Saturday, March 3, 2012

Options – cash generator or money loser? Puts or Calls?

To own an option means ‘to have the right to… do something’. Thus the buyer of an option buys the right to … do something and the seller or writer has the obligation to do that something. After all that is what the buyer paid for!

A call option is the right to buy a share for a certain price. The buyer of a call option has the right to buy that share at any time prior to the expiry of that option and the seller MUST sell to the option buyer a share at that certain price (the strike price).
A put option is the right to SELL a share for a certain price. The buyer of a put option has the right to sell that share at any time prior to the expiry of that option and the seller MUST buy from the option buyer a share at that certain price (the strike price).
Why would anyone want to have the right to sell a share at a certain price? Well, one of the more useful applications of a ‘put option’ is insurance. If the share price of a stock collapses suddenly, say because of a poor earnings report or the sudden death of the CEO or the discovery of accounting fraud, the owner of shares may want to be able to limit his losses. The investor could have a ‘stop loss’ order in place, which instructs his stock broker to sell the shares when the price falls below a certain price. But there is no guarantee that the broker is able to sell at that price. The market may fall at such a fast rate that by the time the order has been entered, the price is already much lower, i.e. nobody is buying and everybody else is trying to sell. Now, if that investor had bought a ‘put’ option, he would have somebody’s guarantee to buy his share at the option’s strike price no matter what.
Say, Investor A bought a put option during a recent market rally when nobody was expecting a market crash. Investor A bought the option for the TSX60 index EFT with symbol XIU. The option was bought for a measly $0.10 premium for a term of 6 months and a strike price of 10% below the XIU’s share price at the time. Say the XIU price was $21 at the time the put option was purchased with a strike price of $21-$2.10 (10%)= $18.90.  Three months into the option contract there is a market crash and the TSX60 and thus the XIU drop $25% in value to $15.75; possibly with no end of the crash in sight. It may well fall another 15%, who knows?
Luckily, the put option buyer has now the right to sell his XIU for $18.90 not $15.75 or possibly even less. He is quite happy to exercise his put and cash in for a loss of ‘only’ 10% rather than 25% or worse. That was an excellent insurance which saved the put buyer at least $3.15 in losses if not worse for a mere $0.10 premium. Looks like a good deal to me! 

Of course, if the crash did not occur, Investor A would have lost $0.10; the put option’s price or premium. But hé, that is a cheap price for a heck of an insurance. Of course, the put option writer has to eat the losses and if the crash would have driven the market down all the way to 0, his losses could be enormous. Because the put seller took that risk, this investor, call him or her ‘Investor B’ got a $0.10 premium when nobody thought that a crash was likely to occur.
In fact, Investor B had sold put options for XIU shares many times before – sometimes for much higher premiums. Over the last year, Investor B wanted to buy XIU shares but he considered the market too expensive but would be quite prepared to buy XIUs at $18.90.  He also knew that any market crash is often not much more than a reflection of market psychology and not a reflection of the share’s real value. Investor B has collected close to $4.00 in option premiums selling puts several times before she was finally forced to buy the XIU shares for $18.90. Really, including the collected premium she paid only $14.90 for the XIU and Investor B is convinced that it is only a matter of time, probably a few months, before the market will resume its upward trend and the XIU share will be worth even more than $18.90.
So, maybe both Investor A and B got what they wanted. The merits of an investment lie in the eyes of the beholder.

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