Single options offer a quick way to make money from shares, but at the risk of losing your initial stake. However, there's a similar, cheaper and less risky way to profit with options the spread trade.
How single options work
Say you've bought a December call option when the share price was £2.60. An equity call option typically requires the buyer to pay an up-front, non-refundable premium, say 20p per share, for the right to buy 1,000 shares at a fixed strike price say £2.50 before the option expires. A month later the share price has hit £3. You could demand your 1,000 shares from the option seller for the agreed £2.50 each, then sell them on, banking 50p a share, or £500 in total. Knock off your up-front premium of £200 (1,000 x 20p) and you've still made £300.
Alternatively, you could sell the option itself for say 55p a share and bank £350 (55p minus 20p times 1,000). This higher profit arises because whoever buys the call option for 55p still has time (to the end of December) to make money if the share price keeps rising. Meanwhile, the original seller of the option is hoping you get the bet wrong, the share price falls and you abandon the option. That way they get to keep your £200 premium for doing very little.
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Put options are similar except that the buyer pays a premium to bet on falling prices, and the seller takes the other side of the trade, hoping that prices will rise.
But assuming you're a bull why not just buy the shares themselves? Well, because, for a start, it would mean shelling out £2,600 (1,000 shares at £2.60 a go) up front. Using a call option instead costs just £200 up front for exposure to the same 1,000 shares. There's also no 0.5% stamp duty to pay. And you can make bigger profits. Sell 1,000 shares for say £3, having paid £2.60, and you make 40p a share, or £400. That's a return of about 15% on your initial £2,600. By buying and selling the option you made £350, having invested £200, a 175% return.
Of course, there's a catch. Should the underlying share price fall, you would lose just some of your initial £2,600 if you bought the shares. But with options, you could lose all of your initial £200 a 100% loss. That's where spreads come in.
The bull call spread
Let's take the example above. As well as the £2.50 strike call, another option is available with a strike of £2.90, for a premium of just 5p a share. It's much cheaper because the underlying share price has to rise from £2.60 to £2.95 before you break even (since at that price you could in theory demand 1,000 shares for £2.90, sell them all for £2.95 and recover your 5p outlay). So with a 'bull call spread' you can limit your potential losses. You still buy the £2.50 call option for 20p, but you also sell the £2.90 call option for 5p a share.
How does this work? If you get this bet wrong, your initial outlay is capped at the £200 you pay for the £2.50 call, less the £50 (5p times 1,000) you receive for selling the £2.90 call. So that's a maximum loss of £150. But you have also capped your profits. With the share price at say £3 when you sell the first option, you'd bank £350. However, you'll need to buy back the option you wrote for 5p a share, which might cost you say 12p a share or £120. So, your total profit is limited to £350 minus £120, or £230. But that's a decent return on an initial outlay of £150 a gain of just over 153%.
Options are not just available on shares; they can also be bought or sold on indices such as the FTSE 100. But be aware that in all cases you will suffer a bid-to-offer spread on each option just as you do when you buy and sell shares. This will cut into your profit slightly. And like shares, options profits attract capital gains tax (bearing in mind that the annual CGT tax-free allowance is £10,100).
Also, because regulators view options as risky, you will need to jump through a few more administrative hoops to open an options trading account with a firm such as IG Index (igindex.co.uk).
Last, you don't have to be a bull to profit from spread trades. Bears can put the same principles to work using a 'bear put spread'. This time you pay for a put option the right to sell shares with a high strike price, and simultaneously sell an option on the same share (or index) with the same expiry date, but a lower strike price.
That way, should share prices rise rather than fall, you limit the initial outlay to the difference between the two premiums, and your maximum loss to the same amount. And if the underlying shares fall as you expect, your maximum profit as a rule of thumb is the distance between the two strike prices multiplied by 1,000 shares, less the net premium paid up-front.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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