There is a wide range of strategies involving options which an investor can apply. The following section discusses some of the most basic option strategies. These may be suitable to general investors as they can offer profits while limiting risk or maintaining risk at similar levels that investors are accustomed to in stock trading.
There are many more strategies available which are not described here but which your broker may be able to advise you about.
In the examples below, the share prices and premiums cited are for illustration only and do not necessarily represent actual behaviour, though they do reflect realistic situations. Also, brokers’ commissions and other levies are not taken into account.
No option strategies should be attempted until you are satisfied that you understand the risk. See Section D of this booklet.
The current share price of XYZ as of mid-September is $55. You expect it to go up, so you buy an XYZ Oct 55 call at $2. The option entitles you to buy one board lot of XYZ shares (1,000 shares) before the last but one trading day in October (the expiry date). Your investment is $2,000.
Payoff Diagram of Buying a Call
Profit/Loss
$
2 Stock Price level
0 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65at Expiration Date Premium Value = $2
-2
If the share price goes up to $60 by the expiry date, you can exercise the call to buy the shares for $55 and resell the shares in the market at $60, and make a profit of $5 per share. Your final profit would be the difference between the market price and the strike price, minus the premium i.e. $60,000 - $55,000 - $2,000 = $3,000, a profit of 150%.
Alternatively, you might sell the option in the market before it expires. For instance, when the option becomes in-the-money as a result of the rise of the share price to $60, the premium may increase to (for example) $6, which is $5 intrinsic value plus $1 time value. Selling this call option in the market at that time would return $6,000, a profit of $4,000 or 200%. This compares with 9% if you had bought the shares outright.
On the other hand, if the share price drops to $50 before the call expires, the call becomes out-of-the-money and the premium falls to, say, $1 (or less, this is purely extrinsic value). Although you would not exercise it, you may still be able to sell the call for $1,000, reducing your loss to $1,000. Even if you allow the option to expire unexercised, your loss would be no more than the entire premium of $2,000.
XYZ shares are trading at $55 in mid-September. You are optimistic about the share movement, but for cash flow reasons, you do not have the cash to buy the shares until October. You fear that, by that time, the share price would have risen and become no longer attractive for you.
Under these circumstances, you buy a XYZ Oct 55 call, which could be trading at $2. If your expectations are right, the share price does rise to $60, and if you have the cash ready, you can exercise your call and still obtain the shares for $55 each, instead of $60 in the market. Your total cost for owning the XYZ shares is $55,000 + $2,000 (premium) = $57,000. This compares with $60,000 if you had not bought the call, a saving of $3,000.
If you do not have the cash readily available to pay for the shares, it may still be possible to sell the call itself. The option should still be worth its intrinsic value of $5 ($60 minus $55 strike price) giving you the same type of return as in the previous example.
If the share price remains at $55 or falls, the call does not move in-the-money but you may still sell the call to receive the remaining time value. The maximum loss occurs when you allow the call to expire worthless. In this case, the maximum loss is $2,000.
In both of the above cases, buying the call allows you to gain if the share price goes up (prior to the option’s expiration) but if it falls, the maximum loss is the premium of the call.
You are holding a board lot of share XYZ, purchased at $49. The current market price is $55. You feel that you would like to take your profits, but there is a possibility of further rises in the stock.
You sell the XYZ shares for $55 and realise a profit of $6. You decide to buy a $55 call expiring in 2 months for $2, thus sacrificing $2 of your $6 profit for the opportunity to continue to participate in any increase in the stock price.
If the market rises to $57 prior to the option’s expiration date, you should, by selling the option, be able to retrieve the $2 between the market price of $57 and the strike price of $55. You therefore benefit from the price rise - all the time having already taken $4 in cash profits.
If the stock price falls, you lose the $2 premium for the option but you will have retained your $4 profit from the sale of XYZ.In this case, your profits from the sale of the stock were already realized. But the buying of the call gave you the chance to keep some of your profits and benefit from any further upside.
The current share price of XYZ is $55 in mid-September. You are pessimistic about it and you want to gain from the expected fall. You might buy an XYZ 55 Oct put at $2, obtaining the right to sell the share for $55. If the share price falls to $50, you can buy the shares for $50 in the market and exercise the put to sell them for $55, thus making a profit of $5,000. After deducting the $2,000 premium, your net gain will be $3,000 or 150%.
Alternatively, you can sell the put which has now become inthe-money and could be trading at $6, receiving $6,000, thus making a profit of $4,000 or 200%.
