Diary Of A Private Investor: Survival in the dangerous world of the option

Options, like a Spice Girl, can be scary. To start with, it is difficult to get your head around the concept, then you are faced with a new vocabulary of puts, calls, long strangles, short straddles, time value and combos. You can be "in, out or at the money". Even when you have read the books and been on the courses it's difficult to shake off the feeling that options are a synonym for high risk.

I have always felt that pitting one's wits against the market by dealing in futures and options derivatives is a job for the professionals. It is all too difficult for my tired old brain. But for the private investor who has a portfolio of blue-chip shares there is one use of options that is the opposite of high risk. In fact, it is a form of insurance for your blue chips, protecting them against the whims of the fickle stock market and at the same time producing extra income for you.

The system involves traded options and I use some of the jargon which plagues this form of investment. But brief definitions are included. For our purposes, we are interested only in traded call options, defined as "a contract which confers on the holder the right, but not the obligation, to buy a fixed quantity of underlying shares at a specific price for a limited period".

Let us assume you hold in your portfolio 10,000 shares in a fictitious FTSE 100 company, Bigdeal plc. I am suggesting you consider writing (ie granting) through the market, the right to another investor, let's call him Mr Smith, to buy your Bigdeal shares at the strike price (the price specified when the deal is struck).

Mr Smith will pay you a premium for the opportunity to acquire your 10,000 shares and he can take up the option to purchase at any time up to the option expiry date, but he is not obliged to take it up at all. Options are available at three-monthly intervals and the precise dates are published in most of the quality daily newspapers.

A word of warning at this point. Never write an option against a share you do not own. This would involve you in considerable risk and a lot of hassle because, through your stockbroker, you would have to make an adequate deposit of funds with the LOCH (London Option Clearing House). So the first thing is to buy the shares and have documentary proof that you own them.

Let us pretend you bought your 10,000 shares on 23 November and you paid 266p each for them. A week later, when the transaction with your broker was completed and you were the legitimate owner of the shares they had gone up to 281p.

The various options available on that date, 30 November, are listed below. When you look at the list, remember you are the seller so you will get the lower of the two prices quoted. Mr Smith will have to pay the higher price. The bit in the middle goes to the anonymous people who put you and Mr. Smith together and are seamlessly performing the transaction.

Now, which option should you offer to sell to Mr Smith? December is too close and the premiums are too low. So we must look at March. The March 300p options might suit Mr Smith but they are not very attractive as far as you are concerned.

The price is already moving up and 300p is too close to 281p. It is quite possible that by March the price could reach 320p, Mr Smith would exercise his option and you would lose the 20p (320p-300p). You would have Mr. Smith's 16p option premium to compensate you but you would still be out of pocket.

The March 330p options are a better bet. That's an increase of 49p on today's price which is 17.5 per cent. Over three months, that is a grand gain, so if Mr Smith exercised his option you would have that 49p plus your 8.5p premium (say 8p net after costs). That's more than 20 per cent profit on your Bigdeal shares.

But what if the share price does not reach 330p by March and Mr Smith decides not to exercise his option? It is still good news for you. You have not sold any of your Bigdeal shares and you have the premium money which adds 2.8 per cent to your profits. That an annualised rate of more than 10 per cent which is over and above your dividends and any capital gain you may make. There are two other possible scenarios. For some reason, perhaps a takeover or similar momentous happening, the Bigdeal share price might rise sharply to much more than 330p. Mr Smith would be delighted but you would have to be satisfied with 64p (the difference between the 266p you paid and the 330p you received from Mr Smith) plus his 8p premium.

And finally, before March the Bigdeal price could fall below the price you paid for it. This would have happened whether or not you had written the option agreement, and at least you would have the small degree of comfort provided by Mr. Smith's premium. So let me recap the process:

1: Buy blue-chip shares.

2: Through your broker, lodge the shares with LOCH and write a call option between three and five months ahead at a premium of about 10 per cent to 15 per cent to your buying price.

3: When the option has expired, if it has not been exercised, write another option in the next series at a similar premium.

4: If the option is exercised start the whole cycle again with another blue-chip share.

Before you consider applying my suggestions to your portfolio you should obtain as much information as possible about options. A private investor information pack is available free from LIFFE (The London International Futures and Options Exchange) on 0171 379 2580.