What is a traded option ?


A traded option is a tradeable financial instrument that grants its owner the right, but not the obligation, to buy or sell an asset at fixed price within a prescribed period.

Traders utilise two types of traded option ; Calls and Puts.



Call Options


confer the right, but not the obligation, to buy shares* at a fixed price (and if you are bullish of a particular share, these are what you might buy).



Put Options


on the other hand, confer the right, but not the obligation, to sell shares at a fixed price i.e. you will buy these if you are bearish of the underlying shares. (* Buying calls and puts on FTSE is covered in another section).



Traded Option Contracts


Options are traded in contracts, or lots, each representing 1,000 shares of the underlying security. If, therefore, one is attempting to establish the cost of an individual option contract, one takes the price (normally quoted in pence) and multiplies it by one thousand. Thus, a Corp X May 1050 call, priced at 67p will actually cost £670 per contract. Traders should note that companies do occasionally reorganise their capital structure, through rights issues, stock splits etc., and this can have the effect of altering the size of the option contract, so always check with your broker first.



Options Expiry dates:


Each stock option has a predetermined expiry date, and the next expiry date will be three months after that etc.. At any given moment any equity option will have contracts with three different expiry dates, the furthest one away being nine months. An option will have one of the following expiry cycles:


  • January, April, July, October
  • February, May, August, November
  • March, June, September, December

It is important to know that when one contract expires another is created: Thus, when a February contract expires a new one for November is created.



Traded Options Exercise Price:


This is the price at which the holder of the option has the right to buy or sell the underlying share and is fixed by LIFFE according to the following scale.



20p

50p

110p

200p

330p

25p

60p

120p

220p

360p

30p

70p

130p

240p

390p

35p

80p

140p

260p

420p

40p

90p

160p

280p

460p

45p

100p

180p

300p

500p



Strike prices above 500p rise in increments of 50p, and above 1,500p the increments rise to 1100p. Should an option holder wish to exercise it, this may be done on any day up to and including the expiry day.

Option prices: Traders wishing to access option prices now have several sources. On UK cable and satellite television, Sky provides some prices with a 20-minute delay (page 350). The LIFFE website offers the same service, but shows far more strike prices. Ceefax no longer shows option prices.

Prices are also published in the Daily Telegraph and, of course, the Financial Times.

Typically, option prices will be displayed in the following format.

Option
   
Calls
     
Puts
   
     
Apr
July
Oct
 
Apr
July
Oct
Corp X.
500
 
70
87
105
 
6
17
23
(*563)
550
 
40
60
77
 
24
35
44
 
600
 
20
34
54
 
48
63
71


Readers should note that the prices shown above are mid prices. In real trading you will be quoted two prices, the bid and the offer. The bid is the price at which you can sell, and the offer is the price that you will have to pay. For example, the bid-offer spread on the XYZ July 550 call might be expressed as 48-52.

In-the-money or out-of-the-money


If an option strike price is near the current share price it is said to be at-the-money.

If the strike price is much higher than the current share price (in the case of calls) or much lower (in the case of puts) it is said to be out-of-the-money.

If, in the case of a call, the strike price is much lower than the share price (and much higher in the case of a put) then the option is referred to as being in the money.

How are option prices decided?


There are several factors that have a determining influence on the price of an option, chiefly:


  • The price of the underlying shares.
  • Time left to expiry.
  • Volatility.
  • Dividends.
  • Interest rates.

The price of the underlying shares is crucial as it determines whether the option has any intrinsic value. For example, if the option strike price is 550p and the share price is 500p, the option is said to have intrinsic value of 50p.

If we find that the option is priced at 75p we would say that the option, in addition to the 50p of intrinsic value, also has 25p of time value.

The longer the amount of time left to expiry the greater the amount of time value contained within the option. This is because there is greater opportunity for the share price to move. In cases where the strike price of the option is higher than the current share price, then the whole amount of the option premium is time value.

