History has shown through the ages that options were used by astute individuals. The Phoenician and Roman merchants would underwrite the expense of a sailing ship with the "option" to participate in the cargo upon the ship's return. Options were used in Holland during the great boom of the tulip bulb craze over 300 years ago.
Options are used daily in real estate transactions. Let us suppose Mr. Schmidt wants to sell 100 acres of land for $20 an acre or $2,000, and will take a 10 percent option deposit ($200). Mr. Able believes he can sell the parcel of land to Mr. Wolf for $30 an acre or $3,000. Mr. Able would not want to buy the property if he is unable to sell it to Mr. Wolf for $3,000. If, during the agreed period of time, Mr. Able was able to consummate the sale to Mr. Wolf, he (Mr. Able) will exercise his option to purchase the parcel of land from Mr. Schmidt and in turn sell the land to Mr. Wolf. The net difference between the option deposit ($200) plus the cost to purchase the land ($2,000) and the ultimate sale at $3,000, is Mr. Able's profit ($800). If Mr. Able has been unable to complete the sale to Mr. Wolf, the option would have lapsed and the loss would be limited to the cost of the option contract—$200.
The only difference between the above and a stock transaction is that the deposit on real estate is generally used to reduce the purchase price. In the case of the stock option, the premium ($200) is received immediately upon the acceptance of the terms and is not part of the agreed price of the underlying security.
In the case of the stock option if the price of the underlying security has risen to $30 a share during the agreed time the option would have been exercised with the buyer paying the holder of the security $20 a share and selling the security in the open market for $30. The net profit would have been $800 on a $200 investment.
For well over 100 years European investors have been using stock options. The option as an investment tool has been used by large and small investors alike.
Until recently the variation of stock options, put, call and straddles, strips and straps has been limited to the wealthy individual investor, institutions, and professional traders. However, there has been a dramatic change. The average investor has discovered he can participate and benefit from options. An outgrowth of the average investor's desire has been the establishment of two Federally regulated option exchanges: the Chicago Board of Option Exchange (established in April of 1973) and the American Stock Exchange Option Market (established in January of 1975).
Total option volume in 1942 was 685,000 shares. In 1960 volume increased to 8.5 million. The total number of options traded in 1974 was estimated to be a staggering 57 million! Stock options are a versatile investment tool.
Let's look at who's involved in an option transaction and their objectives:
—Individuals or institutions seeking bigger profits on a small investment.
—To hedge against a stock investment already made or to be made. A form insuring your investment choice.
—An opportunity to increase the return on invested capital.
—Reduces the cost of purchasing stock.
—Offers by the amount of the premium, downside protection of a stock investment.
—In considering the statistics over an extended period of time only about 40 percent of the stock options are exercised.
Let's follow an option transaction beginning with the review of the underlying stock. The stock meets the qualifications of the investors and is paying a dividend of five percent. The stock is selling at $50 a share and a $2.50 per share dividend. At the time of purchase, February 1st, a six-month and ten-day option is available expiring on August 11, 1975 for a premium of $600 (12 percent of underlying stock). Consider these alternatives:
1) Buy stock and sell a call for $600 using the premium and purchase securities for a net invested capital of $4,400. Dividend return on invested capital is 5.68% ($250.00 yearly dividend divided by $4,400 = 5.68%).
2) Purchase stock and do not sell the option—net invested capital of $5,000.
If the stock remains the same during the option period:
1) The option will expire giving the option seller a return of 16.47% (Premium $600 plus dividends of $125) on invested capital of $4,400. 2) The holder of the stock received the dividend ($125) for a return of 2.5%.
If the stock were to drop to 44:
1) The seller of the option would not have lost any money due to the option premium ($600) and would have a return of 2.8% (dividend of $125 on invested capital $4,400). Another option could be sold for approximately $535.
2) Buyer of stock would have lost $600 of capital and the return of 2.5% ($125 dividend on invested capital of $5,000) and must wait for a 13.6% increase in the stock (44 to 50) to break even.
If the stock were to rise 20 percent or to $60 a share:
1) The writer of the option has limited his profit to the premium $600 (16.47% on invested capital of $4,400).
