Options Investing E-learning - Positions

Making a profit

Buyers of options expect a change in the price of the underlying value. The buyer of a call option generally expects a rise in the price, while the buyer of a put option may expect a fall. In both cases, the investor can make a relatively larger profit with options than by investing a similar amount in the underlying value, because only the option premium needs to be invested to benefit from price movements in the underlying value. This is known as leverage. If the price of the underlying value rises, the price of call options will usually rise as well. Similarly, if the price of the underlying value falls, the price of put options will usually increase. This makes it possible for investors to make a profit on their options.

Earning extra income

An investor can also decide to write options in order to receive the option premium. Investors who actually own the underlying value can obtain an additional return on their portfolios in this way (for example: sell a call option if you own 100 shares). However, if they are assigned to deliver the underlying value, they must sell the underlying value to the holder of the call option. When holders of put options exercise their rights, the writers have to buy the underlying value.

Protection against price falls

Options also allow investors to protect themselves against falls in the price of the underlying value. Maximum protection is obtained by buying put options. Writing call options gives investors partial protection against decreases in the price of the underlying value, but in this case protection is limited to the amount of premium received.

Fixing the purchase or selling price of the underlying value

Options also make it possible to fix in advance the price at which the underlying value may be traded at a future date. For example, an investor who wants to set a maximum purchase price will be interested in buying call options. An investor who wants to set a minimum selling price will be interested in buying put options.

When buying options, the investor is not initially required to pay the notional value of the contract, but just the premium, while exposure is on the full underlying value. In this way leverage is created. Investors pay a relatively small premium instead of investing a large investment by buying stocks, bonds or commodities.

Buyers of call options can benefit from increases in the price of the underlying value during the lifetime of their options because they have the right to buy the underlying value at a fixed price.

Possibilities

If the price of the underlying value rises, the options holder must take steps to realise the profit on the option. There are two possibilities:

• The options holder can sell their options on the derivatives market. The holder’s objective in this case is normally to benefit from the increase in the option premium instead of acquiring the underlying value. In general, the price of a call option increases in line with the price of the underlying value. The profit in this case consists of the proceeds from the sale, less the original option premium and transaction costs paid. Because of leverage, a small rise in the price of the underlying value can generate a high profit (in percentage terms) on the original investment, and vice versa.
• Options holders can exercise their options. Remember that American-style options can be exercised at any time during the lifetime of the option, while European-style options can only be exercised on the expiration date. Depending on the specifications of the option, either the underlying value is delivered when the option is exercised, or settlement takes place in the form of cash.

Risk – Maximum loss

If there is no increase in the price of the underlying value, call option holders can lose their entire investment, i.e. the option premium plus the transaction costs. This is the maximum possible loss that buyers of call options can incur.

Sellers of call options take on the obligation to sell the underlying value at the exercise price, if assigned to do so. In return, they receive the option premium.

Possibilities

Selling covered call options

The main objective for investors who sell call options on an underlying value which they own (covered call options) is to obtain an extra return on their investment portfolio by receiving the option premium. A consequence of this is that the investor must accept the risk of having to sell the underlying value at the strike price. If the price of the underlying value falls below the strike price, the option may expire without being exercised and the option seller will retain the premium. The seller can also liquidate a position through a closing buy transaction on the derivatives market. However, if the price of the underlying value rises above the exercise price, there is a good chance that the call option will be exercised. The seller will then be required to deliver the underlying value. In addition to earning income from the option premium, investors may decide to sell call options as a means of fixing a selling price for the underlying value. The selling price is then equal to the strike price plus the premium received, less costs. If the option is not exercised, the investor does not have to sell the underlying value.

Selling naked call options

Investors who sell call options on underlying values which they do not own (naked call options) should be aware that they run a potentially unlimited risk. If the price of the underlying value rises above the exercise price, there is a good chance that the call option will be exercised. Option sellers will then be required to sell the underlying value at the exercise price. Because sellers of naked call options do not own the underlying value, they will have to buy it first at the market price, which will be higher than the exercise price. The increase in the price of the underlying value can, in theory, be unlimited, which means that the seller of a naked call option runs an unlimited risk. Sellers of naked call options must therefore have the financial means to purchase and deliver the underlying value if the option is exercised. To guarantee this, they have to provide an amount of margin.

Risk – only suitable for experienced investors

Because of the large losses which may be incurred, selling call options is only suitable for experienced investors who have the financial means to sustain such losses. The extent of the seller’s risk depends largely on whether the options are covered or naked. Sellers must therefore provide collateral. If the options are covered, the underlying value is held as collateral. If the options are naked, margin must be deposited. Sellers of call options (covered or naked) who expect to be required to deliver the underlying value because of a rise in its price may be able to avoid delivery by concluding a closing buy transaction on the derivatives market before being assigned to make the delivery.

Buyers of put options can benefit from a price drop in the underlying value which may occur during the lifetime of their options.

Possibilities

If the price of the underlying value falls, put option holders who wish to profit from this price movement can choose between the following alternatives:

• The options holder can sell their options on the derivatives market. In this case, the profit consists of the increase in the option premium. In general, the price of a put option increases as the price of the underlying value falls. The profit consists of the proceeds from the sale, less the original option premium and transaction costs paid. Because of leverage, a small fall in the price of the underlying value can generate a high profit (in percentage terms) on the original investment.
• Option holders can exercise their options. Remember that an American-style option can be exercised at any time during the lifetime of the option. A European-style option can only be exercised on the expiration date. Depending on the option specifications, the underlying value is delivered when the option is exercised, or settlement takes place in the form of cash.

Risk – Maximum loss

If there is no fall in the price of the underlying value, or if the price of the underlying value increases, put option holders can lose their entire investment (i.e. the option premium plus the transaction costs). This is the maximum possible loss that buyers of put options can incur.

Sellers of put options take on the obligation to buy the underlying value at the exercise price, if assigned to do so. In return, they receive the option premium.

Possibilities

The main objective of investors who sell put options is to receive the option premium. A consequence of this is that the investor has to accept the risk of having to buy the underlying value at the strike price. If the price of the underlying value rises above the strike price, the option may expire without being exercised and the seller will retain the premium. As long as the option has not been exercised, the seller can liquidate the option position with a closing buy transaction on the derivatives market. However, if the market price of the underlying value drops below the strike price, the put option may be exercised. The seller will then be required to buy the underlying value at a price that is higher than the current market price. In addition to making a profit on option premiums, the investor may also consider selling put options as a means of fixing a purchase price for the underlying value. The purchase price is then equal to the strike price, less the option premium, plus costs. If the option is not exercised, the underlying value will not be delivered and the investor will keep the profit earned on the option.

Risk

The seller of a put option accepts the risk of having to buy the underlying value at a price that is substantially higher than the current market price. A sold put option is always naked. The investor must therefore have the financial means to pay for the underlying value in the event that the option is exercised, and hence has to provide the margin. Sellers of put options who expect to have to take delivery of the underlying value because of a fall in its price can avoid doing so by concluding a closing buy transaction on the derivatives market before being assigned.

Each derivatives contract involves a buyer and seller. They are (indirectly) each other’s counterparty. What one party makes on the contract is lost by another party. No value or wealth will be created by the deal itself. Trading in derivatives will only result in the transfer of risk or financial result.

There are risks involved in buying and selling options. Investors should not buy options unless they can afford to lose the premium they have to pay. Nor should they write naked options if they are not in a position to sustain a substantial financial loss.