Banjo Smyth

PART 2: Investment Strategies Using Options - When to buy and When to Sell

Before we start to look at some Investment Strategies Using Options it is vital that we understand the exact functions that each Option has.

Why would you buy a Call Option?

- Buying a call option gives you the right (but not the obligation) to buy a set number of shares on or before a set date at a predetermined price.

- Therefore you would BUY a CALL option if you thought that the Share price was going to rise.

- eg. Lets say the current share price of ABC is 20.00 and you think that it is going to rise. You can buy a call option that will give you the right (but not the obligation) to buy ABC shares at a set price (lets say 21.00) before a certain date (lets say within the next 60 days). No matter what the share price is within the next 60 days you have the right to buy them at 21.00. If the share price goes up to 24.00 then this is fantastic if it goes down to 17.00 then this is useless as it would be cheaper to buy the shares at market price.

- If you thought the share price was going to go up why wouldn’t you just buy the actual shares? Buying the call option will give you more leverage therefore increasing your profits (and losses).

- How much will the call option cost? This will depend on a number of things - the main factors being the strike price and how long the option has until expiry.

Why would you buy a Put Option?

- Buying a PUT option gives you the right (but not the obligation) to SELL a set number of shares on or before a set date at a predetermined price.

- Therefore you would BUY a PUT option if you thought that the Share price was going to fall.

- eg. Lets say the current share price of ABC is 20.00 and you think that it is going to FALL. You can buy a PUT option that will give you the right (but not the obligation) to SELL ABC shares at a set price (lets say 19.00) before a certain date (lets say within the next 60 days). No matter what the share price is within the next 60 days you have the right to SELL them at 19.00. If the share price goes down to 16.00 then this is fantastic  as you will be able to sell shares for $19 that are only worth $16 - if the share price goes up to 24 then your Put option will expire worthless as you won’t sell your shares for 19.00 when the market price is 24.00

Why would you Sell a Call Option?

- The main reason you would SELL a CALL Option is because you will receive a premium.  Selling a CALL option means that you have agreed to SELL a set number of shares on or before a set date at a predetermined price - IF the BUYER of the option decides he wants to exercise his CALL Option.

- You would SELL a CALL Option if you thought the Share Price was going to FALL or remain steady.

- eg. Lets say the current share price of ABC is 20.00 and you think that it is going to FALL. You can SELL a CALL option that will give the BUYER the right (but not the obligation) to BUY a set number of ABC shares from you - at a set price (lets say 21.00) before a certain date (lets say within the next 60 days).

If the share price goes down to 16.00 then this is fantastic as you get to keep the premium and you wont need to sell your shares because it would be cheaper for the BUYER of the CALL Option to purchase the shares on the open market (16.00) - if the share price goes up to 24 then you will be forced to sell your ABC shares at 21.00.  The BUYER of the Shares will be happy because they have brought the shares at a $3 discount and you will be happy because you still get to keep the initial premium that you received.

Why would you Sell a Put Option?

- The main reason you would SELL a PUT Option is because you will receive a premium.  Selling a PUT option means that you have agreed to BUY a set number of shares on or before a set date at a predetermined price - IF the BUYER of the option decides he wants to exercise his PUT Option.

- You would SELL a PUT Option if you thought the Share Price was going to RISE or remain steady.

- eg. Lets say the current share price of ABC is 20.00 and you think that it is going to RISE. You can SELL a PUT option that will give the BUYER the right (but not the obligation) to SELL a set number of ABC shares to you - at a set price (lets say 19.00) before a certain date (lets say within the next 60 days).

If the share price goes up to 24 then this is fantastic as you get to keep the premium and you wont need to BUY any shares because  the BUYER of the PUT Option would prefer to sell the shares on the open market for $24 than sell them to you for $19 - If the share price goes down to 16.00 then you will be forced to BUY the ABC shaes at the agreed strike price of 19.00.  Therefore losing $3 on every share.

PART 1: Investment Strategies Using Options - An Overview

Why would you want to trade options?

Options are an incredibly useful and versatile investing tool. They can be used by everyday investors or large Fund Managers. The main feature of an option is the incredible leverage that they offer - with a relatively small amount of money options will allow you to control a large portion of shares (very similar to using a home loan to buy a house - you are able to control a $300k house by only putting in a $30k deposit).  Options can also be used to help insure portfolios and manage downside risk.

Are Options Risky?

Options are highly leveraged so therefore there can be greater risks involved if used in the wrong way. Investment Strategies using options are generally slightly more advanced than the typical ‘buy and hold strategy’ that will be recommended by your broker. In saying this Investment Strategies using Options seem to have developed a bad name and it is generally believed that Options should only be used by Professional Investors and traders. This is Simply not the case.

What exactly is an Option?

An option gives the holder the right - but not the obligation - to buy or sell a set number of shares, on or before a set date at a predetermined price (strike price).
When you buy an option it is then up to you to decide if you want to use this right. If you are to use this right then you would purchase or sell the set number of shares that you had agreed on in the contract. This is known as exercising the option. Remember it is the buyer or holder of the option that gets to decide whether or not they want to exercise the option. If they choose not to exercise the option it will expire worthless.

When using Options you have potential to make money no matter which way the share price goes - Up or Down. Before we look at some individual Investment Strategies using options lets try and understand the basics.

There are two main types of Stock Option

Call Option - gives you the option to buy shares

Put Option - gives you the option to sell shares

So if the market is going up you want to buy Call options and if the market is going down you want to buy put options.

The easy way to remember this is you ‘PUT DOWN’ something.

PUT = DOWN and CALL = UP
The slightly confusing part about options is that everybody can BUY and SELL them. This means that you could make money by selling a Put in a rising market.

Don’t worry if this is a bit hard to understand.  As you learn more information Options will become easier and easier to understand.  I promise. The most important thing to grasp is that PUT = DOWN and CALL = UP.

In ‘Investment Strategies Using Options’ PART 2 we will look at the 4 Main possibilities that you have when using Options in conjunction with your Investment Strategies.

- BUY a CALL Option

- BUY a PUT Option

- SELL a CALL Option

- SELL a PUT Option