Guide to Options Trading for UK Investors (Part 1)

Options and similar instruments such as warrants are risky but can play a useful part in a portfolio, whether you're using them to hedge, or to gear up your investment. Because so few investors seem to use them, I thought I'd put up the basics - and this article is very, very basic; if you already know about options, you can stop reading now.

Options and warrants are derivatives - that is, their value depends on the value of the share - so you'll need to have done your underlying analysis of the share's prospects before you start considering  buying the options. One of the most attractive - but equally the most dangerous - aspects of options  is that they can provide you with the ability to greatly leverage your money. With an options contract, you can - in effect - control a significant amount of stock with a relatively limited initial outlay (at least when compared to the cost involved with buying the stock outright).

Essentially an option is just what the name suggests - it is an option to buy or sell shares at a particular price, as if you said to a friend 'If you ever want to sell that car of yours, I'll give you five hundred quid for it.' Your friend doesn't have to sell you the car - but he can sell it to you at that price.

Yes, that's a childish example. But it's quite an important distinction between options and some other derivatives, such as futures, that you have the choice, and can let the option lapse. With futures, you don't have the choice - you have to exercise them. Traded options give you a third choice - as well as exercising the option (buying the shares), or letting it expire, you can trade it on the market. You can have a call or put option - a call gives you the right to buy the shares at a given price, a put gives you the right to sell them at that particular price. (In fact, very few traded options are ever exercised - that's not what they're there for.)

Traded options are available on LIFFE (the London International Financial Futures and Options Exchange), now part of NYSE Euronext. Be warned that a lot of regular online stockbrokers don't offer options trading, so you may need to find a specialised broker.

Traded options are available on most of the larger stocks, for instance FTSE 100 stocks, in a range of (1) time periods and (2) prices. Generally you'll find one, two and three month options, and then options expiring at the end of six or nine or twelve months. To purchase an option you need to specify both the date and the price, as well as whether it's a call or put option; for instance, a Tesco June 250p call, which lets you buy the shares at 250p.

The pricing of options is a horrifically rocket-scientist job if you do it properly, involving the Black-Scholes Formula [ref] Wikipedia, Black-Scholes: http://en.wikipedia.org/wiki/Black%E2%80%93Scholes [/ref] . I have actually used the wretched thing and it's hard work unless you have a certain aptitude, and I think I can confidently say it's an aptitude I haven't got.

A simpler way of looking at options pricing is that the option has two potential sources of value. First, intrinsic value, the difference between the share price now and the 'strike price' of the option. If you've got Tesco 470p call options and Tesco is trading at 443p, there's no intrinsic value at all - the options are 'out of the money'. On the other hand if you have Tesco 420p options, you have 23p intrinsic value - if you exercised the option you would have saved 23p a share on your purchase.

But there is also a time value to the option. If your Tesco 470p option expires tomorrow, it's probably worth very little if anything - it's unlikely the shares will go up 27p in a day. On the other hand a Tesco 470p option that expires in a year's time has a value, because it's much more likely the shares will move that amount at some point during a one year period.

The premium (that is, the price) of the option should reflect both these sources of value. Remember that options are wasting assets, since they expire at a particular date - if you buy an out of the money option and hold it all the way to expiry, it will gradually decline in value until you have lost all your money. So buy and hold is not a strategy that works with options, as it does with shares. If you buy Tesco today, believing it has value that will eventually be rewarded by a rerating, it doesn't matter whether the rerating happens tomorrow, next week, in a month or in a year's time. If you buy December Tesco calls, though, and the rerating happens in January, you're stuffed.

Obviously, if you think the share price is going up, you'd buy a call option (you could, equally, sell a put option short), and if you think the price is going down, you'd buy a put.

There are all kinds of strategies that options traders use to generate income and capital returns - writing options, straddles, collars and so on. I'm not going to cover those here - they are for the trader, not the investor, and if you're mainly an equity investor, they're probably not very relevant to you.

The simplest way of using options is to gear up your investment on shares you want to buy - getting more exposure for the same stake. You might decide to use options rather than buying the underlying shares if you think the share price movement will occur suddenly - for instance if there's a regulatory decision coming up, like the bank charges case in the High Court or the water regulator's decision on pricing, you could use options to take a position on it.

But you can also use options to hedge your portfolio. Suppose you held water shares for the income from dividends, but you were worried about the water regulator coming out with a very adverse decision. It's not worth trading in and out of your whole portfolio, if you want to carry on holding the shares as long as the decision is a good one. Instead, you could defend yourself against downside risk by buying a put on your United Utilities shares. If the shares go down, you make money on the put that offsets your loss on the shares. If the shares don't go down, you've lost a little money on the put, but that's your insurance premium - and less than what you might have lost on the shares.

You might also prefer to use options to protect a position, rather than selling your stock, for tax reasons - if the sale would put you through your CGT limit for the year.

There are a few other products that work in a similar way, but are more commonly available through stockbrokers. These are warrants and covered warrants.

Warrants are usually issued by a company as part of a package together with shares or bonds, but are tradable in their own right. They give the right to purchase shares in the company at a given strike price, and can have a lifetime of up to 15 years (usually 3-5 years). Of course these are only available as calls, so you can't use them for downside defence.

Covered warrants are not issued by the company, but by a bank which holds collateral, and they are traded in the same way as shares. Some covered warrants are also available on indices, currencies, commodities and even on house prices. They were introduced in 2002, but they haven't really taken off - they can be expensive compared to options.

Puts are available in covered warrants, so if for instance you wanted to hedge your portfolio of income stocks by taking a put on the FTSE 100, you would be able to do that with covered warrants as well as with traded options. You cannot hedge away your downside risk totally, but you can limit it.

One major warning that should accompany both options and warrants is that they can be highly illiquid, with big spreads. That's something you need to look out for - 'go where the money is' to take advantage of the best spreads, if possible.

Another key concern is margin calls - these happen when an options trading account no longer has enough money to support the open trades. Because of the leverage effect of using options, these margin calls could wipe an investor out so you would need to be particularly careful about using options to trade in volatile stocks.

Finally, you should be aware that these are very technical markets and you really need to do your own research if you're going to use these products. If you're the kind of person whose approach to analysing a stock is to sit down and run a huge spreadsheet, then you probably have the right mindset - it really is all about the numbers.