How volatile the underlying shares are will have a big impact on the value of an option – the more volatile the share, the more expensive the option. The reason for this is that if a share price is likely to move around a lot then it is more likely to make money for the option holder. Conversely, quiet shares have lower premiums since they are less likely to move.

Since share prices usually fall by the amount of the dividend when the shares go ex-dividend, this needs to be taken into consideration when setting the option price. Interest rates do influence option prices, but their effect is fairly negligible.



How can traded options be used?


Generally speaking, options tend to be used for one of three reasons:

  1. For pure speculation, with a view to profiting from an anticipated rise or fall in a share or index.
  2. As insurance against a fall in a share or the FTSE.
  3. As a method of enhancing the return from one’s portfolio.

How do I trade Options.


If you are a speculator the chances are that you will be buying calls or puts to profit from a move in the underlying share or index. Let us suppose, for example, you reckon that Corp X. is likely to rise from 565p to 600p in the next three months. Rather than buy the ordinary shares, you might be tempted to buy a call option that will be profitable if the share behaves in the way that you anticipate.

Call Options

.

So, what can you do? One course of action would be to buy the July 500 call option, priced at 87p. If, at the time of expiry, the shares are at 600p then the option will be worth 100p, which against a purchase price of 87p would represent a profit of 15%.

Had you purchased the ordinary shares at 565p and sold at 600p the return would have been a mere 6%. Of course, the beauty of the option lies in the fact that you are not obliged to hold it until the time of expiry – if the shares move as anticipated before expiry then the option can be sold at a profit, and this would be more appealing since the price of the option would probably still reflect some time value.

Now let us alter the perceived outcome. Suppose that, come expiry, Corp X shares have advanced to 700p. The call option bought for 87p is now worth 200p, giving a profit of 130%; if one had simply bought the shares at 565p, the profit would be 135p, or 24%. To illustrate more clearly:


Comparison between buying shares and options


Equity purchase
Buy 1,000 XYZ shares @ 565p
Cost £5,650

Option purchase
Buy one July 500 call @ 87p
Cost £870

Equity sale
Sell 1,000 XYZ shares @ 700p

Option sale
Sell one July 500 call @ 200p

Profit = 135p, or 24%

Profit = 123p, or 130%


As you can see, not only is the cost of buying the ordinary shares significantly greater, the return is a lot less.

However, at this point it is probably wise to remember the risks involved. If the Corp X share price should retreat instead of advance to the extent that, come expiry, the shares stand at 500p, the option for which you paid 87p (or £870) is now worthless, whereas the XYZ shares you could have bought instead have lost just 11% of their value. If you had anticipated that outcome you could have considered buying a put option.

Put options


A put option is what you will buy if it is your intention to profit from a fall in a share price or index. Going back to our Corp X. example - if, with the share price at 565p, you thought that the shares were likely to fall back to 500p within the next three months, then one course of action would be to buy a put.

If you bought the July 550 put for 35p and the underlying shares stood at 500p at expiry, your option would be worth 50p, yielding a profit of 43%. If we assume, on the other hand, that you were holding ordinary shares in XYZ and, rather than buy the puts, you sold your stock which you then repurchased at 500p, we could say that you made a profit of 50p on your share transaction, or 9%. Clearly, buying the put was the better option in this case.



Hedging with Options:


It might be the case that you hold a substantial amount of XYZ stock and are sitting on a good profit following a strong run. In this situation you might wish to protect your profit by buying puts against your XYZ shareholding. If you held 10,000 XYZ shares you might choose to hedge this position through the purchase of 10 contracts of July 550 puts at 35p.

What can happen? If the shares are 550p or higher at expiry then the option will expire worthless. If the shares are below 515p at expiry then the put will return a profit, and so we can confidently assert that through the purchase of the puts you have locked in a sale price of 515p for your shares.

Writing options


To write an option is to sell an option that you do not already own. Unlike ordinary shares, there is no physical delivery of options, so once you have sold there is nothing to hand over to the market. However, writing options carries certain obligations.

