When a company is in difficulties and its shares are beaten down, it's often impossible to work out what the outcome will be. Maybe the firm will work through its problems, maybe it will have to raise capital diluting existing shareholders or maybe the shares will go all the way to zero as it ends up in bankruptcy. But one thing is often clear in advance there will be a dramatic shift in the stock price, one way or another, as soon as the situation is resolved.
Take a topical example a bank trading at 500p, and promising a dividend yield of 8% as a result of the credit crunch and investors' fear of the financial sector. If all the concerns are allayed, then the shares might easily double, putting the firm on a valuation in line with normal. On the other hand, the bank may be in worse trouble than people think, facing loan write-downs, dividend cuts and rights issues to rebuild its balance sheet. In a worst-case scenario, the price could halve.
Such massive moves offer the opportunity to make a lot of money but at this stage, it's impossible to know which is most likely. However, there is a good chance that things will be clearer by the end of the year. So what investors really want is to find a way to bet on the shares making an explosive move one way or the other in the next nine months but without having to take a view on which direction it will be.
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How to wring profits from options
One way to do this is via an options strategy called a strangle. This involves buying both a put and a call (see below) on the same share, with the call strike price above the current price, and the put strike below. In the example above, you might buy a put and a call, expiring in December 2008. A call at 700p might cost around 12p, while a put at 350p might cost around 20p, meaning that the position costs you a total of 32p per share. As long as shares rise above 732p or fall below 318p, you make a profit. And once the option passes the strike price, returns build quickly: a move to 750p would give you a return of more than 50% on your 32p outlay. (Of course, if the price doesn't move far enough, you'll lose money potentially the whole of your stake.)
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The strategy sounds simple, but there are two problems. First, you need to balance how out of the money' (see below) the options should be. Far-out-of-the-money options are much cheaper, but there is a greater chance that the share price won't move enough for the option to be in the money' when the expiry date arrives.
Secondly, as a private trader over an exchange, you're at the mercy of the big institutional sellers and you'll pay a lot more for your option than the recent volatility of the share suggests you should especially for far-out-of-the-money puts when markets are particularly volatile. That means it can be hard to build a strangle with an attractive risk/reward ratio, but they can pay off very well in the right situation.
UK banks may well be one. Most trade at depressed valuations and shares will rocket if they turn out to be squeaky clean, but could plummet further if there are more balance-sheet shocks. Barclays looks a prime candidate its valuation is far too low if its problems are limited, but there is also clear downside risk to its Alt-A (near-subprime lending), commercial property, corporate loan and credit card portfolio. How options actually work
A call option gives you the right but not the obligation to buy a share at a given price and a given time in the future, while a put gives you the right to sell a share. The price is called the strike or exercise price, while the date is called the expiry or exercise date.
If an option is out of the money, it means that based on current prices it will expire worthless. For example, a call is out of the money when the strike price is higher than the market price, while a put is out of the money when the strike price is lower than the market price. If this situation persists, it will not be worth exercising the option at the expiry date.
An in-the-money option is the opposite on current prices, exercising it at the expiry date will be profitable. In general, however, options are not held until expiry, but resold in the market so as to take a profit (or loss) beforehand.
The price of an option depends on a number of factors: the strike price, the expiry date, the current price of the share and the expected volatility of the share price. The value of an option goes up as the current price gets closer to the strike price or as volatility increases; it declines if the opposite happens and as (all other things being equal) you get closer to the expiry date. Since the volatility pricing aspect is just an (educated) guess, this is one of the keys to success as an options buyer; you're looking for stocks that will be more volatile than the market expects.
