Thursday, March 15, 2012

Options – cash generator or money loser? What if scenarios 3

Buying a put is buying the right to sell a share at the strike price of the option. The longer the option term, the higher the chance is that the option will be exercised. The closer the strike price is to the current trading price the higher the risk the option will be exercised. The farther current share price is below the strike the higher the intrinsic value of the put. The more volatile the share price is, the more likely it is that the option is being exercised. All three factors lead to a higher option price or premium,

Buying puts is often seen as buying insurance against a falling share price or market price. The question is, how expensive is the insurance visa vie the risk to be covered. Selling puts is betting against the chance that the market or share price crashes. However, it can also be used in a more conservative fashion. For example, in a rising market where our Royal Bank share has become a bit expensive, you, the investor would love to own RY at $58 but not at the current market price of $60.

So rather than buying the shares, you take on the obligation to buy RY at $58 at any time during the next 3 months. You write a put option with a strike price of $58 that expires on 21 JUL 2012 and in return you receive a premium of say $2.04 If the RY falls over the coming three months to $58 or less, you will be obliged to buy it for your target price of $58.00 – well in fact for $58.00 – 2.04 = $55.96 Hmmm… not bad eh? But… you need to have the financial means to purchase the share, i.e. you need to have $58.00 in your bank account or you need to have access to a $58 credit (loan).

If you don’t, you may have to buy that share at $58 and sell it in a crashing market. Say the share price fell to $55.00 then you have to come up with $58-2.04-55.00 = $0.96. If the shares fall to $50 you have to make up for a loss of $5.56 per share. If the RY would go broke and it shares fall to $0 you would have to pay $55.56 per share or $5556.00 for 1 option contract. Ouch!

Writing puts is always a ‘naked’ transaction because there are no shares to cover your obligations! The graph in Figure 1 shows the transaction graphically:


Figure 1 - shows your profit or loss (on the X-axis) with the changing share price of RY (on Y-axis).

As long as the share price of RY does not fall below strike you make a profit ($2.04 per option) but once RY falls below strike the losses can be enormous. Thus you should always ensure you have the means to buy the shares at strike and be willing to hold on to the share until the price has recovered or until you have made your target profit.

In a rising market the risk of having the put exercised is relatively small, especially when you choose a prudent strike price. However, selling a put in a falling market is asking for trouble! Thus an astute investor, combining the sale/purchase of call and put options can make money in both falling and rising markets; but this should only be done with an acute awareness of the risks the investor takes and with the financial strength/backing to fulfill the obligations that are taken on.

Buying a put option can generate cash during a falling market (see figure 2) nearly perfectly mirroring the seller’s performance. Rather than being forced to sell the underlying shares, such an investor has now the cash flow (option gains plus dividends) to build a sizeable net egg to cover his/her costs of living or to take advantage of investment bargains.

 Figure 2. Profit/Loss of a RY 21JUL12 58.00 put owned by the investor (X-axis) versus share price (Y-axis). Maximum loss is $2.04 per option.

Is the option trade for you? Can you figure out the odds to make money with options. That will be discussed in the next and final installment of this posting series.

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