Seeing a bit of interest in options so probably as good a time as any to regurtitate something I wrote on the VTX threads about options, or at least my take on them:
So here’s my attempt at shedding some light on those pesky options. This is all from the mouth of a rank amateur and should not be taken as even reasonable advice. I’ve used a few examples of other companies during the discussion, this is not intended as cross-promotion and indeed many of them (options-wise) have expired anyway.
Keeping your options open
Whilst options can be traded, at their heart options are really just that, options to at some later stage finally invest in a company (or bail if you don’t).
Options can be listed or unlisted and tend to be offered as a sweetener to investors during an IPO or cap raise. They can be used as an investment tool or traded, ST to LT.
An option will first of all have a “strike price”. This is the amount of money you’d have to pay to convert the option into a full share of the company. Typically when first offered this strike price will be more than the current SP or listing price of the company. In doing so it offers an investor a “reward” for investing in a company that does well in the future. It also offers the company a means of injecting cash down the track. If they get the strike price (and expiry) right then that cash injection would hopefully come at a time when it’s needed for further growth. Remember though that with the cash injection comes a whole new bunch of shares and subsequent dilution of heads. I suspect when back door listing (like VTX) there is some thought given to what the SP is currently doing and will do in the near future. In VTX’s case they likely want the money. In NXR’s case they didn’t need the money so much and therefore didn’t want the dilution, thus there was pressure to keep the SP under the strike price, or at least they didn’t try to get it over.
Secondly options have an expiry date, the time when you must pay up or let them expire. Once this date is hit your options become worthless if you have not exercised them. Options can be converted at any time, you pay your strike price to the company and the shares appear in your account. Generally speaking you wouldn’t see many options converted until fairly close to their expiry date, nor would you see them being converted if the strike price was considerably lower than the head price. Having said that there could be a reason to convert options if they were just a little bit under, but you wanted a lot of shares and couldn’t buy them on market. Takes some marbles but “sophisticated investors” do this sometimes when a cap raise is conducted slightly higher than the share price.
Generally speaking though the head price needs to be a reasonable premium to the strike price for investors to convert. If a share is trading at 21cents and the strike is 20cents for the options then you’ll find most people would simply buy the heads on market. Despite a 5% difference you have to factor in the volatility of the share price whilst the options are getting converted, what if in a days’ time the SP drops and when the shares hit your account they are worth less than the strike price you paid?
Options have no intrinsic value, they don’t offer any dividends, they don’t offer any exposure to the long term growth of a company and they often get treated with far more contempt by companies and institutional traders. An example of this is ERIOB which pretty much got stolen from holders when they went into a halt 3 days prior to the options ceasing to be traded, then the SP price appeared to get manipulated just below the strike and magically they found someone to underwrite the options that of course never got exercised. Despite knowing the pitfalls of options, even this move left a bitter taste in my mouth.
Despite a little bit of doom and gloom though options do offer a lot. They give the trader or investor some interesting choices:
1) With a similar amount of money you can significantly increase your exposure to ST price movements
2) With a lot less money you can have a similar level of exposure as if you’d bought heads
3) With a small amount of money you can dip your toe in a coy that you aren’t sure about
Realistically the only reasonable choice here is option 2. If you go for option 1 short term price movements, manipulation, liquidity etc could lose you a significant amount of money, or all of it. This is where you should consider buying a portion of heads and options, if you truly believe in the company. Option 3 is, let’s be honest here, putting your money on black at the casino, it’s a bet. If you don’t believe in the FA or TA of a coy then you shouldn’t be investing a cent in them until you do.
Let’s focus on option 2 and what gives options value?
At the heart of valuing an option you need to look at the current head price and the strike price of the option. All things being equal if I offered you an option to later buy a share then the value of the option would be the head price less the strike price. If XYZ is trading at 3c, the strike price of XYZO is 1 the XYZOA should be worth 2c. Simples? No. Not simple. Some options trade at a much higher price than that equation would suggest, whilst some options that have a strike price higher than the head price are trading at decent money. What the hell? Shouldn’t I be paying YOU to take my sub-strike options?
