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SCMP Reporter

AN ''option'' is an entitlement that comes in two varieties called a ''put'' and a ''call''.

  A call option is the right, but not the obligation, to buy and the put is the right, but not the obligation, to sell.

  The entitlement pertains to a right to buy or sell a commodity or security at a fixed price, the ''strike'' or conversion price, over a predetermined period.

  The ''premium'' on an option is the price of buying the option expressed in index points, with each point being worth $50.

  This should not be confused with the premium on a warrant, which is the relative price of buying the stock through a covered warrant expressed as a percentage of the stock price.

  The ''gearing'' associated with an option is a measure of expected volatility and relative outlay. It is calculated by dividing the commodity price by the option or warrant price.

  So, if you buy an option with a 10 per cent premium to the share price, you can effectively gain exposure to 10 times as many shares with your money for the life of the option.

  Investors planning to play the index options at the futures exchange are essentially betting on the direction in which the index will go over a given period.

  In the case of a put, the investor is betting the index is going to fall below the issue price, plus the premium.

  Buying the call will enhance anticipated returns on a rising market.

  But investors do not just buy or sell the underlying investment because it is cheaper to trade options as all the investor is asked to put up is the initial premium price of the option.

  Options are also less risky. Unlike a futures contract, where the liability is technically unlimited, all the investor loses on an option is the premium. Yet the potential return on an accurately guessed position is technically unlimited.

  Buying an option is less expensive than buying a stock or a futures contract. Yet it offers the investor simulated and geared exposure to the underlying investment.

  If the investor has correctly calculated the actual movement in the underlying security, the option can replicate or outperform the underlying security to provide the targeted return. This will be at a fraction of the cost of buying the underlying investment, with limited liability.

  ''In-the-money'' options are those that, in the given market circumstances, are making their holders money. This is when the strike price of a call option is below the underlying investment price, or the reverse situation for a put option.

  The greater the strike price is in the money, the higher the price of the option. This also means the more intrinsic value is in the option price.

  ''Intrinsic value'' is the value of an option if it were expired immediately. A call option with a strike or conversion price of $10 has an intrinsic value of $2 if the value of the underlying investment is $12. You cannot have negative intrinsic value.

  An ''out-of-the-money'' option is one where the option has no intrinsic value and, if exercised, will not make the holder any money. It is where the investment price is below the strike price for calls and above for puts.

  Valuing an option is not a straightforward calculation. According to option trading general principle, time, volatility, interest rates and dividend yield can be key factors.

  The greater time to expiration the higher the option price. The less time to expiration the lower the option price.

  An option with nine months to run will be of more value than one with nine hours to run as the one with nine months ahead of it has longer time in which it can make money for its holder.

  Time decay can be the worst enemy of an option investor. An at-the-money option should technically fall continuously during its life until its value is zero on expiry. Options are wasting assets.

  Theoretically, the time value of an option plus the intrinsic value equals the price of the option.

  An ''at-the-money'' option is one where the exercise price is equal to or near to the price of the underlying investment.

  Volatility is a measure of how much the price fluctuates over time. The higher the volatility the higher the option price. The lower the volatility the lower the option price.

  The chances of a greater move in a given stock, like a property developer, over the life of an option compared to the relatively stayed volatility of a utility would mean the price of an option on a property developer would be higher than the price of an option on a utility.

  ''Implied volatility'' is an important measure of worth. It is the future volatility of the stock that is implied by the current option price.

  In an options primer from Kidder Peabody, it states: ''Given an option price, the implied volatility is the volatility that must have been used to price the option given the current price of the underlying investment.''   Interest rates have a differing impact on calls and puts. For calls, higher interest rates mean higher call option prices, lower interest rates mean lower call option prices.

  On puts, higher interest rates reduce the price of put options and lower interest rates increase the price of put options.

  Similarly, the yield of the underlying investment can have different outcomes for calls and put options. Call option prices fall on higher yields and rise on lower yields. Put option prices are higher on higher yields and lower on lower yields.



Options carry minimal risk