Options a great instrument with an undeservedly bad reputation

Standardized call and put options, a type of financial instrument traded on an exchange, are a great instrument, but they have an undeservedly bad reputation. Over the years, many people have tried to use this type of instrument to make a quick buck, but the fact is that many people believe that they should be used the other way around, that this is when they help build long-term cash flow and help build portfolio value.

As usual, this text should be seen as an introduction to the subject and not as a recommendation of any kind. It is now also a requirement that banks and stockbrokers require anyone who wants to trade in options to take a knowledge test, so if the subject interests you, keep reading. This text does not address the valuation or pricing of options, the practicalities of trading or anything else. It should only be seen as a short, very short introduction to the options market. The text then concludes with a possible long-term way of working with options in an existing stock portfolio.

In 1987, the City of Stockholm lost almost half a billion kronor on options trading, which led to the City of Stockholm having to sell the so-called Folksamhuset for 218 million kronor to cover these losses.

Ironically, Folksam also lost some money speculating on options, around 270 million, which led to the resignation of the then CEO Hans Dahlberg and the CEO of Folksam International, Per Olof Granstedt.

In the early 1990s, a broker at the then stockbrokerage firm Alfred Berg caused losses of almost SEK 150 million. He tried to cover up an initial embarrassing loss-making deal by “rolling” the loss forward with ever more elaborate deals.

A few years later, the British bank Barings was hit by a scandal in Singapore. It was the so-called ‘scandal broker’ Nick Leeson who caused this, even though he was formally in charge of the back office when the first options trades were made. Regardless of the title, his deals cost almost ten billion dollars, and it ended up with the failure of Barings Bank, which was taken over by the Dutch bank ING. Nick Leeson was sentenced to prison and got out after only three and a half years. He then suffered from cancer, which he overcame. Today, Leeson makes his living investigating cases of financial misconduct.

In May 2007, the Swedish investment bank Carnegie reported that three members of the company’s so-called trading department had been suspended after being accused of inflating their profits by SEK 630 million by manipulating the prices of certain options.

Options have an undeservedly bad reputation. All the examples we see above are basically the same: traders incurring losses that they are trying to hide. Then they tried to catch up with them, raising the stakes, which rarely works well. This is called casino trading, and can be likened to betting on black with increased stakes. The so-called waiting value is lower than 1.00, which means that it is very rarely successful.

What is an option? In fact, in its simplest form, there are two types of options: call options and put options.

Options are bought by investors when they expect the price of a stock to go up or down (depending on the type of option). For example, if a stock is currently trading at 40 kroner and an investor believes the price will rise to 50 kroner next month, they can buy a call option with a strike price of 40 kroner today, which would give them the right to buy the stock at that price, in this case 40 kroner, before the contract expires.

Then, if the share price actually increases to SEK 50 per share, the investor can turn around and sell it for SEK 50, making a profit of SEK 10, minus the cost of the option, called the “premium” and brokerage fees. Normally there is no exercise, but the option is sold. The buyer in this example has thus had the right – but not the obligation – to buy the share until the date of redemption, at a predetermined price.

If the share price had instead fallen to SEK 30, our buyer would have made a loss. If he (or she, because there are also female options traders) had owned the stock, he would have made a loss of ten kronor, i.e. the difference between 40 and 30 kronor. Now, with the option, the loss is limited to the so-called option premium.

So why is anyone willing to sell an option, to give away the right to continue rising? The answer is simple, the option writer believes in a fairly stagnant market. These are often foundations that need ongoing income. Let’s take a hypothetical foundation that owns Volvo shares, of series B.

The Foundation then issues, for example, call options, such as Volvo B December 240 BUY. In this case, the hypothetical foundation will receive an option premium of SEK 5.50. The Foundation can issue options on its Volvo shares four times a year, which, all else being equal, yields an extra SEK 22, or 9.56%. The Foundation risks a drop in the share price, but it has been compensated for this by receiving regular option premiums. They also risk the share price of Volvo surging, either on good results or a takeover. By issuing options, the Foundation waives all rights to a price above SEK 240, at least until December.

