For those already familiar with the stock market and the way it works, equity and index options can be a useful additional tool to use to enhance performance. They need, however, to be used with extreme care and with a clear understanding of the risks involved.
Options have a long history, but in effect they are simply legal contracts that give the buyer the right but not the obligation to buy or sell a specific asset (in this case shares) at a fixed price for a specified period of time - after which the option expires.
An option that gives the right to buy is a 'call'. A 'put' confers the right to sell. Options traded on LIFFE are denominated in lots of 1000 shares. One contract therefore gives the buyer the right to buy or sell 1000 shares in the company concerned at the strike or exercise price until the expiry date, which may be up to three,six, or nine months hence.
The person granting the contract is known as the 'writer', or seller, of the option. Writers assume the obligation to either buy (in the case of a put) or deliver (in the case of a call) the appropriate amount of stock at the exercise price, if the buyer of the option chooses to exercise it. Writers are betting that there will be insufficient volatility in the price of the underlying share to make worthwhile the holder of the option exercising it. They receive the premium (or price) the buyer pays to acquire the option - and keep it under all circumstances.
The attraction of traded options is that they do not necessarily need to be exercised. They can be bought and sold just like shares. Their value will change as a result of movements in the underlying price of the shares, the expected future volatility of the shares, the relationship of the underlying shares to the strike price, and the time remaining to expiry. As an option approaches expiry, it becomes less valuable, because the probably of it being capable of exercise at a profit gets progressively less.
Options can be used in a variety of ways and are perhaps best seen as a flexible tool for managing portfolio risk. Simply buying calls or puts is best seen as an outright, though perfectly legitimate, speculation on whether a particular share will rise (in the case of a call) or fall (in the case of a put). But options can also be used in other ways, for instance as insurance. An offsetting call option transaction is a cheap way, for instance, of hedging your bets after selling a particular stock, just in case it continues to rise.
Writing options in a stock you hold in the context of a stable market background can be a good way of generating extra portfolio income. This is known as 'covered writing'. Writing options under any other circumstances exposes the writer to unlimited risk of loss. IT SHOULD BE AVOIDED BY THE PRIVATE INVESTOR UNDER ALL CIRCUMSTANCES.
Various other more complex strategies exist. These include 'spreads' which allow an investor to profit from the move of a share price between two fixed points, and straddles, which allow an investor to benefit from a big move in a share irrespective of its direction. With any option strategy the important point to bear in mind is the cost of the strategy relative to the likely profit generated, and dealing costs, which can be significant in more complex ones.
Dealing in options may require you to deal through a different broker to the one you normally use. Not all brokers like dealing in options, because clients often start off small and because options are administratively complex for the broker. There are, however, a significant number of full service and execution-only brokers now offering an options service to their clients. Choosing a broker entails much the same process as choosing one for ordinary share dealing. Clients are required to sign an agreement form and a 'risk warning notice' to ensure that they understand the risks involved.
Options are mathematically more precise than ordinary shares and tend to behave it ways that can to some degree be pinned down by statistical formulae. Option prices and trading strategies are therefore particularly suitable for computer analysis and several forms of proprietary software exist for analysing and pricing options.
Understanding how share price charts work and the role and significance of various chart indicators can also be a useful adjunct to trading in options. An equally important factor is the establishment of good trading disciplines, such as the setting of objectives and price targets, cutting losses where necessary and keeping up a close an systematic monitoring of option position. Dealing in options is time-consuming, and may not be for everyone.
The best first step for new option investors is to go on one of the series of course run by LIFFE. Details can be obtained from LIFFE's Equity Products staff on 0171-623-0444.
Alternatively Peter Temple's book 'Traded Options - a Private Investor's Guide' gives a good basic grounding in the subject. It is available in hard cover, priced 16.95, from the publisher Rushmere Wynne Ltd., Cavalier House, 21 High Street, Leighton Buzzard, Beds, Tel: 01525-853726; fax: 01525-852037, or through Bookpoint (credit card sales only) tel. 01235-831700 quoting Reference Number 0-948035-06-4.
Remember, above all, that the value of investments can go down as well as up and that options are much more volatile than ordinary shares and should only be dealt in with a full understanding of the risks involved.
Peter Temple is a former City analyst turned freelance financial journalist. He writes regularly for the Investors Chronicle, Investors' Stockmarket Weekly, and a number of other specialist investment magazines.