Using Options as a Hedging Tool

Q. What about Options?


A: Ok, Options huh? Let's start with the basics - An option gives you the right, but not the obligation, to buy or sell a security at a fixed price on a specified date. A call option gives you the right to buy a security at a fixed price. A put option, on the other hand gives you the right to sell a security at a fixed price and here you are speculating that the market will fall.

Options come with gearing which makes them highly leveraged instruments. The options listed on Liffe, which covers the UK market, are American style which means that the exercise date is not limited to a single day (unlike European-style options).

With options you can either take or effect delivery of the underlying instrument or close your position before expiry; this gives rise to volatility on expiry days (which are every third Friday of the month) since most traders choose to unwind their positions (as opposed to taking delivery). This volatility is at its greatest on the third Friday of March, June, September and December when the futures also expire and these are referred to as 'quadruple witching' days.

Q. Can you show me a practical trading example of Options?

A: Ok, let's take one involving the purchase of Ladbrokes shares. Anybody having any confidence in the stock being depressed at current levels (119p at time of writing) could buy the 'option to buy' rather than the actual shares. In November 12, that's exactly what I did having bought 50 June 110 options for 19p (there was thus a time element cost of 10p). This means that at any time up to June next year I can sell this option.

For anyone who doesn't know much about options, they are sold in blocks of 1000 and you can lose the lot if you hang on and the shares end up lower than 110 on expiry. I bought the June 110 for 19p when the share price had dipped to 119. When the shares reached 135, it would have cost about 35p to buy them (same time cost of 10p). Both shares and option had risen by 16p. I could have probably sold them for 31p.

When an investor, let's call him Dave, could have simply bought 7000 shares at 119p each say, I thus bought 50 June 110 options @19p each. If both of us were to sell our holdings when Ladbrokes was trading at 135p (at time of writing), Dave, would have made a profit of £1120 on an outlay of £8330 (+ dealing fee). I would have got 16p, a profit of £8000 on an outlay of £9500 [50 options x 1000 (1 option = 1000) x .19p)].

Of course I would stand to lose the lot if I didn't sell sometime before next June and the price was below 110.. The option prices move up and down at approximately the same amount as the shares. There is a time element built in which reduces gradually until the date when that particular option ends (Of course, you can trade at any time until then).

Note: I deal by phone using Rensburg Sheppards. The only UK shares you can buy and sell options are those quoted by LIFFE and are mainly FTSE 100. You can see the prices fluctuate (15min delay) by 'subscribing' (it costs nothing) to their service ( Ladbrokes were in the FTSE 100 when they had Hilton and have remained one of the shares dealt in the option market.

Q. What are the intrinsic value and time value of Options?

A: Options have both an intrinsic value and a time value. An option has intrinsic value if there is some gain to be made by exercising it. This means that an option has intrinsic value if it confers the right to buy the FTSE 100 Index at less than the current price of the FTSE 100 Index. Supposing a security is trading at £5.60 and the exercise price of a call is £5.10 the intrinsic value would amount to £0.50. Options with positive intrinsic value are referred to as being 'in the money', those with no intrinsic value are referred to as being 'out of the money' while those where the underlying's price is equal to the strike price are 'at the money'.

Options also have time value. This reflects the fact that even if the option is currently worth more than the underlying market, i.e. the option is effectively worthless because buying it would cost more than buying on the underlying market, it may have an intrinsic value in future if things change. In other words the time value of an option is the price one pays for the possibility that the option will move either in to the money, or more deeply in to the money, and is the call price, or as it is sometimes referred the call premium minus the intrinsic value. Supposing as in our security example that the call premium is £0.65, then the time value would be equivalent to £0.15 (0.65-0.50).

Example -:
Share price: £5.60
Call premium: £0.65
Exercise price: £5.10
Intrinsic value: £0.50
Time value: £0.15

There are two key advantages of betting on options. Firstly, they are highly leveraged bets. If your prediction of the market proves correct your win will not only be based on the change in the value of the underlying market but also the change in the value of the option. They also provide a degree of limited risk. If you bet that the price of an option will rise and it falls you can only lose a fixed rather than an unlimited amount, since the value of an option can never fall below zero. Indeed, an option will almost always have some time value even in the unlikely event that its value in the underlying market does fall to zero. The one main disadvantage with options is that, in some circumstances, the win from a successful bet can be less than betting directly on the market in question. Spread Betting on Options is explained in more detail here

Q. Hi, I use spreadbets to hedge my options positions, and would like to know how to use contingent orders in this respect.

A: To explain myself further, say for example the Dow is currently on 12400, and I want to go short at 5 pounds a point when it reaches 12200, how can I leave a contingent order on the system that will be triggered should be Dow fall to this level, and attach a stop loss 100 points above, at 12300?

This type of order is also referred to as a 'momentum order', 'break order' or 'if done order' -:

To do this with Capital Spreads:

To create an order, click on the order button next to the market you want to create an order for. Then in the 'create opening order' box, enter the level 12200 and your stake size. Then click the 'if done' button to attach a stop loss order. Once you've done this, click confirm and the order will be created. While the order is still pending, it will be in the 'order book'. You can amend the details here, including the stop level. When the order triggers it will move to 'open positions', but you can still amend the stop through the order book.

 ...Continues here - Covered Warrants versus Spread Bets

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