Highlights in this issue:

*** Get the price you want...
*** “Naked” options explained...
*** How not to do a “Nick Leeson”... and more...

From the overworked laptop of Julie Brownlee...

Dear Investment Academy Reader,

No one likes to overpay for shares. Say you like the look of Vodacom, but you don’t want to pay more than R55 a share (the current price is around R56.50). What can you do? You could use a “limit” order and instruct a broker not to pay more than R55. But even if they fall that far, you’ll still pay securities transfer tax at 0.25% of the purchase price, plus dealing fees. There’s an alternative, says Lee Lowell at InvestmentU.com – selling ‘naked’ put options. It’s risky. But get it right, and you can end up with the shares you want, at the price you want, plus a bonus in the form of an option premium.

But, before we go any further, just bear in mind that you may have to have a fair amount of capital behind you to do this in SA at the moment.

What are put options?

If you hold, say, 1,000 Vodacom shares and then buy an equity put option, you pay an upfront premium to a broker in return for the right to sell those shares at a preset “strike” price. In effect, you’ve bought a type of insurance contract. If Vodacom’s share price falls, you can sell at the fixed strike price, capping your losses. If it rises instead, you simply keep the shares and abandon the option, which (just like car insurance) expires worthless if, within a fixed period, it isn’t used (or “exercised”).

Better still, options are flexible. You can change the strike price, length of cover and, depending on the share, the number of contracts bought. However, there’s a catch: Whatever option you buy, and regardless whether or not you choose to use it, you lose the upfront premium. But you could turn the tables and sell options instead.

How the “naked short put” works

Imagine you want to buy 1,000 Vodacom shares at a maximum price of R55. You could tell your derivatives broker you’d like to sell (or “write”) a Vodacom put option, expiring in, say, September, with a strike price of R55. This creates a “short” position. For this, you get an upfront premium of, say, 50c a share, or R500. The word naked (or “uncovered”) describes the fact that you don’t yet have any Vodacom shares.

One of two things will happen next. Vodacom’s share price may rise from its current level of R56.50. If that happens, the option won’t be exercised because the holder has no need to sell you 1,000 shares for R55 when they can get more by selling their shares in the open market. That’ll leave you with R500 for doing very little. Or the share price may fall. The option can be exercised once it drops below R55, committing you to pay for 1,000 Vodacom shares delivered via the option. As Andrew Wilkinson notes in Forbes, in practice few options are exercised, but the one you sold might be. But if you were happy to pay R55 for 1,000 Vodacom shares at the outset, you’ll now get them, plus R500 on top – the non-refundable premium. And if you change your mind, you can always “close out” by buying back the option you sold, although you may suffer a small loss. What’s not to like about that?

The risks

Beware, “selling naked puts is not for everyone”, says Kopin Tan on Smartmoney.com. Problem one is volatility – as it rises, so do option premiums, which is good news for those selling them. But don’t forget, if Vodacom’s share price rises far above the option strike price after you sell the naked put, the cost of buying the shares you wanted all along will have rocketed too. Then there’s margin requirements. Selling naked puts can be dangerous, so brokers tend to ask for a high upfront initial deposit (or “margin”). This is refundable and usually earns interest. It's there to ensure you’ll be able to pay for those 1,000 Vodacom shares if the option is exercised. So never sell naked put options on shares you’re not prepared, or can’t afford, to buy.

But, before you get carried away...

A warning on options from Nick Leeson

Nick Leeson was the rogue trader blamed for bringing down his employer Barings Bank in the mid-1990s. The bank was eventually bought by ING for £1. One of his more calamitous trades involved selling multiple naked short put options on Japan’s Nikkei 225 stock market index. The trades earned Barings huge amounts of option premium income. But there was a big catch. For the trade to work, the Nikkei 225 had to stay above the option strike price, or he’d face big losses. The enormous Kobe earthquake in January 1995 sent the Nikkei spiralling down. Suddenly, Leeson faced huge margin calls on his naked short puts from the Singapore exchange. In an attempt to generate some income, he kept selling Nikkei 225 put options, this time earning much higher premiums thanks to the sudden increase in stock market volatility. But a series of aftershocks saw the Nikkei lurch down rather than bouncing back as he’d hoped. These trades contributed to Barings being unable to fund margin calls – and to Leeson ending up in jail in Singapore for four and a half years.

Happy trading!

Julie Brownlee
for The Investment Academy