Call and Put Options, What, Why, How.
What is an Option?
An option is a contract between a buyer (taker) and seller (writer) of shares giving the buyer the right to buy or sell a security a security at a predetermined price on or before a predetermined date. The buyer is not obligated to buy or sell the security. To get an option the buyer pays a price (premium) to the seller of the contract.
Generally 1,000 shares are covered by one option contract.
An option price is made up of the intrinsic value and the time value. The intrinsic value is the difference between the current share value and the exercise price. The time value is the amount you are prepared to pay for the possibility that the share price might move in your favour during the life of the option. The time value decreases over time and becomes more rapid closer to the expiry date. An option will generally lose one third of its time value during the first half of its life and the remaining two thirds of its value during the second half.
On average less than 15% of options are exercised.
Call Options
Call options give the buyer the right, to buy the underlying shares at a predetermined price on or before a predetermined date. The buyer is not obligated to buy the shares. The seller must deliver the shares if the call option is exercised.
Example
A particular share has a last sale price of $15.00. A three month option is available.
Buyer: The buyer has the right to buy 1,000 of that particular share for $15.00 at any time until the shares expire in 3 months time. The buyer pays a premium of $1.50 per share for this right. The buyer must exercise the option on or before the expiry date.
Seller: The seller must deliver 1,000 shares of that particular share at $15.00 per share if the buyer exercises the option. The seller receives the $1.50 premium per share whether the option is exercised or not.
Put Options
Put options give the buyer the right to sell the underlying shares at a predetermined price on or before a predetermined date. The buyer is not obligated to sell the shares. The seller (writer) is required to buy the shares if the put option is exercised.
Example
A particular share has a last sale price of $15.00. A three month option is available.
Buyer: The buyer has the right to sell 1,000 of that particular share for $15.00 at any time until the shares expire in 3 months time. The buyer pays a premium of $1.50 per share for this right. The buyer must exercise the option on or before the expiry date.
Seller: The seller must buy 1,000 shares of that particular share at $15.00 per share if the buyer exercises the option. The seller receives the $1.50 premium per share whether the option is exercised or not.
Why use Options?
Risk Minimisation
Put options allow you to hedge against a possible fall in the value of shares you hold. This is similar to taking out an insurance policy on your car guaranteeing a value for the car.
Time to Decide Whether to Buy or Sell
A call option locks in the purchase price, it gives the call option holder until the expiry date to decide whether or not to exercise the option. The taker of a put option has until the expiry date to decide whether or not to sell the shares.
Speculation
If you own shares and decide that the market is going to rise you may decide to purchase call options to get a higher return on your shares. If you own shares and expect the share price to fall you may decide to buy put options as insurance against this.
Leverage
Leverage allows you to potentially get higher returns from a smaller outlay. Leverage is more risky than investing directly in the underlying shares. Trading options can allow you to benefit from a change in the price of the share without having to pay the full price of the share.
Example
If you purchase 1 call option and 1,000 shares.
|
|
Option |
Stock |
|
Bought on March 1st |
$260 |
$3,000 |
|
Sold on May 1st |
$420 |
$3,500 |
|
Profit |
$160 |
$500 |
|
Return on Investment |
61% |
17% |
Diversification
Options allow you to use a lower initial outlay than purchasing shares directly, so you can build a diversified portfolio more cheaply.
Income Generation
You can earn extra income in addition to dividends by writing call options against shares. You receive the option premium upfront. Note that there is a possibility that your shares could be exercised and you will have to deliver your shares at the agreed exercise price.
How to Use Options to Your Advantage
- Earn Income: If you own or are purchasing shares you can write call options against your shares.
- Protect the Value of Your Shares: If you are concerned about a short term fall in the value of your shares you can buy put options. You can also write call options to generate extra income from your shares, offsetting a decline in share price.
- Profit from Share Price Movements: You can profit from changes in share price without having to trade the underlying share. If you expect the market to rise you can buy call options. If the share price increases the value of your call option increases, you can then sell an equivalent call option to close out any time prior to the expiry date and take your profit instead of purchasing the shares. If you expect the market to fall you can buy put options. If the share price decreases the value of your put option increases, you can then sell the put option to close out any time prior to the expiry date and take your profit.
- Using Options to Give You Time to Decide: Taking a call option can give you time to decide if you want to buy the shares. Taking a put option can lock in a selling price for shares that you already own. In both cases the most you can lose is the premium you paid for the option.
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