Options
Every now and then I see people on Hotcopper asking what OPTIONS are all about. I have always liked to buy options and decided to put my 2 cents worth of thought in here.
word OPTION aptly describes this instrument; it gives you an option to decide at its end of maturity what you want to do – exercise or let it lapse.My synopsis is on OPTIONS issued by ASX listed companies and traded on the ASX. There is a whole different world of options which deals not only with listed companies but also with indices and currencies etc., which I do not cover with this article.
An option has an exercise price and a date of maturity. The exercise price is the amount you need to pay the company and you will receive a share for each option which you are exercising, in most cases this will be a fully paid share in the company. Date of maturity is the last day on which you can exercise your option by paying the exercise price to the company. Failure to get the money to the company by closure of business on that day means you have forfeited your option(s).
Where to get info regarding exercise price and maturity date: I generally look at the NEWS thread of a company and look for an appendix 3B, scroll down and it tells what shares/options are currently on issue. Another source is: https://www.ozstockstats.com/company-option/all/ but I have found that this database is not always up to date.
What are the benefits of OPTIONS? For the company they represent a future pool of money. Initially option may be given away as part of a capital raising or they may be made available by a payment of a minimal amount.For the investor they are an opportunity to have an interest in a company with little initial outlay.
For the trader they represent a greater risk/reward opportunity than the shares. This is where it needs to be said that it is far more of a gamble than an investment especially as options are generally issued by companies in which investment is high risk in the first place. I would suggest that if you are not familiar with options stay away until you have a better understanding; especially if the money you intend to invest is money which may be needed soon.
OPTIONS are generally not as liquid as the shares they represent thus it may not always be easy to dispose of them if the need arises; this becomes even more relevant as the expiry date nears.
LEVERAGE, this is what options are all about if you are a trader! Let’s say XYZ shares are trading @ 45c and they have options with an exercise price of 40c. The intrinsic value of the options is 5c. To simplify things I shall ignore any time value for the moment. If you invest $900 in XYX you will receive 2000 shares or if you buy OPTIONS you will receive 18000 options. If XYZ now rises to 50c, the intrinsic value of the options is 10c. Had you gone the share way you made a profit of $100 whereas going the option way your profit would have been $900.It is unlikely that one could have bought the options at its intrinsic value unless the expiry date was imminent as there is also a TIME VALUE component. I.e. the further out the maturity date is the larger the time value. This is at its most obvious when the OPTIONS are “out of the money” i.e. the price of the underlying share is less than the exercise price. Even though there is no intrinsic value, often these “out of the money” options are still traded. The reason for this is that investors believe that some future news may lift the share price above the exercise price of the options thus putting them “in the money”.
If you follow some options for some time it will soon become obvious that these make a great trading proposition with the accompanying high risk/high reward syndrome. Are they worthy investing in? I think so; if the time value is low or absent, which may be the case near the expiry date, you receive the shares by paying for the options now and some time later paying your exercise price to the company. In the meantime, you have the money needed for exercising earning interest and have a lower risk if the share price or market conditions move against you.
How do I spot an option? Every company listed on the ASX has a three-digit alpha/numeric code; if this code has a fourth digit “O”, it is an option. Some companies issue more than one type of option over time or concurrent in which case there is a fifth digit starting with “A” then “B” etc.
Hopefully this synopsis is of some value to newcomers to options and I wish you all good and successful trading.
W2
