Suppose shares in Barclays are trading at 300p. If you thought the shares would recover you could buy via a spread bet a call option. At the time of writing this article with the shares at 300p, IG Index was quoting the 320 September call at 20p.
So you decide to buy 1000 options at a premium of £200 (1000*.20).
If Barclays share price does not rise to 320p the options are worthless.
Between 320p and 340p it is worth selling the options but the profits won't cover the £200 premium.
If the shares in September are trading over 340p the trade will register a profit. Suppose Barclays share price at expiry is, say 390p, the gain would be £500 (which represents a return of 250% on the original £220 investment.
Of course the shares could also be sold back at anytime during the life of the option and, if held to expiry, would make a profit as long as Barclays were trading above 340p at the time. Whatever happens you can't lose more than the original premium of £200.
A put option would work the other way. Again, assuming a 300p share price, a 290p spread bet put expiring in a few months' time might cost 20p. If you bought this put you would not exercise it unless the share price expired below 290p (between 270p and 290p the option would be worth exercising but again the gains would not cover the premium). So only if Barclays went down to say 250p would a profit be made (1000*.20 = £200).
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As well as buying options you can also easily sell puts using spread betting, which effectively turns the key disadvantage of a buyer of options (time to expiration - wasting asset) into an advantage to the short seller.
Suppose Barclays is still trading at 300p and you expect the price to rise, but this time instead of buying a call spread bet you opt to sell puts instead. The 290p spread bet put is still trading at 20p and you short-sell 1000 of them. The buyer of those options will pay you the premium amounting to £200 which is the most you can win.
If Barclays continued to trade above 300p, you keep all of the £200. Below 300p you make a lesser profit down to a price of 270p (290p minus 20p). Below this level you start losing money and if the share price crashed down to 200p, you would lose £700. In this case the potential profits, not the potential losses are limited and you may lose far more than you stand to win.
Selling Calls is even more risky especially in a bull market as a share price can only go down to zero but there's no limit on the upside. Suppose you believe the 300p share price won't hold. Instead of buying calls you decide to write calls. So you sell 1000 320p calls at 20p each. You gain £200 in premium but this is the maximum you can make on the deal. As the price rises from 320p to 340p you make an ever-diminishing return. If Barclays share price were to recover to 400p say in response to a better than anticipated earnings report, you would lose £600 [(400p - 340p)*1000].
Although to succeed in options calls for some study of not just options but of the underlying market a useful strategy to follow is this: Buying options usually proves profitable when the market is fast moving. Selling options usually proves profitable when the market is static.
Most calls are written naked meaning that the person writing the options doesn't own the shares he's selling.
However, there is a more sophisticated alternative called writing a 'covered' call. This is when you sell (i.e. write calls) calls on shares you already own and it's really a low-risk strategy. Suppose you thought Barclays will recover - you could go long (either via spread betting or by actually buying the shares) at around the 280p mark. You could then sell (go short) on the spread of an out-of-the money call option. The September call with a strike price of 320p is currently trading at 8p, so if you sold the spread you could use this premium towards reducing your initial investment on the stock. If Barclays were to rise sharply you make bigger gains on the shares you own than you lose on the options trade; though, of course you would have made much more money if you had not written the calls in the first place. This strategy is useful to boost returns in a market that's moving sideways or rising slowly. More brokers are now allowing investors to write covered call options against their shares. The main risk you run is that of the stock being called off you; say for instance the stock surged upwards due to a takeover bid you would stand to lose the stock. So you have to decide at what level you would not be too unhappy to sell the stock.
So, let's assume for simplicity's sake that Barclays is currently trading at 280p and you owned 10,000 Barclays shares. You believe that Barclays will continue to rise so you could hence write 10 September calls, with each one equivalent to 1,000 shares, with a strke price of 320p. The September call is trading at 8p a share so the 10 contracts would have have translated into an income of £800 equivalent to a return of 2.5% on your capital. If on the options expiry date the shares were trading below 320p, this return would represent a gain - if the shares were trading at 340p you would still keep the premium and the 40p rise to the strike price but would have to give up the additional gains.
Shares Magazine mentions another strategy involving going long on a stock with a stop loss, while selling the spread on an out-of-the-money call option on the FTSE 100 (i.e. taking out an index call). The reasoning is to take in the premium from writing the call to offset the risk. Such a strategy would produce a good profit if the stock rises but the market stays constant or falls. The worst-case scenario would be if the stock fell and was stopped out while the market rallied, as both legs of the position would then make a loss. So this isn't a perfect hedge but as index options are more liquid than individual stock calls, the spreads are tighter and this way you don't cap your upside on your stock position.
This strategy involves simultaneously buying puts and calls at the same strike price. Sounds dumb huh!? Yet, this strategy is not as contradictory a position as it may first appear. For instance shares in Barclays are currently trading at 300p. September calls and puts with a strike price of £300 cost 20p each and you buy both. Should Barclays share price move to above £340 (i.e. £300 plus the two premiums) you stand to make a profit. If the strike price falls below £260 you also make a profit. If the share price remains in the range between £260 and £340 you lose money. So you stand to make money regardless if the market rises or falls BUT only if the market rises or falls substantially! A straddle strategy may be appropriate when a company is about to release key news.
A good strategy would be to sell options at times of high volatility using some sort of protection on the way while buying options if you think volatility is low.
>> Using Options to protect a FTSE Share Portfolio against Market Storms
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