How to make the right call: Options trading

THE FOUR TRADES that follow illustrate the main uses of options:

Example 1

On 5 April 1994, the price of Sears shares was 115p. To buy 1,000 shares would cost pounds 1,150. However, the May 120 call option, securing the purchase price of Sears shares at 120p until 11 May, were trading at 41 2 p per share. With each traded options contract being for 1,000 shares, the total cost of the option would be pounds 45.

By 19 April, the share price had risen to 124p. The holder of the option now had the choice of exercising the option and buying the shares for 120p each, or selling the option back into the market. Having already paid 41 2 p per share for the option, the effective purchase price of the shares, using the option, was 1241 2 p (the exercise price plus the premium). However, the premium of the May 120 call option had risen from 41 2 p to 9p per share, or pounds 90 per contract, giving a profit of pounds 45, or 100 per cent, if the option was sold in the market.

The graph for the above trade shows that if the share price stays below the 120p exercise price of the option at expiry, the investor will lose the whole of the premium paid. This represents the maximum loss the investor can suffer. Once the share price rises above the exercise price, the losses start to erode until the trade breaks even at 1241 2 p (the exercise price plus the premium). If the share price continues to rise, the investor has the possibility of an unlimited profit.

Example 2

On 5 April, after a short rally, the share price of Scottish Power was 420p but was expected to fall back. Not wishing to sell the holding, it was possible to purchase the May 420 put option at 17p per share, or pounds 170 per contract, giving the right to sell Scottish Power shares at 420p at any time until the expiry of the option in May. By 19 April, Scottish Power had fallen to 372p. The value of the May 420 put option had risen to 52. The investor could now either sell the underlying shares at 420p, in effect 403p (exercise price minus premium), or sell the option back into the market for 52p, a profit of 35p or 200 per cent.

The graph shows that if the share price remains above the exercise price, the investor is looking at a loss equal to the premium paid. As the share price falls, so the losses are reduced - until the position breaks even at 403p. If the price continues to fall, the investor will make a penny profit for every penny fall.

Example 3

In August 1993, an investor buys 5,000 shares in Abbey National at 400p each. In April this year, Abbey National shares had fallen from an all-time high of 522p to 470p, and were expected to fall further. Not wishing to sell his holding the investor bought five June 460 puts at 141 2 p. The put option gives the investor the right to sell his holding at 460p at any time until its expiry in June. The hedged position has now locked in a profit, at expiry, of 451 2 p, compared to the original purchase price of 400p.

Example 4

It is Monday, 21 Feb 1994, and an investor has a holding of 3,000 shares in Argyll Group. The share price is 252p and the investor expects the share price to trade within a narrow range for the next four to five months. In order to take advantage of this, and increase the return from his holding, he writes three July 260 call options with a premium of 18p, or pounds 180 per contract.

As long as the share price does not rise above 260p before the expiry of the option, the investor will keep the premium received, plus any dividends paid, and the shares. If the share price does go over 260p, the investor is liable to have to sell the stock at the exercise price of 260p. However, having already received 18p per share, the ultimate sale price would be 278p.