KEY AREAS

• Options Introduction
• Options Overview
• Why use Options?
  • Traders versus Investors
  • Basic Uses
  • Covered Call Writing
  • Insurance
  • Tax Planning
  • Trading Examples
• LIFFE Links
• Charges & Client Documents

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Basic Uses of Options

The decision as to which type of option to buy is dependent on whether the outlook is positive (bullish) or negative (bearish). If the outlook is positive, buying a call option creates the opportunity to profit from the potential increase in the value of a stock without having to risk more than a fraction of its market value. Conversely, if a downward movement is anticipated, buying a put option enables investors to protect against downside risk without limiting profit potential.

For example, buying a July 500p call option provides the investor with the right to purchase 1,000 shares of Company X at a cost of £5 per share at any time before the option expires in July. The right to buy stock at the fixed price becomes more valuable, all other things being equal, as the price of the underlying stock increases. Assume that the price of the underlying shares was £5 at the time the option was bought and the premium paid was £350. If the price of Company X's shares climbs to £5.50 before the option expires and the premium rises to £700, the investor has two choices available:

1. The option could be exercised, meaning the underlying Company X shares are bought for £5 a share for a total cost of £5,350 (including the option premium). If the shares are simultaneously sold on the stock market for £5,500, a net profit of £150 is yielded (£5,550-£5,350).
2. The position could be closed by selling an option contract for £700. The difference between the premium received and paid is £350 (£700-£350), meaning a profit of 100% on the initial investment of £350.

Put options can also provide an attractive investment in declining markets, as the risk is known and predetermined. The most that can be lost is the cost of the option compared to the stock market where the potential loss, in the event of a price upturn, is unlimited.

For example, buying a July 500p put option provides the investor the right to sell 1,000 shares of Company X for £5 per share at any time before the option expires in July. The right to sell stock at a fixed price becomes more valuable, all other things being equal, as the price of the underlying stock declines.

Assume that the price of the underlying shares was £5 at the time the option was bought and the premium paid was £400. If the price of Company X's shares falls to £4.50 before July and the premium rises to £750, there are two options available:

1. 1,000 shares of Company X could be bought at £4.50 per share for £4,500. The put option could simultaneously be exercised, meaning the underlying Company X shares are sold at £5 per share, netting a profit of £100 (£500 profit on the shares less the £400 option premium).
2. The position could be closed by selling a put option for £750. The difference between the premium paid and the premium received (£750-£400) would be £350 in this case.
   
   If, however, the holder had chosen not to act, the maximum loss using this strategy would be the total cost of the put option, or £400.

Note

The above information is provided for illustrative purposes and should not be relied upon in making any investment decision, portfolio review or any other decision. No warranty or accuracy is given and you should obtain relevant and specific professional advice.