This can be controlled with stop-losses, but some investors prefer not to have the complication of managing these, especially while getting to grips with leveraged trading for the first time.
Stop-losses also may see you knocked out of a position when the share price hits your stop, only to see the share reverse course, and the bet turn profitable if it had been allowed to continue.
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They have a fixed expiry date although you can choose to sell beforehand and will remain in force up to that date, regardless of what happens to the price of the underlying share.
How options work
Options can seem complicated at first, but the principles are relatively simple. There are two types: call options, which give the right to buy shares in a company at a fixed price, and put options, which give the right to sell at a fixed price.
Say we use a call option to bet on a share that we believe will rise significantly in the near future. The share price is currently 220p and we think it will rise to at least 250p. So we buy a call option on that share, with a strike' price (also known as an exercise' price) of 250p.
Since we believe the trade will pay off within three months, we choose an option with an expiry date of 31 December. Note that for each share, there will be a range of options available with different strike prices and expiry dates and we will pick the most suitable for our purposes each time.
To buy the option we pay a premium', which is essentially the price of the option. The level of the premium is determined by a number of factors, including the share price, the strike price, the time until the option expires, and how volatile the share price is expected to be. In our example, let's assume the premium is 11p.
Making a profit
If the share price rises above 250p to 300p, say the option is in the money'. We have a paper profit determined by the difference between the current price and the strike price, minus the amount we paid for the option.
In this case, the gain would be 300p-250p-11p = 39p per option. That's quite a substantial return on our initial premium of 11p, demonstrating the power of leverage.
The value of the option will also rise to reflect this, so we could sell it, or hold it until the expiry date.
Some options are cash-settled, meaning that at expiry, you receive a cash payment equal to the difference between the price of the share and the strike price of the option.
Others are physically settled, meaning you will be able to take delivery of the underlying shares by making an extra payment equal to the strike price.If you don't want to take delivery, you should sell a physically settled option shortly before the expiry date.
If the share price is not higher than the strike price at the time the expiry date comes around known as being out of the money' the option expires worthless and we lose our 11p per option. But that's our maximum loss, even if the shares drop substantially to 150p by the expiry date.
Introducing covered warrants
Given that options offer high potential upside and limited downside, they look attractive. So what's the catch?
Well, for one, most options expire worthless. For this reason they are seen as high-risk investments that carry a substantial risk of losing your entire investment.
Also, option pricing is quite complex you need a reasonable level of mathematical knowledge to understand what's going on. None of this means they're no good, but it takes experience to get the best from them.
Making big profits is not as simple as our example might suggest. Another disadvantage is that they are not widely used by British retail investors, so few online stockbrokers offer them (two who do are iDealing and Interactive Brokers).
So if you want to experiment without needing to open a new brokerage account, you may instead want to look at covered warrants instead.
From a buyer's perspective, a covered warrant looks almost the same as an option. The main difference is that while options trade on derivatives exchanges such as Liffe, covered warrants trade on the stock exchange, and can be bought via most brokers.
Covered warrants are popular in many European markets, but have never taken off to the same extent in Britain.However, Socit Gnrale offers a range of covered warrants on major UK and international shares, as well as bonds, commodities, currencies and indices.
All covered warrants are cash-settled at expiry, giving new options traders one less complication to watch.
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