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O is for Options – The Elite Investor Club’s A – Z Guide of Investing

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We’re racing through the alphabet in the A-Z of investing now. This month we reach the letter O and it’s one of those financial instruments that can supercharge your returns in either direction. Because O is for Options. What makes options so powerful is the concept of leverage. You pay a small sum of money to buy the right, but not the obligation, to buy or sell a particular asset at a given price on or before a given date. It’s most often used in the context of stocks and shares, but you can be far more creative with options than that. Take the property market for instance. You could see an investment property you really want to buy, but all your money is tied up until an endowment policy matures in three months’ time. You could negotiate an option to buy the house for £300,000 on or before September 30th. You agree a premium of £3,000 for this option. During those three months lots of things could happen. Maybe they discover oil in the back garden and the land is now worth £1 million. You have a binding contract with the right to buy for £300,000 so you trigger the option, immediately sell it to the oil company and trouser the £700,000 difference. Alternatively, plans for the new Cross Rail station show that the home will now have a railway line ten feet from the back garden and a multi storey car park overlooking the bedrooms. You can simply let the option lapse because, although you had the right to buy, you didn’t have an obligation. OK there’s a £3,000 loss to take on the chin, but compared to paying three hundred grand for a worthless white elephant it’s a ‘get out of jail free’ card. The point is, a mere £3,000 stake put you in charge of a £300,000 asset for three months. That’s leverage. In this case we had a buy option which is referred to as a ‘Call’ option. The other type is a ‘Put’ option, where we have the option to sell an asset at a certain price on or before a certain date. The call is effectively a long position where you hope prices will go up, while a put is a short position where you’re betting that prices will go down. The amount you pay for an option is the premium, and the actual price that would trigger the option is the ‘strike price’. Your call option is ‘in the money’ if it’s above the strike price, while a put option is in the money if the price goes below the strike price. Why do people use options? Two main reasons. The first is speculation. If you believe there’s going to be a strong movement of a price in a given direction, the leverage of options means you could add an order of magnitude to your profits. Imagine the fortunes that were made with put options as the oil price collapsed in late 2014. Or if you bought call options in Apple just before the announcement of a new wonder product like the I-Phone. Equally, get the call wrong and you’ll lose ten times as much as if you’d just bought the shares. That’s why you should only speculate with money you can afford to lose and preferably after having training from people like Marcus de Maria and Siam Kidd. The second use of options is employed by many sophisticated investors and it’s called hedging. This is more like an insurance policy. Let’s say you make your main investment in the shares of ITV because you think they are undervalued and likely to rise quickly. But, just in case you’re wrong, you take out put options that will be triggered if the price falls. Either way, you can make money IF there’s a significant price movement. This strategy is less successful if the price just stays flat. A final use of options that I’ll mention to any business owners reading Elite Lifestyle is employee stock options. That’s an off market transaction between employer and employee, giving the staff member the right but not the obligation to buy shares in the company they work for at an agreed, usually preferential price. A great way of aligning everyone’s priorities. As you become more experienced in investing, I’m sure there’ll be a place for options in your trading strategy.