To become a serious investor, do I need options?
by Peter Switzer
I have been advised if I want to be a serious investor in stocks I should use options. What are they and is that advice on the money?
I don’t think serious investors have to be users of options but I think a lot of serious traders play the options game. And to be totally upfront, I do know some serious investors who do use options to maximise their results but I would advise that you become an expert in doing so before you get too exposed to options.
To explain, I should tell you that there are call and put options and I will explain a call option to get you up to speed. A call option, or a call, is a financial contract between two parties – the buyer and the seller of the option over a stock such as BHP Billiton. The buyer of the call has the right, but does not have to buy, a designated number of BHP shares by an agreed expiration day at a certain price, which is called the strike price. The seller, who is called the options writer, must sell the stock if the buyer stumps up the rest of the money. When the option is purchased, the buyer pays a premium, which is a percentage of the strike price for the right to exercise the option.
Obviously the buyer of the call option hopes BHP will rise to be higher than the strike price so they have paid a fraction of the price of the share to hopefully watch the share price ride up. The writer is betting against BHP or gets use out of holding the money tied up in the premium. Let’s have a look at why someone would punt on an option.
Say BHP shares are $40 and the investor has $40,000 to invest. If he buys the shares and they rise to $45, he would have bought 1000 shares and he would pocket $5000. On the other hand, if he bought 4000 options at a premium of $10 each, he would make $20,000 on the call options.
If the price fell, you could walk away from your option or you can exercise it and simply hold onto your shares until they rose. You would lose, but if they eventually rose, the losses could be wiped out. The big problem with options might be that you invest or punt a lot harder and it could lead to short-term or even long-term losses. Interestingly, with a European call option you have to wait for the expiration date but with an American call option you can exercise it anytime before the expiration date. Obviously, a put option is the opposite of a call and it’s something you might try if you thought a share’s price was going to fall.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Published on: Wednesday, February 01, 2012blog comments powered by Disqus