How to Make the Right Call
THE FOUR TRADES that follow illustrate the main uses of options:
On 5 April 1994, the price of Sears shares was 115p. To buy 1,000 shares would cost pounds 1,150. However, the May 120 call option, securing the purchase price of Sears shares at 120p until 11 May, were trading at 41 2 p per share. With each traded options contract being for 1,000 shares, the total cost of the option would be pounds 45.
By 19 April, the share price had risen to 124p. The holder of the option now had the choice of exercising the option and buying the shares for 120p each, or selling the option back into the market. Having already paid 41 2 p per share for the option, the effective purchase price of the shares, using the option, was 1241 2 p (the exercise price plus the premium). However, the premium of the May 120 call option had risen from 41 2 p to 9p per share, or pounds 90 per contract, giving a profit of pounds 45, or 100 per cent, if the option was sold in the market.
The graph for the above trade shows that if the share price stays below the 120p exercise price of the option at expiry, the investor will lose the whole of the premium paid. This represents the maximum loss the investor can suffer. Once the share price rises above the exercise price, the losses start to erode until the trade breaks even at 1241 2 p (the exercise price plus the premium). If the share price continues to rise, the investor has the possibility of an unlimited profit.
On 5 April, after a short rally, the share price of Scottish Power was 420p but was expected to fall back. Not wishing to sell the holding, it was possible to purchase the May 420 put option at 17p per share, or pounds 170 per contract, giving the right to sell Scottish Power shares at 420p at any time until the expiry of the option in May. By 19 April, Scottish Power had fallen to 372p. The value of the May 420 put option had risen to 52. …