If the market went against you and the share price rose to $60, and the XYZ 55 Oct put premium fell to $1 (although it could be less), you could still sell the put and reduce the loss to $1,000. The worst case is for the put to expire worthless and the maximum loss is the whole premium paid.
In this case, buying a put allows you to gain if the share price falls (prior to the option’s expiration) and the maximum loss will be the premium paid.
Payoff Diagram of Buying a PutProfit/Loss
$
10
8 Payoff of Short Sell Stock Payoff of Option
6
2 0 Stock Price level
45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65at Expiration Date Premium Value = $2You are holding a board lot of XYZ shares in mid-September at a market price of $55, which you have bought earlier and which is now showing a profit. Now you fear a fall in the share price but you do not want to sell the shares because, for example, you believe there may be further rises to come. To protect yourself on the downside, you can buy a put. Let’s say you buy a XYZ Oct 55 put at $2. If the share price falls to $50, and at that time you are willing to sell the shares, you can exercise the put and sell the shares at $55. Deduct the $2 premium per share you paid for the put, and the effective selling price becomes $53. This compares with selling at the market price of $50.
If you still want to hold on to the shares, you can sell the now in-the-money put which might be trading at $6, i.e. $5 intrinsic value + $1 time value and receive $6,000. Minus the $2,000 premium, your net gain on the put is $4,000. This will reduce your $5,000 loss on the stock to $1,000.
If the share price does not fall but rises instead, you can still gain from the rise as you still own the shares. However, your gain on the shares will be reduced by the cost of the put premium.
In this case, buying a put provides insurance to existing shareholding (prior to the option’s expiration) while allowing the investors to gain from a rise in the share price.
You are holding 1,000 XYZ shares in mid-September at a market price of $55. You are short-term pessimistic but longterm optimistic about the stock, so you will not consider disposing of the shares. In this situation, you may consider writing a call, granting the right to someone to buy shares from you. Say you write an XYZ Oct 60 call for $1, receiving $1,000 in premium. If your expectation is right and the share price of XYZ does not reach $60 by the time it expires, you will take the $1,000 as your profit. However, the risk is that if the share price reaches $60 or beyond, you will be assigned. But since you have received $1 per share as premium, your effective selling price is $61. Therefore, only if the share price on expiry closes higher than $61 will this strategy prove worse than doing nothing at all.
Payoff Diagram of Writing a Call Profit/Loss1 Premium Value = $1Stock Price level
0 at Expiration Date 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65
-1
You are interested in buying 1,000 XYZ shares but think the share price in mid-September of $57 is too high. You would buy it if it fell to $55. Instead of waiting for the share price to fall to your desired level, you write an XYZ Oct 55 put at $1. This way, you earn $1,000 for taking on the risk of a put writer. If the share price does fall below $55, you may be assigned and able to buy the shares you want at a price you think reasonable. Moreover, you have earned $1 per share as the premium which reduces your entry price to $54.
Payoff Diagram of Writing a Put Profit/Loss $If the share price rises after you have written the put and, by the time it expires, stays above the strike price, the put will not be exercised, and you would keep the $1,000 premium as your profit.
The risk is if the share price continues to fall below $55, you still need to buy the shares at $55 rather than at the lower market price. The difference between strike price and the lower market price (assuming you manage to sell the shares immediately at that market price) will be your loss, which could be large.
In this example, an important principle to observe when writing unhedged puts would be only to write puts on shares one is prepared ultimately to own.
There are many other option strategies which involve more complex profit and loss profiles than those described above. These generally require the trading of more than one option series at a time.
A “spread” is created where an investor has a long position in one series and simultaneously has a short position in a different series of the same class, but of the same option type (i.e. either put or call). For example, a position where you are long an XYZ September $50 call and short an XYZ September $55 call is known as a call spread. Although it contains a short position, the overall spread has a limited risk profit and loss profile. Spreads can be used to achieve many different objectives but they do carry their own special risks which are described in Section D.
A “straddle” is a position where you short (or long) both a call option and a put option at the same strike price and with the same expiry date. This is a more sophisticated strategy which benefits from a change in market volatility. It can also be extremely risky, particularly when a short straddle position is taken. A short straddle is only suitable for those who have looked carefully at the risks involved and are financially able to handle those risks. Again the reader is referred to Section D.
You should consult an Options Trading Exchange Participant or Options Broker Exchange Participant of HKEx to receive further advice on these and other strategies.
Also, many good books have been written about options trading and the pricing of options. Such books are widely available in Hong Kong.