2) The stock buyer has participated in full ten point gain in underlying stock or 20% on the invested capital of $5,000.
The safety of reducing your investment capital to $4,400 and the ability to employ someone else's assets ($600 premium) far outweighs the capital gain difference of 3.6 percent. The use of margin on the above transaction will change the percentage and increase the risk.
The effects of dividends, splits, rights, or warrants vary with the listed options (Chicago Board of Option Exchange and American Option Exchange) and those traded off the exchange. The listed option buyer is not entitled to the cash dividend declared during the life of the contract; all other benefits are the same.
In the case of a buyer of an unlisted option, if during the option life a cash dividend is declared, the striking price will be adjusted downward to reflect the actual amount of such dividend. All other splits, rights, and warrants issued during the life of the option accrue to the holder (buyer) of the option.
Individuals who write options will occasionally find a stock, in which a call has been sold, has appreciated substantially by the time the option term is expiring. The option seller is able to convert short-term to a long-term gain. To illustrate: 100 shares of XYZ Co. has been purchased at $40 a share and simultaneously a six-month and ten-day call is sold on the security for a $600 premium. On the day the option expires, XYZ Co. was selling at $70. If the original 100 shares XYZ Co. were delivered at $40 against the call, the option seller would have a long-term capital gain of $600 minus commission. If the option writer had already realized a considerable amount of short-term gains for the current fiscal year, he could convert these gains to long-term.
First—Sell the original 100 shares of XYZ Co. purchased at 40, six-month and ten-day call prior, at the current market 70.
Sold 100 XYZ Co. - $7,000
Bought 100 XYZ Co. - 4,000
Long term capital gain - $3,000
Second—Buy new stock at 65 (current market) and deliver against call.
Bought 100 XYZ Co. - $7,000
Sell against call 100 XYZ at 40 - 4,000
Less premium received from sale of call option - 600
Short-term loss - $2,400 Loss
The option seller uses the $2,400 short-term loss (excluding brokerage fee) to erase the short-term gains realized from other transactions, while in the meantime establishing long-term gain. It is important that the above sequence is followed. You must first make your sale to establish the long-term gain, then new stock can be purchased and delivered against the exercised call.
The tax consequences for the option buyer and seller are intricate and your tax counsel should be consulted for a final opinion.
In the past three years gold securities have proven to be an exciting adjunct to a rather dull market place. Until recently option availability in gold securities were not marginable. Because of these factors, the premium on these securities was quite high, ranging from 15 to 25 percent. Imagine: purchasing a gold stock at a low price, seeing the price move rapidly upward, not wishing to sell right away and wanting to invest some of the profit in other securities. Then an option could be sold. The premium could be used to protect your investment should there be a downside correction of short duration. The premium funds could be used to invest in other securities, thereby broadening the investment base and protecting your assets. Dividend income is increased by the new securities. If you were so inclined an option could be sold on the new security, thus compounding your return.
The ramifications of an option program are varied and the opportunities are great. The intelligent investor must be able to use every investment tool to seek a greater return on his invested capital. Options are not new. But are you new to options?
Victor Chigas is an option specialist with Drexel Burnham, having specialized in options since 1968. He has lectured before Ohio, Illinois, Pennsylvania, New Jersey and Indiana State Convention business groups and was a guest speaker at the National Pre-Arrangement interim of America Association. Funds presently managed by Mr. Chigas & Associates (Mr. Richard Konst and Mr. Robert LeClercq) are in excess of 10 million dollars.
OPTION: Privilege of buying or selling 100 shares of a certain stock at a specified price over a stated time period.
WRITER: The Seller or Maker of an option
BUYER: The Holder or Owner of an option
PUT: Option which allows the Holder to sell 100 shares of a certain stock at a stated price to the Maker during the option period.
STRIKING PRICE: Stated price at which the option can be exercised. Usually the market or last sale price a the time the option is written.
CALL: Option which allows the Holder to buy from the Writer 100 shares of a certain stock, at a specified price, during the option period.
PREMIUM: Cash amount for the option paid by the Buyer to the Writer.
This article originally appeared in print under the headline "How to Use Options".