This article was originally published here in September 2002
Last month I made a nice little profit with one of my more risky investments. This is buying options on shares and hoping the share price moves the way that you expect before the option expires. I also use another form of options trading which is much less risky. I traded in options in Vodafone, the telecommunications company.
I had had my eye on Vodafone for some time as the steep fall in the value of all telecommunications shares had left some looking cheap. I would not say that they were true value shares, but I felt that some good companies like Vodafone deserved a higher share price. Good companies entering value share territory will have a floor under which their share price will not fall. The trick is determining that price.
On the 22nd of April I bought 4,000 Vodafone shares for 113p a share including dealing costs. However, the share price continued to fall and I began to suspect that it might be some time before I saw a profit. On the 16th of May I wrote four call options against my shares. Remember that a UK share option is for 1,000 shares, so the four options I wrote matched the 4,000 shares I held. The options expire in October with a strike price of 110p.
After dealing costs the money from selling the options set against the initial cost of buying the shares reduced my purchase price to 98p. It is important to note that writing a "covered call" like this is not excessively risky. The risk that you expose yourself to is that if at expiry time the share price is above the strike price the shares will be called away from you. By writing the option you agree to forgo possible profits in the future but gain cash in hand today.
In my case, if the price of Vodafone shares is above 110p in October the four options I wrote will be called. I will receive 110p a share for the 4,000 shares I hold. So I will have £4990 in cash (the £4400 from the shares and £590 from writing the option). This is a gain of £465, just over 10% in a period of 5 months.
The other possible outcome is that in October Vodafone shares are still trading below the 110p option exercise price. In this case the option that I wrote will expire worthless and I will get to keep the shares along with the cash received from writing the option. I would be free to write another call option, further reducing the effective purchase price of my shares.
Having written the call option Vodafone's share price continued to fall. It reached a low of 82p in early July before recovering a little by mid July.
I felt sure that the price would continue to rise and that there was an opportunity for an additional profitable trade. I bought six call options with an exercise price of 100p and an expiry date in October. After dealing costs these six options cost me £610. By mid August Vodafone's share price had reached 110p and I felt it may have peaked. I sold the six options, netting £829 after costs. In a period of two months I had made £219, a profit of 35%.
I still have the original 4,000 shares with the call options written against them. At the time of writing this article Vodafone's current share price is a bit below option exercise price. I shall continue to watch the share price with interest. The ideal price movement for me is if the shares are below 110p at the October option expiry date then climb steeply, here is hoping.
Finally I should note a few things. Buying options is a very risky thing to do. If the underlying share price does not move as you expect it to the option will probably expire "out of the money" and will be worthless. However, getting an options trade correct can be far more profitable that buying shares in the underlying company. If you feel sure that a share will rise or fall in the short to medium term you might want to see if you could buy call or put options in it instead. As a rough rule of thumb options are quoted in FTSE-100 companies only. Finally, although I buy and sell options through my normal stockbroker, not all brokers handle options trading.