Options for conservative investors

Whether you use options or not it is important you be aware of what options can do and the benefits they can offer. Yes options can be risky and unfortunately options do have an image problem but, like driving a car, once you learn how and are aware of the risks then the potential uses become clear. Putting options in the too hard basket and ignoring them could be likened to saying learning to drive a car is too dangerous so I'm going to catch a train.

What is an option?
The links on the right hand side of the page will take you to a number of sections within the ASX website that outline options in great detail, suffice to say the table below is a summary of the rights and obligations of an option investor:

Strategy 1 - Covered call writing
Selling (or writing) a call against shares you own is one of the most common options strategies. All types of investors from large institutions through to small investors sell options to earn income from shares they currently own.

When share prices are expected to remain flat or decrease, this strategy can be used. It is not appropriate for strongly rising markets, as it caps the profits that can be made as the share price rises.

How does it work? Assume it is now January 2 and you own 1,000 Coles Myer (CML) shares currently trading at $7.57. So you sell 1 CML call option (1 option contract usually covers 1,000 shares) expiring on 29 January with a strike price of $7.50 and a premium of 25 cents. This means you have the obligation to sell 1,000 CML shares at $7.50 if the option buyer exercises the option at any time between now and the end of January.

For taking on this obligation you will receive:

1,000 x $0.25 = $250 less commissions.

What is the worst that could happen? If the shares stay above $7.50 then you will be exercised and forced to sell your 1,000 CML shares for $7.50 when the market price is above this level.

What is the best that could happen? CML falls to just below $7.50. The option would expire worthless, you would keep your shares and the $250. You can then write another option.

What actually happened? CML closed around $7.35 at expiry on 29 January. This means the option expired worthless, so you keep your shares and the $250. You can now look at writing an option expiring in February; the $7.25 options are about 19 cents and the $7.50 about 10 cents.

Strategy 2 - Buying a put
Another simple low-risk strategy is to purchase a put option when you think the market is going to fall. So often you get a feeling the market is going to fall - might be because of economic circumstances or the price of a share has run up and you expect it to come off - but apart from selling your shares there is not a lot you can do to avoid this drop. This is when you would buy a put.

When you buy a put option you have the right to sell shares at the strike price on or before the expiry date. Think of it like insurance for shares, if the market falls you are going to put the loss onto someone else.

How does it work? Assume it is now 1 December and you thought Cochlear (COH), currently trading at $28.96, was going to fall in the next couple of months. So you buy 1 COH put option expiring on 29 January with a strike price of $28.00 and a premium of $1.00. This means you have the right to sell 1,000 COH shares for $28.00 at any time before January 29.

For this right you will pay a premium of:

$1.00 x 1,000 = $1,000 plus commissions.

What is the worst that can happen? If COH stays above $28.00 your option will expire worthless and you will lose your $1,000 investment.

What's the best that can happen? COH falls to zero. You can then exercise your put and sell your COH shares for $28.

What actually happened? COH fell to $21.74 on 29 January. Holding the put means you have the right to sell 1,000 COH shares for $28, or $6.26 above the current market value. The put has protected the value of your holding.

Interested? - Here are some things to ask your adviser or broker about:
1. Your broker will need you to read and sign some paper work before you trade
2. When selling options your shares will have to be locked in Chess, your broker will explain how this happens.
3. How much brokerage they will charge for the options trade and the share sale (should you exercise or be exercised)
4. Which series should trade? This depends on your view of what the market is going to do.

What do you do next?
Have a look at the options pages in the Financial Review newspaper or on the ASX website at the links above. Look up some shares you own and see what option series are available ? there will be quite a few but start with options expiring in the next couple of months and with a strike price close to the current market price. Then try some paper trading.

After you have done this for a couple of weeks talk to your adviser or broker about how to get started.

What about courses?
We also recommend doing a course about options. ASX runs courses around the country on options, more details are available on the ASX website. There are also a number of other groups who run courses on options but before you sign up, run through this checklist to make sure you choose wisely.

1. Will the educator provide a balanced coverage?
With all investments, and options in particular, the risks need to be clearly spelt out. Options trading need not be any more risky than buying shares. In fact using the strategies above it can be made even less risky, but you need to know what you're doing. If the seminar sounds too good to be true, it probably is.

2. Will the educator provide on going support?
Becoming proficient takes time and on-going support by either answering questions or offering follow up seminars.

If you decide to commit yourself to learn about options you can look forward to an improved bottom line but not without some work on your behalf. As with most things, if it were that easy it wouldn't be worth doing.

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