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Options

An option is one of the most straightforward and popular types of derivative. There are two forms of option. The call option gives you the right but not the obligation to buy the underlying asset for a specified price at a future date. The put option gives you the right but not the obligation to sell the underlying asset for a specified price at a future date. Although options are sometimes applied to real assets, the underlying assets are usually equities (company shares), which are financial assets. Let’s see how that works.

Call option

The person who sells an option is generally referred to as the writer. The writer receives a premium up front from whoever buys the option. Suppose you think that oil prices are likely to rise during this year, and that the current share price (560p) for BP doesn't fully take account of these rises. You decide to buy a call option on 1,000 BP shares at a striking price of 580p per share with an exercise date six months ahead, and pay a premium of 25p per share. Your outlay is £250. If you decided to buy the shares instead, your outlay would be £5,600.

If the share price rises above 580p, your option is said to be ‘in the money’. You can choose whether to sell the option, or hold until the exercise date. At that point you can choose whether to exercise the option and take (and pay for) the underlying shares, or simply pocket any profit you would have made if you had exercised and immediately sold the shares. If the price of BP shares remains at or below the striking price, your option is ‘out of the money’ and is worth nothing when it expires.

Let’s suppose the share price reaches 630p by the exercise date. Your profit is the difference between the striking price (580p) and the market price (630p) per share, on 1,000 shares, less the option premium. You have made £250 profit on a £250 investment, a rate of return of 100%. If you had simply bought the shares at the original market price of 560p and held them for six months, you would have made a profit of £700 on a £5,600 investment, a rate of return of 12.5%. It’s this gearing effect that makes derivatives attractive.

Suppose however, the price of BP shares reached 580p by the exercise date. Your option is worthless and you have lost the amount you paid in premium (£250). Had you bought the shares instead you would have made a profit of 20p per share (£200) plus any dividend paid during the period. Gearing amplifies your returns but increases the risk significantly.

The person who writes the call option will normally be a holder of the shares, otherwise he or she stands to lose a lot of money if the share price rises well above the exercise price. The writer stands to miss out on any profit he might have made if the share rice rises above the striking price, but has made a guaranteed £250 for the option plus the difference between the market price when he wrote the option and the striking price (another £200).

Put option

Suppose you had bought BP shares and the price is now 630p. After a time you feel that oil prices might weaken and oil company shares might fall in price. You decide to buy a put option, which would give you the right to sell 1,000 shares at a striking price of 600p at an exercise date six months ahead, for a premium of £250. If your feelings are right and the price falls below 600p your option is ‘in the money’. Even if there is a total collapse of oil prices, and oil company shares, your position is protected. You have hedged your investment in BP.

Index options

As well as options on individual shares, you can buy call and put options on a market index such as the FTSE100 or the All share index. Since share prices tend to move in line with the market as a whole (as well as in response to company specific news), you can use an index option to hedge your portfolio of shares against falls in the market.

Other options

Besides equity options, there is a wide range of derivatives contracts on bonds, currencies, and interest rates. In the UK, the London International Financial Futures Exchange (LIFFE) is the primary market for derivatives trading. It is now integrated with the pan-European exchange, Euronext.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page