There is a myth that all derivatives are complicated and therefore best avoided. In reality, options are fairly simple to understand. And if you use them conservatively and wisely they can be an extremely valuable addition to your investment toolkit.
Consider this example. There is a prestige housing development and you want to secure one of the units that will be ready to move into in a year’s time. You pay a deposit of £20,000 that gives you the right but not obligation to buy a property at £500,000 in a year’s time.
Now suppose in a year’s time the value of the property is £550,000. The value of your deposit is now £50,000, because you are allowed to buy the property at £500,000.
You may elect to purchase the property, or alternatively sell your “right to buy” at £500,000 to a third party for £50,000 booking a £30,000 or 150% profit. If, on the other hand, in a year’s time there is a property market crash and the property of your dreams is worth £400,000, it would be absurd to exercise your right to buy at £500,000 so you just walk away with the loss of your £20,000 deposit. Whatever happens to the property market your maximum loss is limited to your deposit while your maximum gain is theoretically unlimited. In options terminology the above contract that gives you the right but not obligation to buy an asset at a specified price before a given time is called a call option.
Now the same principles apply to buying a call option on a share. The deposit in the case above is called the premium, the deadline for the purchase is called the expiry date and the price agreed in advance is called the strike price. The main difference with the example above is that options on shares traded in London can be exercised at any time after the option has been purchased. In other words you do not have to wait until the expiry deadline to realise your profit.
The profit and loss of a call option
Now let’s suppose the price of XYZ shares are 50p. You buy an XYZ call option strike price 50p expiring in December for a premium of 5p per share. Now come December if the share price is 80p you make a profit of 25p (80p – 50p strike less 5p premium paid upfront). If the share price finishes at 50p or below then you lose your premium of 5p and nothing more, while the break even share price at expiry is 55p (strike price plus premium). It is important to bear in mind that the underlying share price has to go up by a greater amount than the premium you pay for you to make a profit.
The strike price does not have to be the same as the market price of the share. With call options the higher the strike price relative to the share price, the lower the options premium. This is logical because the right to buy an asset at 70p is worth more than the right to buy it at 110p. The table below gives an array of premiums for call options at different strikes and expiries when the underlying share price is 98p.
|
Strike price |
December 2009 |
March 2010 |
June 2010 |
|
70p |
29 |
31 |
32 |
|
80p |
19 |
21 |
22 |
|
90p |
10 |
12 |
13 |
|
100p |
3 |
4 |
5 |
|
110p |
1 |
2 |
3 |
You will also notice that options that have a longer time to expire have higher premiums.
Just like car insurance
As Michael Winner might say – calm down dear, it’s only a call option!
If the pricing of options premiums is still elusive you may wish to consider an everyday example: the cost of insuring a car. The premium you pay is dependent on a number of factors: a) time period of insurance, whether for a week or a year, b) the value of the car, c) risk factors like age of driver, past driving record and the likelihood that the car will be vandalised or stolen.
The cost of buying an option on a share is also called a premium. Similarly the value of that premium depends on a) time, e.g. an option that expires in a week will cost you less than an option which expires in a year’s time, b) the value of the share and c) risk factors like the past record of price volatility, e.g. the option on a share that has a tendency to fly all over the place will be more expensive than one whose price action is steady.
Indeed, as someone that spent most of the 1990s trading options, I’ve learned that the most important determinant of options premiums is volatility. When markets are extremely choppy options premiums are pushed higher, while in calm market conditions options premiums tend to erode. Just as the cost of insuring your car after an accident goes up, and tends to decline if there is a sustained period of no claims. The secret of options trading is to buy options when volatility is low and everyone is complacent and sell when volatility is high and everyone is losing their heads. This is the essence of the executing the stock replacement trade during the summer lull.
Options glossary
Call option: A contract that confers the right but not obligation to buy an asset at an agreed price on or before a given date.
Strike price: The agreed price at which the options holder can buy the asset at a future date.
Expiry date: The date on which an options contract comes to the end of its life.
Premium: The price of an option.
Volatility: A measure of how much the price of an underlying asset varies. If volatility rises, call premiums rise. If volatility falls, call premiums fall.
