Q. Should a modestly self-funded retiree dabble with Options?

A. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (strike price) on or before the expiration date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and obligations.

A Call option gives you the right to buy an asset at the pre-determined price by a pre-determined time.  A Put option gives you the right to sell an asset at the pre-determined price by a pre-determined time.

There are four different types of participants in the options markets:

  • Buyers of Call options
  • Buyers of Put Options
  • Sellers (or writers) of Call options
  • Sellers (or writers) of Put Options.

Buyers of Call or Put options are not obligated to buy or sell the underlying assets at the expiry of the option. As the name suggests they have the option to do so.  Writers of Options are obligated to buy or sell if the counterparty wishes to fulfil the contract. It is unlikely that you would participate as writer of options.

The pricing of options is determined by the strike price of the underlying asset relative to the market price of underlying asset at any given time.  The time left until an option expires will also influence the market price of the option.  Finally the price will be determined by the market forces and the supply of buyers and sellers in the market at any given time.

I have tried to keep this as simple as possible but as you can see these things are not simple.  Options are complex investments and should really only be used by market professionals or sophisticated investors. Terms like “modestly self funded” and “dabble” concern me.

If you wish to trade options you are strongly advised to do a course to understand how they work, how to price options and how to manage the risks.  Make sure the course is offered by a reputable provider who has no vested interest in you doing the course!  The ASX www.asx.com.au  runs courses on options trading.

Anyone who is considering trading options needs to be clear as to what they hope to achieve; is it to protect the value of their existing portfolio? Gain greater exposure to a stock or market? Limit exposure to a market or stock? Or is it taking a “punt” on the prospective fortunes of the market or a stock.

Regardless of why you would want to “dabble” with options, do not consider options trading as the primary mechanism to fund your retirement income or to generate wealth.  Please ensure you manage and limit your risk and exposure.  Ensure you put in place limits to how much you can lose.

At best consider options trading as a diversification tool to manage risk or enhance returns.  Be clear on what you hope to achieve, how you want to achieve it and most importantly why you are doing it

Follow Andrew on Twitter @AndrewHeavenFP. This article was originally published in The Australian