Taking Stock – Benefits of equity options to investors
ALTHOUGH returns from equity investments seem to be more attractive given the local scenario where money market rates trail the inflation rate by a significant m
argin, the potential risk associated with them can be enormous to the extent of throwing someone into a state of bankruptcy.
Introduction of facilities, which sought among other things to reduce the risk level, was a welcome development whose acceptance by investors serves to show that their emergency was long overdue.
In this week’s article we will take a close look at options in a bid to explore how they work and their possible benefits to the investment community.
An equity option gives a buyer the right, but not the obligation, to buy or sell a specified counter/share at a stipulated price called “exercise” or “strike” price.
The buyer or holder of an option is said to take a long position while the seller, or writer assumes a short position.
Options can be either “American” or “European” depending on the manner in which the contract can be exercised. While “Europeans” are exercisable on the day the contract expires, “Americans” can be exercised any time up to expiration and these somehow give the holder flexibility.
An option, which gives a buyer of the contract a right to buy, is called a “call” while a “put” gives the buyer a right to sell shares.
The option price is called the “premium”, which is usually a fixed percentage of market price on day one (the day in which one gets into the option contract).
The potential loss for the holder of an option is limited to the initial premium paid for the contract.
The writer (the company which sell options) on the other hand has unlimited potential loss that is somewhat offset by the initial premium received for the contract.
Let’s assume that on October 1 someone has $500 000 that he wants to invest on XYZ Co Ltd shares whose market price per share is $100.
If he makes an outright purchase he will buy 5 000 XYZ Co shares.
If, on the same day, he decides not make an outright purchase, but instead buy a 30-day American call option with 20% premium, the risk profile will be rather different.
(It is important to note the 20% premium is not a down payment but a price for ‘rights to price freeze’.)
The $500 000 if used as option premium will enable one to buy 25 000 XYZ Co shares since he will be paying a premium of only $20 per share.
These shares will be representing an investment of $2 500 000 (that is: a strike price of $100 per share multiplied by 25 000) which one acquires by paying only $500 000).
The premium payment will entitle one to be able to buy 25 000 XYZ Co Ltd shares at $100 each within a period of 30 days even if the market price increase double-fold.
In the event that price has increased from $100 to say $200 after only a week into the contract and the buyer feels it is good enough a price, he can exercise the contract at this price.
The option trader will sell these shares and realize gross proceeds of $5 000 000 from which he takes $2,5 million (the amount which the buyer must have paid for 25 000 shares at $100).
The resultant balance of $2,5 million will represent the client’s profit.
If the price drops to say $50, the option buyer will just do nothing and in that event losing only the premium that he would have paid instead of bearing the actual loss induced by share price decrease.
On the other hand someone who would have bought these shares outright will bear the whole loss to him/herself.
Why trade in call options?
Options are financial instruments that are capable of providing flexibility someone needs in almost any investment situation.
Option contracts give you options by giving you the ability to tailor your position to your own situation.
Call options give one an opportunity to buy a larger volume of shares than he can get if he buys straight from the market.
An investor can also position himself ahead of a big market movement even when they do not know which way prices will move. By the time the movement occurs he can also reap the returns from such an event.
With these derivative products someone can actually benefit from a stock price’s rise or fall without incurring the cost of buying the stock outright.
One of the most important advantages of options is their ability to give the buyer leverage.
This means that an option buyer can pay a relatively small premium for market exposure in relation to the contract value.
An investor can reali-se large percentage gainsfrom comparatively small,favorable percentage mo-ves in the underlying index.
Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage could magnify the investment’s percentage loss.
Options offer their owners a predetermined, set risk.
All these factors clearly explain why options have generated an overwhelming interest despite the fact that the market is still in its infancy.