If you write a call on a share, you effectively agree to sell it at a fixed price in the future. Conversely, if you write a put you accept the obligation to buy the underlying shares at a fixed price. Furthermore, the writing of options requires you to lodge collateral with your broker which is then held as margin, and the amount of margin you are required to deposit will be at least the minimum stipulated by the exchange. This margin is recalculated daily and, as a consequence, you will have to deposit more than is initially required most brokers.



Why write options?


Perhaps the main use of written calls is to enhance the return from one’s portfolio. If you hold 10,000 shares in Corp X you might decide that, with the shares at 565p, you would be happy to sell them if they advanced to 600p.

Rather than just waiting for the shares to achieve this price, you could write a call against your stock with a strike price of 600p, thereby agreeing to sell your shares into the market at a price of 600p if the shares are at or above that level at expiry. In return for agreeing to sell at this level you take in a certain amount of option premium, in this case 34p.



Comparison between selling shares and writing calls


Equity purchase
Buy 1,000 XYZ shares @ 565p
Cost £5,650

Option sale
Sell one July 600 call @ 34p
Take in £340

Equity sale
Sell 1,000 XYZ shares @ 600p

Option assignment
Sell 1,000 XYZ @ 600p

Profit = 35p, or 6%

Profit = 69p, or 12%



We can see, therefore, that the sale of the calls gave the shareholder an extra return of 6% once the shares had climbed to 600p. This method of selling calls against shares already held is known as covered call writing.



What is the difference between FTSE and equity options?


There are a number of crucial differences between equity and index options with which traders should be familiar.


  1. Equity options trade in three-month cycles, whereas FTSE options go in monthly cycles for the three nearest months, and then quarterly.
  2. FTSE options are contracts for differences, since there is no underlying asset. What this means is that if you hold a 5,000 call option and, with the FTSE at 5,600 you decide to exercise your option, you will get the difference between 5,000 and 5,600. Since FTSE trades at £10 per point, that means that you would get £6,000.
  3. One can trade calls and puts in both FTSE and equity options, and one can also write options on both.
  4. Trading FTSE options is potentially riskier than trading equity options because of the index's volatility. This is especially true if you intend to write FTSE options, where changes in price can be dramatic and increases in margin quite sudden.

Traders should also be aware that there are two types of FTSE option, European and American. The key difference between the two is that the American-style options can be exercised on any business day up to and including expiry day, whereas European-style options can be exercised only on the day of expiry.

These options also have different strike prices: American-style strike at 50-point increments, at the 100-, 150-point levels e.g. 5,500, 5,550, 5,600, 5,650, 5,700 etc. The European-style options also strike at 50-point increments, but at 5,475, 5,525, 5,575, 5,625 etc.



How risky are traded options?


If you are a buyer of options your risk is finite, since your potential loss is limited to the amount that you have paid for your calls/puts. While it is obvious that the reason we trade options is to make money, traders should bear in mind that:


  • They are highly volatile.
  • They have a finite life – as soon as you have bought your option the clock is ticking, against you./li>
  • You should not, for the reasons stated above, invest more in traded options than you can reasonably afford to lose.

Writers of options should be aware that they can lose far more than their initial investment if, particularly, they choose to write calls naked i.e. without holding the underlying shares.

Let's say, for example, that when Corp X reached 650p you felt that it had run far enough, and sold 10 contracts of the 700 calls for 40p without holding the underlying shares first. However, suddenly XYZ is going to merge with ABC and the shares are trading at 900p. The calls that you sold for 40p are now worth at least 200p, giving you a loss of £16,000 on the trade. Not a very appealing position to be in.

Fundementally, it must be remembered that Traded Options are inherently risky as you do not own any underlying security. with time value being finite, as options approaches expiry the value of the option may be highly geared but at expiry, the traded option becomes worthless. With more complicated option types and strategies traders can loose more than their initial investment. As such, trading derivatives is not suitable for new or inexperienced traders.



 
 
 



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