Options and warrants are derivatives, meaning their value depends on the value of the stock, so you should have done your underlying analysis of the stock’s prospects before you start considering buying the options. One of the most attractive, but equally dangerous, aspects of options is that they can provide you with the ability to make the most of your money.
Essentially, an option is just what its name suggests: it is an option to buy or sell shares at a particular price, as if you were to tell a friend, ‘If you ever want to sell that car of yours, I’ll give you five hundred Quid for it. Not your friend to have to sell you the car, but he may I will sell it to you at that price.
Yes, that is a childish example. But it is a pretty important distinction between options and some other derivatives, like futures, that you have the option and can let the option expire. With futures, you don’t have a choice: you to have to exercise them. Traded options give you a third option: in addition to exercising the option (buying the shares) or letting it expire, you can trade it on the market. You can have a call or set option: a call gives you the right to buy the shares at a certain price, an option gives you the right to sell the shares at that particular price. (In fact, very few negotiated options are exercised, that’s not what they’re there for.)
Pricing options is horrifyingly scientific work if done correctly, involving the Black-Scholes Formula. In fact, I have used the miserable and it is hard work unless you have a certain aptitude, and I think I can confidently say that it is an aptitude that I do not have.
A simpler way of looking at the price of options is that the option has two possible sources of value. First, the intrinsic value, the difference between the share price now and the “exercise price” of the option.
The option’s premium (i.e., price) must reflect both sources of value. Remember that options are wasting assets as they expire on a particular date – if you buy an option out of the money and hold it until maturity, it will gradually decrease in value until you have lost all your money. So buying and holding is not a strategy that works with options, as it does with stocks.
Obviously, if you think the stock price is going up, you would buy a call option (likewise, you could sell a short put option), and if you think the price is going down, you would buy a put option.
There are all kinds of strategies that option traders use to generate income and capital returns: write options, astride, necklaces, etc. I will not cover them here: they are for the trader, not the investor, and if you are primarily a capital investor they are probably not very relevant to you.
The easiest way to use options is to increase your investment in the stocks you want to buy, gaining more exposure for the same share. You may decide to use options instead of buying the underlying shares if you believe that the movement of the share price will occur suddenly, for example, if a regulatory decision is approaching, such as the case of bank charges in the Superior Court or the decision of the regulator of water on prices, you could use options to take a position on it.
But you can also use options to cover your portfolio. Suppose you have water stocks for dividend income, but you are concerned that the water regulator will make a very adverse decision. It is not worth trading inside and outside your entire portfolio if you want to continue holding stocks as long as the decision is a good one. Instead, you could defend yourself against downside risk by buying a put option.
An important caveat that must accompany both options and guarantees is that they can be highly illiquid, with large margins. Another key concern is margin calls – this occurs when an options trading account no longer has enough money to support open trades. Due to the leveraging effect of using options, these margin calls could eliminate an investor, so be especially careful when using options to trade volatile stocks.
Finally, you should be aware that these are very technical markets and that you really need to do your own research if you are going to use these products.
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