Dateline: 3/8/99

With stock markets displaying considerable volatility, some people reduce their risk with stock options. This was the purpose for which options were invented, according to Chris Bunka (The Outsider's Guide to Speculative Stocks), although many people trade options as a speculative investment.

What is an option? Basically an option is an agreement to buy or sell a security at a later date at a predetermined price. If you buy an option, you have the right but not the obligation to buy or sell the security. If you write (technical term for sell) an option you have an obligation to buy or sell the security if the person who bought it from you decides to exercise her option. The vehicles used are called puts and calls. Here's how they work.

Put Options

Suppose you hold high quality stock in your portfolio that you believe will gain over the long haul, but you are concerned about a possible downturn in the market in the short term. You can buy a put option for the stock giving you the right to sell your stock at a set price called the strike price within a certain time frame. If the stock price stays above the strike price, you would let the option expire unexercised. But if the market declined severely, you could exercise your option and sell your shares at the strike price. You could then, if you wanted to, buy the shares back again at the lower market price.

This is insurance plain and simple. The premium you pay to buy the option can be considered an insurance premium. Whether it is worth it or not depends on the cost of the option. Let's consider an example.

Suppose you have shares in ATI Technologies. ATI had a spectacular run up to mid-August last year peaking close to $20.00, then fell steadily to a low of around $12.50, then climbed steadily to around $17.50 by mid-January. ATI then announced record sales and earnings in a quarterly report and the stock shot up to over $27.00. After that there were fears that it's graphics chips market would be severely impacted by Intel's new Pentium III chip which has extensive graphics capabilities. The stock slumped back to $20.00 where it closed on Friday.

You believe the stock will recover because, as good as Intel's chip may be, it's no match for ATI's chip, and besides, one of ATI's biggest customers is Apple which includes ATI graphics chips in its iMac, the best selling computer in the world today. But you don't want to take a chance on it dropping further so you look at buying a put.

The Financial Post lists the options available for ATI in its Options sections. An explanation of Newspaper Option Tables can be found at the Toronto Stock Exchange website. Like stocks, the prices for the various options go up and down with the stock price. The column for ATI looks like this:

I've only shown the listings for March and April though the column in the Post goes on to show July and October as well. The headings indicate Strike Price, Expiration Date, Put or Call, Bid, Ask and Open Interest. The strike price, as mentioned, is the price at which the option can be exercised. The expiry date is the third Friday of the month indicated. When an option is introduced to the market it can have a time period of anywhere from a few months to two years. Volume, Bid and Ask are self-explanatory. Open Interest is the number of outstanding contracts in the market.

The table above shows that there was a lot of activity on the call options for March with a strike price of $20 and $22.50. And conversely, there was little activity in puts at $22.50. This shows that more people believe ATI Technology stock will rise than believe it will go down before the expiry date.

Every option contract covers 100 shares of the underlying stock. The bid and ask prices refer to price of the option per share, so in our table above, a put option with a strike price of 22.5 expiring in March will cost you $2.90 a share or $290. Similarly, an April put option with a strike price of $18 will cost you $1.15 a share or $115.

Since ATI's next quarterly report will come out just before the expiration of the April option, you can insure against a bad quarterly by buying an April put with a strike price of $18 for $115 per 100 shares. If the quarterly is bad, the price may drop to $15, but you would still be able to sell at $18. On the other hand, if the quarterly is exceptionally good, the price may go back up to $27 and you would not exercise your option. You would just forfeit the premium. In effect, you would have paid an insurance premium for peace of mind.

The premium you pay for the option is determined by the market and will fluctuate with the stock's actual price and the amount of time remaining to the expiration date. So if ATI Tech stock were at $25 today instead of $20, the price of the March put at 22.5 would be substantially lower. This is because the seller of the put (called the writer of the put) will not likely be obliged to buy the stock from you as you would profit more from selling into the market. But as the price of a stock drops, the price of the put goes up because the writer of the put may well be forced to buy above market value.

The difference between the actual market price of a stock and the strike price is called the option's intrinsic value. With a put, you subtract the market price from the strike price. If it is a positive value, you are said to be in the money. But if the market is not in your favor and the intrinsic value is negative, you are said to be out of the money. The intrinsic value of the option is reflected dollar for dollar in the option's price.

The difference between the option premium and the intrinsic value is called the time value. Time value reflects the market's perception of whether the stock is moving in a favorable direction. It decreases as the contract gets nearer to expiration because there is less opportunity to sell the option as the amount of time remaining decreases.

Call Options

Call options are put options opposite counterpart. Where a put gives the holder the right to sell at the strike price, a call gives the holder the right to buy at the strike price. A call option would be used as insurance by short sellers.I won't go over all the details again, but summarize them in the following table. The difference between the two types of options is also well explained at the Optionsource.com site.

For a holder of equities who is long in the market, put options serve as insurance against a market decline. The best time to buy such insurance is when the market price of the security is substantially higher than the strike price of the put. Whether such insurance is worthwhile depends on your perception of whether the security has a great risk of falling or not. If you think it is not likely to fall, you lose the premium. But if the general perception of the market is that the price will rise, the premium will not be as great as when the general perception of the market is that the price will decline or is very volatile. Each option must be judged on its own merits and your own perceptions and beliefs.

