Options - What I use them for (2)

My previous post looked at writing put options as a means of enhancing yields on cash and forcibly buying the dips. The other use of options is as a speculative investment - either buying call options to benefit from an anticipated rise in the price of the underlying asset or buying put options to benefit from an anticipated fall in the price of the underlying asset.

Why use options instead of buying the underlying?

Options provide a degree of leverage. Put differently, you only have to invest a smaller amount of money to give the equivalent exposure to a much larger amount of money invested directly in the underlying. When you buy an option, you only have to pay the premium - you do not have to pay for the underlying unless and until the option is exercised (which may be never).

Another way of looking at investing in options is that you have limited downside (the premium) but greater and theoretically unlimited (or much less limited) upside. Investing $100 in options has the potential to produce a much bigger return than investing that same $100 in the underlying asset while only risking, at most, that $100.

What's the catch?

You can't get something for nothing. The sum of the premium on a call option and the strike price will always be greater than the market value of the underlying asset at the time the option is purchased. This means that even if the option ends up in the money (i.e. the underlying is worth more than the strike price), an investor can still lose money. Put differently, the price of the underlying not only has to move in the right direction, but it has to move by enough to make the investment profitable.

The other catch is time. Options have a finite life. As they get nearer to maturity, all other things being equal, the value of the option will decay. If you buy a call option and the price of the underlying remains unchanged, the value of the option will fall. Where the strike price remains above the underlying share price at expiry, the option will end up being worthless and an investor will sustain a total loss of the original investment.

An investment of $100 in options is much more likely to suffer a 100% loss than the same $100 invested in the underlying asset.

To use a recent example, the call warrants (options) I purchased over Hutchison Whampoa on 24 July are currently worth about 14% less than what I paid for them. The same investment in shares of Hutchison Whampoa would have shown a loss of about 6% over the same time period. Of course, these warrants do not expire until 19 July 2011 so I still have some time for the underlying to move sufficiently in my favour to make a profit. If this does not happen, then I risk losing the entire investment.

Needless to say, I only put very small sums of money into buying options.