Buying Put & Call Options

WHAT IS A PUT & CALL OPTION

Buying Put Options

Most people are familiar with purchasing insurance to protect the value of their property. For example, the owner of an investment property may pay for insurance which will provide protection in the advent that there is a sudden dramatic decline in the value of the property caused by some unforeseen event, for example a fire. Insurance is used both for peace of mind and also to protect the dollar value of an investment.

Whilst the use of insurance within the context of the property market is widely understood, it is a less known fact that it is possible for an investor to purchase insurance for his/her shares.
An investor who purchases shares is hoping for the share price to appreciate but there are a vast array of both foreseeable and unforeseeable factors which can lead to a decline in a company’s share price. These factors may include an unexpected earnings downgrade, a generally declining market, economic or sector specific factors, or corporate activity. To protect against these and other events which may erode the value of an investors share holding it is possible to buy insurance contracts for shares. These contracts are known as put options. Put options are traded on the ASX Derivatives Market.

How Do Put Options Work?

The buyer of a put option pays a fraction of the value of a share (called a premium) to the seller of a put option. Purchasing a put option will provide the investor with the right to sell a fixed number of shares at a fixed price (called the strike price) on or before a set date in the future (called the expiry date). Most options over shares are of a variety known as “American style” which allows the investor to exercise their right to sell the stock on any date up to and including the expiry date. Another variety of options are known as “European style” which can only be exercised on the expiry date. American style options are the most common type of option.

It can be seen that many of the features of put options are very similar to insurance contracts. Both put options and traditional insurance contracts have an expiry date, a cost (which in both cases is referred to as the premium), and an agreed value for the underlying asset (referred to as the strike price in the case of a put option).

Put options have a standardised contract size which typically covers 1000 shares of the underlying stock. There are some instances (for example in the case where there has been a stock split or consolidation) where contracts may be of a different size but in the vast majority of cases options cover the traditional 1000 units of stock.

It is important to note that a key difference between traditional insurance contracts and put options is that the holder of a put option is able to sell the option back into the market at any stage prior to expiry. The key benefit of this is that it means that it is possible to realise the profit on the put option (should the stock decline) without exercising the option.

The ability to sell put options back into the market also makes it possible to trade put options as a means of profiting from a decline in a share price of a company. Let us review the example of the above trade, but from the stand-point of a speculator hoping to profit from an expected decline in a share price.

Buying Call Options

The holder of a call option has the right (but not the obligation) to purchase shares at a particular price (known as the strike price) on or before a particular date (known as the expiry date). For this right, the buyer of the call option pays a small amount (known as a premium).

Typically speaking an options contract will cover 1000 shares (although there are some circumstances where this figure may be different.

Why Buy a Call Option?

There are many circumstances in which an investor may be expecting a share price increase but is unwilling or unable to purchase the shares outright at that time. Examples of where this may be the case include the following:

�� An investor believes that the shares may rise in response to some anticipated news event but the investor is unwilling to commit funds to the position because the downside risk is considerable if the expected positive news does not eventuate.

�� An investor would like to purchase a particular stock but currently has insufficient funds to purchase the shares.

�� An investor is confident of a dramatic upward surge in a particular stock and wants to gain as much exposure as possible to profit from this move.
In each of these circumstances an investor may choose to buy a call option.

An investor anticipating that a stock may rise for whatever reason but is concerned about the downside risks associated with outlaying all of the funds to purchase the stock can gain exposure to the shares whilst significantly reducing the risk of the position. This is the case because the investor is only outlaying a small fraction of the funds. In the example cited above just 5% of the value of each share is paid to gain exposure to the share price. The buyer of a call option cannot lose more funds than the amount invested (premium paid).

An investor wishing to purchase shares but has insufficient funds can use call options to “lock in” a purchase price with a view to paying for the shares at some stage prior to the expiry of the option once funds become available. In the example cited above, an investor may believe that ABC represents excellent value at $10.00 but is currently not in a position to pay for the shares. By paying just a small premium this investor can secure a $10.00 purchase price until the expiry of the option, allowing time for funds to be arranged.

An investor anticipating a sudden dramatic surge in a stock price of a company can use call options to increase exposure. In the example cited above, assume that ABC undergoes a period of rapid share price growth prior to the expiry of the option. ABC is trading at $16.00 at the expiry date. An investor who had purchased the stock at $10.00 has made a 60% return, whereas the holder of the call option (who has paid just 50c) has made a significantly higher return. The option to buy the shares at $10.00 is worth at least $6.00 if the stock is trading at $16.00. This would represent a 1200% profit for the holder of the call. This demonstrates one of the most attractive attributes of call options- leverage.

To open an account to trade BUY PUT & CALL OPTIONS follow this link and register your interest to open a Trading Account with our Preferred and Recommended Alliance Partner.

IMPORTANT
This document has been prepared without consideration of your specific investment objective. You must therefore assess whether it is appropriate, in the light of your own individual objectives, financial situation or needs, to act upon this information. While this document is based on information from sources which are considered reliable, Tangible Assets Financial Services, its directors and employees do not represent, warrant or guarantee, expressly or impliedly, that the information contained in this document is complete or accurate. Nor does Tangible Assets Financial Services accept any responsibility to inform you of any matter that subsequently comes to its notice, which may affect any of the information contained in this document. This document is a private communication to clients and is not intended for public circulation or for the use on any third party, without the prior approval of Tangible Assets Financial Services. AFSL 309666