When we look at why people trade options as opposed to shares there is one common attraction and that being the element of leverage options provide. This means for a fraction of the price you can obtain the same exposure to the fully paid ordinary share by simply trading options.
For example, if we are looking at XYZ shares trading at $32.00 we may decide to buy an XYZ $30.00 call option with 3 months to expiry for an option premium of $3.30. This means we have the right to buy XYZ shares for $30.00 any time up until the expiry date in 3 months time. Remember the share is currently worth $32.00 so already our option allows us to buy the shares for $2.00 below the current share price. This amount is already priced into the option premium and is known as intrinsic value.
The remaining $1.30 of option premium is referred to as time value. If we are comparing buying options against buying the underlying share we can break the time value down into 2 components. Firstly, the saved interest expense of buying the option against buying the shares. If we were to buy 1000 XYZ shares at $32.00 we will need to outlay $32,000, alternatively to buy 1 options contract we only need to outlay $3,300 which provides us exposure to 1000 XYZ shares. So if we were to buy the call option we are effectively saving an interest expense on $28,700, being the difference in the funding cost for the 2 strategies.
Secondly, the time value also comprises of a built-in option. This provides the advantage of limiting the option holder’s loss in the event the share price of XYZ falls. For example, if our investment decision proves to be incorrect and XYZ shares were to fall to say $27.00 we would not exercise our $30.00 call option and it would expiry worthless. In this case our maximum loss is only the option premium of $3,300. However if we were to buy the shares at $32.00 and they fell to $27.00 our loss on 1000 shares would be $5,000.
In the case the share price increases the call option holder will benefit from greater returns in comparison to buying the shares due to the inherent leverage which options provide. If XYZ shares were to rise to $36.00 by the expiry in 3 months time the return for buying the shares at $32.00 would be $4,000 or 12.5%. In comparison the return on buying the $30.00 call would be $2,700 or approximately 82%. So although the dollar gain on trading the call option is less, the return on investment is significantly more attractive.
Therefore options provide the opportunity to take advantage of correctly predicted price movements with the added benefit of magnified returns from the use of leverage, whilst limiting the loss if the trading decision proves to be incorrect.
By Matt Comyn, general manager, CommSec
Disclaimers: The views expressed in this article are those of Matt Comyn, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 and is not intended as general advice.