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OPTIONS TRADING - which isn't as complicated as it sounds offers an effective way to
dabble in the stock market, but without many of the pitfalls. Here's what you need to know.
There's no denying that the best gamble of recent years has been shares. But, although
losses can be controlled, a gamble they still are.
And, given the recent rapid rises in the stock markets of the Western world, it's
a gamble that's getting riskier.
Traded options offer an alternative way of investing whereby you can reduce the
potential losses while still enjoying the gains. Here's what you need to know about the
sophisticated world of options trading.
Less Risk Than Share Trading
Over the past few years, the London FTSE100 and New York stock markets (Dow Jones,
Nasdaq) have rocketed upwards. So much so, many shrewd judges now believe a huge fall must be near.
The problem is, anyone not putting their spare cash into the markets for fear of a fall is
missing out on continued profits.
What makes this worse is how interest rates on savings accounts have fallen to very
low levels. So many would-be investors have been left between the proverbial rock and a
If they go for shares there is the possibility a massive market fall could wipe them out, but if they
opt for safety they will receive little in the way of interest.
So, what to do? Well, perhaps options are the answer. They are more of a gamble than shares but the
outlay is a lot less. And - if they go the right way they can produce big profits.
How Options Work - Options Trading Explained
At first, options are tricky to understand, but once you've grasped the basic principle
they are easy to get along with and can be great fun.
Perhaps the best way of explaining options is to use an example outside the financial markets,
such as buying a car.
Suppose your local car dealer will shortly have in stock a particular type of model
you really want.
However, the dealer can't tell you when the car will be in and what the exact retail price
will be when it does arrive. But, he can tell you what the price would be if you were able to buy the car today.
So, let's assume that today the car would cost you £15,000. Once the car is in stock
the price might be as low as £12,000 or as much as £18,000.
What the dealer could do, however, is offer you the chance to buy the car at the guaranteed price
of £15,000 for up to three months in the future.
For this privilege he might ask you to pay him a premium of £1,000. This,
in effect, would be an option.
The dealer would be prepared to offer this facility because he thinks the car, when it arrives,
will cost £15,000. Hence in theory he will make £1,000 extra on the deal.
Let's say that once the car arrives its price is £18,000. You would only have to pay
£15,000 (providing the car arrived within three months).
Of course, you would have also forked out £1,000, but your total outlay of
£16,000 is still £2,000 cheaper than £18,000.
After buying the car, you could either keep it or sell it on for a £2,000 profit.
There is always the chance it could go the other way though. The asking price of the car might only
turn out to be £12,000.
You would still have to pay the £15,000, and you would have already lashed out
£1,000 for the privilege. Thus, a car that would have cost £12,000 would now
But that's not as bad as it sounds. If you didn't want the car to cost you £4,000 more
than it would have done you need not buy it. You'd lose the original £1,000, but that's
all - although you wouldn't have the car either.
Options And The Stock Market For Beginners
On the stock market, options are a little more involved but the principle behind them is
the same. Options carry the right to buy or sell a share at a set price at some time in the future.
Generally, options run for three months and cost only a fraction of the share price they relate
to - usually between 8 and 15 per cent.
You should note that options can either be for the right to buy or sell shares. This is where it
becomes a little more complicated and is best explained using our car example again.
If you had taken the dealer up on his offer to have the right to buy the car for £15,000 it would
have cost you £1,000. Unless you were rather eccentric soul, you would only do this if you thought
the eventual price of the car was going to be more than £16,000 (£15,000 for the car plus £1,000 for the option).
But supposing you thought that, when the car came in, it was going to cost less than it would cost
if it were available today. Say you thought it was going to sell for £12,000.
Again we'll assume the dealer holds the view that the car will retail at £15,000. Thus, the
dealer might offer you the chance to sell the car back to him for £15,000.
Of course, he would also charge for this (again, we'll say £1,000). As before, this option would
last for three months.
Remember, the dealer still thinks the car will retail at £15,000 and so believes the £1,000 cost of
your option will be extra profit for him.
If the price of the car did turn out to be £12,000, you'd be able to buy it at this price. With
the £1,000 cost of the option you would have laid out £13,000.
Then, you could sell the car back to the dealer for £15,000 and be £2,000 better off as a
result! Of course, if the car came in and cost £18,000 you would have bought the £1,000 option for nothing.
If you bought the car it would then cost you £19,000, but even if you didn't, the £1,000 would be lost.
