Using Options Ignoring transaction costs, options trading represents a zero-sum game. What options do, though, is allow the transfer of risk between various market participants. Investment guide to Options afr.com© 2007 Investment Guide to Options Investors who have a view on where a stock’s headed have an alternative to buying or selling those shares outright -they can take out an options contract. Options open up the opportunity for profit if the share price moves in the direction the investor expects and limit risk if …

Key Terms • Underlying asset -the asset (such as shares) that’s going to be bought or sold. • Expiry -the time when the asset is to be bought or sold (in the case ofAmerican- style options, the last date to buy/sell) • Exercise price or strike price -the price at which the asset will be bought or sold. • Contract size -the number of shares underlying an option contract (usually 1000 shares) • Premium -the amount paid by the buyer to acquire the option. • Taker -the buyer of the option. • Writer -the seller of the option. Using Options Ignoring transaction costs, options trading represents a zero-sum game. What options do, though, is allow the transfer of risk between various market participants. These participants can be divided into three main groups: hedgers, speculators and arbitrageurs. ‘Hedgers’ buy or write options to reduce risk. ‘Speculators’ buy or write options to make a profit. ‘Arbitrageurs’ buy or write options to earn risk-free profits from market mis-pricings. Let’s look at some examples Investment guide to Options afr.com© 2007 Hedging with put options Let’s say a portfolio manager has $1 million invested in AAA Ltdshares and he’s worried the share price (currently $10) will decline over the next month. Instead of selling the shares now, the portfolio manager can buy’put’ options with an exercise price of $10 that expire in one month’s time. If the price of the shares falls below $10, he can exercise the put option and sell the shares at the existing price of $10 in one month’s time. If the share price rises he simply let’s the option expire and holds onto the shares. Speculating with call options An investor thinks ABC shares, currently worth $10, will grow invalue over the next six months. Rather than buying shares outright now, the investor buys call options with an exercise price of $10 that expire in six month’s time. If the share price rises above $10, the gambler can exercise hiscall option and buy the shares in six months’ time for $10 -below the prevailing market price. Get smart: Put options to work for your safety, John Wasiliev, AFR, November 2, 2005

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