A beginner’s guide to share options.
You have probably heard about shares options. Popular media has referred to them as the dangerous ‘no go zone’ for amateur investors, especially after the Great Financial Crisis of 2008. In reality however, so long as you understand its features and inherent risks, a share option can be a highly advantageous and volatile tool for your investment portfolio.
What is a share option?
The concept of share options is very straightforward. If you purchase a share option, you obtain a contract to purchase a predetermined amount of shares, for a predetermined price, at a predetermined future date, from its seller. Its most defining feature is that it is completely up to its buyer whether or not the contract will be executed. The vast majority of share options listed on the Australian Securities Exchange (ASX) are “American” style options, meaning they can also be executed before the preset future date.
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You can purchase share options over the majority of Australian public companies, including the big four banks, Telstra and Woolworths. There are over 100 different companies to choose from.
The purchaser or owner of the option is termed its “buyer” and its seller is termed the “writer”. Likewise, the predetermined date is called the “expiry date” and the predetermined price is called the “strike price”. Last, the price that is paid by the buyer to the seller is termed the “premium”.
There are two types of options that you can either buy or write. A call option gives its buyer the choice to purchase shares from its writer, whereas a put option gives its buyer the choice to sell shares to its writer.
Share options are listed on the ASX in lots of 1,000, and the price quoted is per unit of the underlying share. For example, if a share option for AMP is listed as $0.30, a buyer can purchase a contract with 1,000 underlying AMP shares for a total price of $30.00.
How can you use a share option?
A share option can be used in numerous practical ways. It can increase your risk exposure and maximise your returns, or alternatively it can reduce your exposure and act as an “insurance” policy.
Fundamentally, you can use a share option to simply buy yourself time. You can lock-in the transaction price now and decide whether or not you want to go forward with it in the future. You will find this strategy extremely useful in times of high market volatility.
Beginner investors are also recommended to use share options to safeguard their shares against a fall in the share price, through purchasing put options. This practice is commonly referred to as “hedging”. For example, if the current price of Telstra shares is $50.00, and you don’t want it to fall lower than this, you can purchase a put option to sell them for $50.00 each in the future. If the price of the shares falls in the future, the writer of the option will be obliged to buy them off you. If the price of the share rises, you can simply not exercise the option. In this low-cost strategy, the most you can lose is the premium you initially paid.
If you doubt that the share price will fluctuate in the future, you can also write call options to boost your income. The buyer of the options will not exercise them if the market is as you predicted, leaving you with the premium initially paid.
In addition, as with all other tradable financial securities, options can be used for speculation. The price of a call option will increase if the price of its underlying security increases. Conversely, the price of a put option will do exactly the opposite. This lets you enjoy the upside of a rising share price through an initial investment outlay much smaller than buying the shares upfront. Notwithstanding this, this approach is not recommended for beginners, as the risk exposure you face will be much greater than that under a position taken directly through the underlying share.
However, you may be able to use this difference in risk exposure and smaller initial cost to diversify your portfolio, though you will have to take into account the complex risk characteristics of options.
You can also use options to optimise your taxes, although the interplay between options and your taxes can be highly complicated.
What risks are involved with share options?
It is crucially important for investors to understand that options are a strictly zero-sum game. That is, in each transaction, one of the parties makes a gain at the expense of the other party. You need to make sure you fully understand the inherent risks involved.
The position you take through options will be a leveraged position. As such, a change in the price of the option is bound to be disproportionate to a change in the price of the underlying share. The ratio of this change is represented by the term “delta”. Delta is positive for call options and negative for put options.
If the share price changes in an unforeseen way, an option may completely lose its value. For example, your Telstra call options with an exercise price of $50.00 will be worthless at the expiry date if the share price then turns out to be only $49.00. Here, if you have purchased a contract with 1,000 units, you would have lost the entire premium you paid. This is a loss of 100%. In contrast, unless Telstra goes bankrupt, Telstra shares will never become completely worthless.
So long as a Telstra stays afloat, there is always a possibility that its shares may increase in price overtime. Options however, with limited lives, naturally decline in value at an exponential rate as they approach their expiry dates.
Whilst the potential loss you can face as the buyer of an option is limited to the premium you paid, as a seller your loss can be unlimited. If the buyer chooses to exercise the option, you will be obliged to deliver the purchase or the sale of the shares at the preset price irrespective of their market value.
You also need to know that holding or writing an option does not have any implications in relation to dividends and voting entitlements. The owner of the underlying shares retains these rights until the option is exercised.
The takeaway message for beginner investors is that ideally, options should be used to complement their current shareholding positions. Standalone positions should only be taken out after consultation with a broker or a financial adviser.
Woolworths put option
You can see an example of how a call option works with the below Woolworths option.
Here, an investor can purchase a WOWRJ7 series call option contract for $1.47 per option, totalling a cost of $147.00 with 100 underlying Woolworths shares. Reading its features above, it gives the buyer the choice of purchasing 100 Woolworths shares at the price of $28.00 each, on any date up to and including the 27th of June 2019.
Let’s assume here that you own 100 Woolworths shares and you are expecting the upcoming market movements to be relatively flat. You will most likely be receiving one or more dividends in the next three years. However, you can further increase your income from your shareholding position through writing the above contract.
If you do so today, you will receive the premium from the buyer, with a total payoff of $147.00. You will also bear the obligation to deliver 100 Woolworths shares to the buyer any time before and including the 27th of June 2019. Of course, you are predicting that the share price will not be higher than the strike price of $28.00 during that time frame.
By the 27th of June 2019, let’s say that your prediction turns out to be correct and the share price is $27.50. The contract will be worthless for the buyer as he or she will be able to buy Woolworths shares for $27.50 per unit at the open market. The buyer will not exercise the contract.
Accordingly, your total payoff from taking this position will be $147.00.
On the other hand, on the 27th of June 2019, if the share price increases to $30.00, the buyer will exercise the contract. You will have to deliver 100 Woolworth shares for $28.00 each, receiving a total of $2,800. Yet if you were to sell the shares at the market, you would receive a total of $3,000 instead. As such, you will miss out on an additional $200.
Considering that you initially received $147.00, you would have made a net loss of $53.00 from this position. In percentage terms, this is a huge loss of 36.05%.