", says PricewaterhouseCoopers tax partner Tony Gault. "You're putting yourself on the radar screen."
The situation may be different, though, if you own the underlying shares and use a share option to reduce risk.
Vernon Phillips, of the IRD, says if your share gains are already taxable and your losses deductible, your options would almost certainly be treated in the same way. There would be situations, then, when a gain on one could be offset by a loss on the other.
If your share gains aren't taxable, and you buy or sell an option for the purpose of reducing risk, it's possible that any gain or loss from that activity may not be taxable or deductible.
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