With the stock market, you would purchase an option to buy a share at a certain price when you
thought its price was going to rise. If you thought a share's price was going to fall, then you'd purchase
the right to sell it.
The right to buy a share at a certain price in the future is called a call option. If
it's the right to sell a share at a certain price, it's called a put option.
Options Vs Stocks Shares (or Options Versus Stock Share)
The big attraction with options is how an individual can back their opinion over whether
a share's price will rise or fall without first having to actually buy the share.
If a share is trading at, say, £5 it would cost someone £5,000 to buy 1,000
of them. Presumably, they would only be buying the shares in the belief they were going to rise.
But, if that individual also thought a massive market crash was not far off they probably
wouldn't want to risk that kind of money.
Remember, in both the 1929 and 1987 market crashes the falls were so sudden great big
slices fell off share prices in a short space of time.
However, "a call option" for the same share would only cost about £500. If
the market crashed the chances are the option would prove to be worthless, but only £500
would be lost.
Also, if an investor believed a share price was going to fall they wouldn't be able to profit
from their opinion unless they bought "a put option".
No mechanisms - other than options or spread betting - exist for ordinary investors
to benefit from a falling share price.
Exercise Your Options (or Exercising your Core option)
That's the basic idea behind options. Exercising an option simply means' "going out and buying
or selling the shares" at the price the option entitles you to do so.
If you exercise a call option (buy shares) it will be because the current price is
higher than the one you are paying (based on the estimated price in the future).
Hence, after buying & the shares could be sold on for a profit if you so wished. If you
were exercising a put option (selling the shares) it would be because the current price is lower
than the one the option entitles you to sell at.
So, you would buy the shares at the current price and then exercise the option to sell them
at the higher one.
In reality it works slightly differently, because you would sell the shares before buying them,
but we'll leave the intricacies of how the stock market works for another time.
Suffice to say that in practice the same profitable result is achieved. That's basically
how options work. Once you grasp the principle they are very simple and traded options are
just one step on.
The Value of Traded Options
A traded option is an option that has a value all of its own. In other words, it can still
be used for the original underlying event, but can also be bought and sold before that event occurs.
To make this point clear, let's again look at our car example.
If another person was willing to buy the option over the car for, say £1,250 you would have
Either, you refuse the offer of a £250 profit and wait and see what happens when the car comes in.
Or, you simply sell the option and take the profit. In doing the latter you would have traded your option.
The market on traded options is a huge one. Traded options are available on the shares of many of
the stock market's leading companies.
For anyone who wants to dabble in the market, but is afraid of a crash, these are also worth learning about.
They can be quite complicated but do offer two chances of a profit. Either:
Another advantage traded options have over traditional ones are in how long they last.
A conventional type of option generally lasts for three months. But a traded option can last for three,
six or nine months.
- through the option being exercised and the shares being bought or sold, or
- through simply selling the option if it goes up in price.
Of course, the prices of traded options that last for longer periods are higher (but then
they would be - the longer the underlying share price has to fall or rise in value the more expensive
an option on it will be).
Again, the option price will be only a fraction of the share price it is associated with.
Furthermore, a traded option can be sold if it starts to fall in value. So, losses can be
restricted. That said, the movements in any type of options are very often greater than the movements in
the price of the share they reflect.
An important point: on any type of option, if the time associated with the option expires without
it being exercised, the money spent on it is lost.
All in all, however, for anyone who has spare cash, is fed up with the poor rates of
interest on savings accounts but is frightened the stock market is going to crash - and doesn't mind
taking what is a fairly sophisticated gamble - options might be the answer.
Options Trading Definitions: Major Terms
You can read more on betting on the
financial markets along with more traditional
football fixed-odds betting systems.
- Strike Price - the price of the share the option entitles the holder to buy or sell at.
- Time Value - associated with traded options. The longer an option has to run the more time value in it.
- Intrinsic Value - again associated with traded options. Concerns the price of the underlying share against the price of the option.
- Straddle Option - where an investor buys both call and put options at the same time on the same
Only for sophisticated investors, this type of trading needs the underlying share price to move out
of a certain range - no matter which way that movement is before a profit is guaranteed.
- Break-Even Price - the price a share must move to before an option - plus the dealing cost
associated with buying it - puts the option in profit.
- Exercising an Option - an option, traditional or traded, is exercised when the underlying
share is either bought or sold at the option price.