The buyer of the option has the complete opposite belief. He is of the opinion that Volvo B will trade in December at a minimum of SEK 245.50, i.e. the strike price plus the option premium. It is only if the price trades above this level that the option buyer has made money.

Put options give the right to sell one share.

Let’s take another example, Castellum. The share is currently trading at SEK 112.50 and there is an option expiring in December with an exercise price of SEK 102.50. The last trade was at SEK 2.75.

Let’s assume there is an investor who owns this real estate stock and is worried about rising interest rates, poorer performance and lower occupancy rates in Castellum. Our investor is afraid that if any of these things happen, the share price will fall, and that if all three things happen at the same time, the value of the share will erode. This is an example, it is not a recommendation or even an opinion on Castellum’s performance.

In order to sleep better, our investor decides to buy this put option. His (or her) risk is then greatly reduced. If the share price falls below SEK 102.50, or actually below SEK 99.75 when we take into account the option premium the investor paid, Castellum is no longer his problem. The investor has the right to sell his shares at the price of SEK 102.50 even if the share price reaches SEK 56 in December. Yes, regardless of the price, he is entitled to sell his shares at 102.50 SEK.

Roughly speaking, the issuer of the option can be likened to an insurance company. The writer of the put option hopes that the price of the underlying stock never comes close to the strike price. In that case, the issuer can do the same thing again next month or quarter and continue collecting option premiums.

Another option is that the issuer believes he wants to own Castellum, but thinks the current price is too high. By issuing a put option, the writer gets paid, i.e. the purchase price decreases, while the whole idea of written options is that they are issued downwards, which means that the purchase price may be lower. In this case SEK 99.75. This is a significant difference from the current SEK 112.

We have mentioned call options and their equivalent, put options, and how they are used. There is actually a third type of option, which, although sometimes traded on an exchange, is not a standardized option. These are warrants that we are talking about now.

There are a number of major differences between warrants and especially call options, although there are many similarities.

A call option gives the holder the right to subscribe to new shares in a company at a certain price and on a certain date. A call option is issued directly by the company concerned; when an investor exercises a call option, the shares fulfilling the obligation are not received from another investor but new shares are issued by the company. Their use results in dilution, but also increases the equity of the issuing company.

A call option, on the other hand, is a contract between two people that gives the holder the right, but not the obligation, to buy or sell a stock at a specific price, before a specific date, called the contract expiry date. The call option does not provide the company with any capital.

What is traded on the exchange must comply with rules, and it must be simple. This is why it is called standardization. All option contracts have the same rules, they almost always cover 100 shares, and one trade entry is 10 contracts, which equals 1,000 shares.

All stock options have a predetermined exercise price, and they are exercised on the third Friday of the expiry month, in the two examples above, on December 15, 2023. After this date they cease to exist, hence they are called financial instruments and not securities as they have a limited maturity after which they expire.

The ticket price is fixed. No matter how much the underlying stock moves, the strike price is the same. The option in Volvo will always cost SEK 240 to exercise, regardless of whether the price halves or doubles. What will change is the price of the option premium. This may not be likely to happen before mid-December, but it is a good, if extreme, way to describe the pricing. If the value rises above the strike price, the option premium will follow suit, rising by the same amount as the stock, roughly speaking. If the price of Volvo shares falls below the strike price, the premium will still have value, but it will decrease over time.

The best way to work with options is to issue options against existing holdings. This was something I learned when I took my first course on options on what is now Nasdaq Stockholm.

Using the option prices published in the newspapers, the lecturer had gone through different outcomes. He created a fictitious portfolio and issued fictitious options on every available stock. He then repeated this over and over again. He argued that it had produced a return that was 33% above the return of the same portfolio that did not issue options.

Now, historical returns are a guarantee of future returns, but the fact is that over time, issuing options over time has proven to be a good deal.

Nasdaq Stockholm, commonly known as the Stockholm Stock Exchange, holds regular options training sessions, which are well worth an evening or two before you start trading options. You can find more information about these courses on the Nasdaq website.

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