July 27th, 2011
The truth about options
Wai-Yee Chen takes a look at options from both sides, and how they can be a secret weapon for profitable trades.
It’s known for its notoriety. It earned its reputation from causing some lose homes or nest eggs. Some advisors even caution their clients to “never touch this thing”.
This “thing” which has attracted much negative press, is called options, a type of investment instrument which goes by the name of derivatives. Its key attribute is in attaching itself to other assets or shares to derive value. For a call option, it rises in value if the underlying rises and for a put options, it rises if the underlying falls in price. Moreover, options have use-by-dates.
These attributes of options and its flexibility in being able to be sold without first owning (or buying ) the options (nor its underlying asset) make it a very powerful weapon to be had for investors. Many use it to trade and gear and hence helped options gained the disrepute that it has. However, this same weapon can be used to protect against the onslaught of the volatile stock market and for extracting income. The secret in using any powerful weapon, options included, is in avoiding self-harm.
Most understand the common strategies of buying call options for a fraction of the price if one predicts the underlying asset to rise in price, hence wanting an option to buy the actual asset. On the other hand, one buys put options if reasonably expects the asset owned to fall in price and want an option to sell the asset. The most these buyers can lose is the small sum they paid for. If losses are mostly small and capped, how then did options get its bad rap?
It’s the other side of the contract, the sellers who received the payment. Buyers who paid to be in these contracts, expect the sellers to fulfil their promises. From the sellers’ perspective, the contract is a good deal as they are paid for their views; which happened to be the opposite of the buyers’. All they need to do is to ensure they fulfil the promise of the contracts. Well, this is exactly the hardest part of the deal, which often gets sellers unstuck. It’s human to like to be paid, but when it comes to fulfilling promises; it takes discipline, prior planning and sometimes forcing ourselves to keep them.
What are sellers promised to do anyway? For sellers of call options, their promise is to deliver or sell the underlying asset to the buyer. To invest sensibly is to hold the required underlying asset to be ready to sell them (generally positioned at a profit). For sellers of put options, their promise is to buy the underlying asset from the buyer. In both circumstances, if the sellers of those call and put options were not asked to fulfil their promises, they would have successfully extracted income from their asset or cash holdings. That’s the best outcome.
However, our rationale minds tell us that based on the law of probability, there will be times when sellers will be asked to do what they promised. Prudent sellers who neither intend to nor are able to fulfil those promises will need to ensure they are protected by exit clauses or not contract at all. Otherwise, they may just find themselves creating headlines!
To use options is sensible investing, it helps investors defend against the unwanted attacks of the stock market and the opportunity to be paid. However, its use must come with the discipline of and the ability to fulfil those contractual promises; otherwise one can move from being self-arm to self-harm.
Wai-Yee Chen of RBS Morgans has been advising in options for 15 years and is the author of ‘OptionsWise how to invest sensibly’.Wai-Yee regularly shares her unique options insights on CNBC and SKY and contributes regularly to YourTradingEdge and TraderPlus amongst others. If you want to invest in options strategically, contact Wai-Yee firstname.lastname@example.org or 0425 304 302.http://www.ytemagazine.com/news-latest/689-the-truth-about-options