Options as Leveraged Investments

If you buy a put option and you own the underlying stock, you are said to be buying a covered put option. That is buying insurance. However, if you do not own the underlying stock, you are said to be buying the put option naked. Similarly if you buy a call option without first shortselling the underlying security, you are said to be buying a naked call option. This is a riskier and a speculation, not insurance. Here's how it works.

Suppose you have $1000 to invest. You think the market will rise but you want to leverage your investment. You could buy, say, 10 shares of company XYZ at $100 a share. If the price goes up to $120 in five months you have made a profit of $200. But if instead of 10 shares you bought a call option at $10 a share with a strike price of $100 and a time frame of five months. You now have the right to buy 100 shares of XYZ at $100 a share. If the share price rises to $120 as before, you now make a profit of $2000. Conversely, if the price goes down, you would not exercise your option and would lose the $1000 premium if the option expires. As the expiry date draws closer, you would probably try to sell the option and salvage something, particularly if the price has dropped just a little.

Suppose you believe that a market correction is imminent and you want to leverage an investment on that premise. You could buy naked put options and leverage your investment. Again you buy a put option for XYZ at $10 per share for a $1000 investment. You now have the right to sell 100 shares of XYZ at $100 a share. If the market declines and the price of XYZ drops to $80 you again have a $2000 profit. But if the market goes up, you lose.

In either case, the downside risk is the complete loss of your investment if the market goes hard against you unless you bail out before the expiry date.

Writing Options to Increase Return

We have talked up to now of buying options, but what about selling them? Michael Campbell in his Cooking the Books With Mike (number 7 this week in our local bookstore's bestseller list), recommends selling covered call options to increase the returns on an investment in certain circumstances.

If you have high quality stocks that you want to hold for the long term, but wouldn't mind selling in the short term for the right price, you might write (sell) a call option. Using his example, suppose you own 100 shares of Bell Canada which you bought two years ago for $19.50 a share. They're now trading at $25 and you sell a call option giving someone the right to buy your shares at $27.50 within the next four months. The buyer pays you a premium of $1 a share.

If the stock rises above that level, the buyer will exercise his option and you will sell the shares at $27.50. In reality, you will have sold them for $28.50 because you get the premium as well as the proceeds from the sale of the shares. But if the price does not rise above the strike price, you still get to keep the premium and you can do it all over again.

On the other hand, suppose you were interested in buying shares of XYZ and were quite willing to pay the current price of $20 a share for them. You want to buy 100 shares for $2000. Instead of buying the shares, put the money in the bank and sell a put for $1 a share and a strike price of $20. The buyer of the put now has the right to sell you 100 shares and pays you $100 for the privilege.

If the price drops and the buyer exercises the option, you will buy the shares from her for $20 a share. In reality you are only paying $19 a share because you get the proceeds of the sale of the put. Since you were willing to pay $20, you are obviously better off. On the other hand, if the price goes up, the buyer of the put will not exercise her option, but you still get the premium for the put plus interest earned in the bank. Of course, you would have gained more by owning the shares.

Campbell stresses that you should only sell puts on stock you would be comfortable owning.

Note also that the call option strategy is for covered call options. Some speculators sell naked call options. This is a potentially lucrative but very risky venture. It has unlimited downside in that the upside potential of any stock is unlimited. If a stock on which you sold a naked call option explodes in price, it could cost you a lot more than you bargained for.

In our example above, suppose the price of Bell Canada rocketed to $50 on some explosive news. You would have to buy 100 shares at $50 in order to meet the option holder's demand for the stock at $27.50. You would lose $2250 on the deal.

Conclusion

Buying put options may be a good way to insure against a downturn in the market on stocks you own, as long as the premium is not too great. A better method would seem to be to sell covered call options on the shares. That way you get the premium for the option and keep the shares. The premium may mitigate the decline in value of the shares. And if you believe that in the long run the stock will rebound, you have increased your long term profitability.

Buying call options and selling covered call options are qualified investments for your RRSP. The other derivative strategies are not.

Other Links of Interest

Introduction to Exchange Traded Options & Futures - a handy online booklet from the TSE that explains everything you need to know about options and derivatives.

Option Strategies - an important excerpt from the above mentioned booklet explains various option trading strategies including the ones I mentioned in the article.

TSE Options & Futures Page - the Toronto Stock Exchange has a wide ranging area on options that includes the In the Money Newsletter, a list of TSE traded options, and FAQs.

Speculating With Spreads - an article from the TSE's In the Money Newsletter explains how to speculate with options.

OptionSource.com - an excellent American website devoted to options. Includes an introduction to options trading as well as a glossary of terms and a search engine to check out available options.

Motley Fool Options Page - the folks at Motley Fool explain options and then proceed to dump on them. They don't even like them as hedges or selling call options to increase returns. They explain why.

CBOE Options Calculator - if you know the right information about a stock you can calculate what the option price should be using this handy tool from the Chicago Board Options Exchange.

OptionProphet - employees often get stock options from their companies as incentives or rewards for helping the company grow. This site focuses on helping holders of such large blocks of options to manage them effectively for profit and to avoid tax liabilities. Site is American but has information Canadians will find useful.

Options, Futures & Derivatives Links - my collection of links on this topic.

Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions. The author may hold interests in a number of the investments mentioned in this article.

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