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Options and warrants are derivatives – that is, their value depends on the value of the share – so you’ll need to have done your underlying analysis of the share’s prospects before you start considering buying the options. One of the most attractive – but equally the most dangerous – aspects of options is that they can provide you with the ability to greatly leverage your money.
Essentially an option is just what the name suggests – it is an option to buy or sell shares at a particular price, as if you said to a friend ‘If you ever want to sell that car of yours, I’ll give you five hundred quid for it.’ Your friend doesn’t have to sell you the car – but he can sell it to you at that price.
Yes, that’s a childish example. But it’s quite an important distinction between options and some other derivatives, such as futures, that you have the choice, and can let the option lapse. With futures, you don’t have the choice – you have to exercise them. Traded options give you a third choice – as well as exercising the option (buying the shares), or letting it expire, you can trade it on the market. You can have a call or put option – a call gives you the right to buy the shares at a given price, a put gives you the right to sell them at that particular price. (In fact, very few traded options are ever exercised – that’s not what they’re there for.)
The pricing of options is a horrifically rocket-scientist job if you do it properly, involving the Black-Scholes Formula. I have actually used the wretched thing and it’s hard work unless you have a certain aptitude, and I think I can confidently say it’s an aptitude I haven’t got.
A simpler way of looking at options pricing is that the option has two potential sources of value. First, intrinsic value, the difference between the share price now and the ‘strike price’ of the option.
The premium (that is, the price) of the option should reflect both these sources of value. Remember that options are wasting assets, since they expire at a particular date – if you buy an out of the money option and hold it all the way to expiry, it will gradually decline in value until you have lost all your money. So buy and hold is not a strategy that works with options, as it does with shares.
Obviously, if you think the share price is going up, you’d buy a call option (you could, equally, sell a put option short), and if you think the price is going down, you’d buy a put.
There are all kinds of strategies that options traders use to generate income and capital returns – writing options, straddles, collars and so on. I’m not going to cover those here – they are for the trader, not the investor, and if you’re mainly an equity investor, they’re probably not very relevant to you.
The simplest way of using options is to gear up your investment on shares you want to buy – getting more exposure for the same stake. You might decide to use options rather than buying the underlying shares if you think the share price movement will occur suddenly – for instance if there’s a regulatory decision coming up, like the bank charges case in the High Court or the water regulator’s decision on pricing, you could use options to take a position on it.
But you can also use options to hedge your portfolio. Suppose you held water shares for the income from dividends, but you were worried about the water regulator coming out with a very adverse decision. It’s not worth trading in and out of your whole portfolio, if you want to carry on holding the shares as long as the decision is a good one. Instead, you could defend yourself against downside risk by buying a put.
One major warning that should accompany both options and warrants is that they can be highly illiquid, with big spreads. Another key concern is margin calls – these happen when an options trading account no longer has enough money to support the open trades. Because of the leverage effect of using options, these margin calls could wipe an investor out so you would need to be particularly careful about using options to trade in volatile stocks.
Finally, you should be aware that these are very technical markets and you really need to do your own research if you’re going to use these products.
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