The answer is not simple, options gain value based on what people expect the head price of a company to be at expiry, or at least some point in the future. As such they can be a bit of a yard stick, a gauge of people’s expectations of a company. If you compare options that have a similarly long expiry, those that trade at a “premium” to their value tend to be for companies that may be in their infancy and/or moving into a growth phase whilst options that trade under value tend to indicate pessimism regarding company value, or likely short term volatility tending towards downward prices. Recently FFGO traded well under its intrinsic value. I bought some reasonably expecting that (along with ST news) both the heads would go up and the options would also close the gap, a double whammy. As it turns out the market was negative towards them for a reason. They are still in play but the medium term outlook for the coy is not as rosy. On the other hand CL8O is trading at a premium. People are bullish on the stock and see that (coupled with the long expiry) there is a good chance that the company will be valued a great deal more than it currently is.
Options don’t last forever
I’ve mentioned the expiry of an option a fair bit and this is the mysterious key to what drives option prices. The actual date though isn’t really that important, it’s what you expect to happen before the option expires that is important. Ignoring prices for a moment; Options in biotech company AAA expire in two weeks but there was an expectation of outstanding phase 2 results being revealed in one week. Options in biotech company BBB expired in 2 years but there was an expectation that their drug “fixyourrash” will have poor results. Which options would you buy?
There’s still no black and white here though because as expiry looms suddenly people realise they are getting closer and closer to having to pony up potentially a lot of cash to convert their options. If you believe a company’s SP will be more than then strike price at expiry then someone WILL be doing this, even if it’s not you. The fact is though not everyone wants to convert so as expiry comes close you will see some selling pressure. As such options tend to lag a little bit closer to expiry. We are seeing this with VTXO to an extent. It will probably always trade slightly under its intrinsic value up until expiry for this reason.
The reasons people don’t want to convert can vary. First of all it can cost a lot of money. Suddenly you’ve gone from a bunch of options worth 5% of your capital to a bunch of heads worth 50% of your capital, now you’re really taking a long hard look at the company and wondering if it’s worth going “all in”. Secondly option conversion isn’t instant. There is always the concern that if a SP is quite volatile then when you finally receive the shares to trade they are worth less than they were when you sent the cheque in, this is even more of a concern if the strike and head price is fairly close. The other consideration is the liquidity of both the heads and options. If this is a trading stock for you then if you end up with a big bunch of shares can you actually sell them? It wouldn’t seem like a problem but it actually can be, the rapid growth in SP. If a company goes on a solid, positive run you will at some point start to see relatively decreased liquidity in the heads and options. Owning a million options at .01cents represents $1000 and should be easily tradeable. If the SP rockets and those options are now at 10cents then suddenly you have $100,000 worth of options to trade. Trust me, that won’t be something you can sell in one go without obliterating the price. Again, a first world problem but this is what happens when an option leaves it’s “goldilocks zone”.
The goldilocks zone
This is the most mysterious part of option trading. We like options because we can increase our exposure to (hopefully) a climbing SP. Lets say the option you bought at .01cents had a strike of 1 full cent. When you bought the options the heads were sitting at .09cents, just under the strike. You buy them expecting some ST news and gains. At that point you can buy 9 times the number of options as you could heads, and only need a very small gain in the head price to start seeing some parity; Once heads hit 1.1cents (strike + your purchase price) then as the head goes up a certain amount, so does the option, wow, you’re making a fortune. Finding this sort of leverage is great, especially if it’s a company you believe in and it can create a great deal of liquidity. But it won’t last forever. A month down the track the head price is 10cents, logically your options should be at 9cents (head price – strike price) but it’s not, it’s hovering around 8. What’s going on, you even have a reasonable amount of time before expiry? Like shares, houses, boats and potatoes price is governed by supply and demand. Despite the links I’ve spoken about to head price option prices are still governed by the same to and fro. Everyone wanted your options before because of the leverage they had (9x) but now they don’t offer the same windfall. Why would you buy an option at 8cents that has inherently more risk to only have 1.2x the leverage? Of course you can always convert, and given the difference in SP and strike price you’d do very well, but as discussed before there are reasons why people won’t want to and this is why you’ll see some slightly depressed trading in the options, especially as they get nearer to expiry. A good example here is of ZIP. ZIPO was fairly heavily traded back at a point where it offered (I think) about 3x the leverage. Now it offers more like 1.4x and guess what? Not so much interest. You really couldn’t sell more than around 10k’s worth of the options without busting the price, and even then you’d need to pick your moment. The main message here is if you are planning on buying options to make your fortune, then make sure you plan on converting at some stage, at least a significant portion of them anyway.
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