Be free, with options

By Wai-Yee Chen author of OptionsWise - Sat Oct 13, 5:08 pm

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To live is to have regrets. Some of us regret the choice we made in the university we attended (“If only I have gone to an Ivy League School”), the courses we took or did not take (“If only I had studied psychology”) or the job we turned down (“How my career would have turned out”), the relationships we chose to hang on to when it was time to let go and the stocks we chose to buy and sell – at the wrong prices.
Our brains torment us with negative choices we made with the imagination of the alternatives. The emotion of regret is found by many researchers to have magnified and in some instances caused stress and depression, while in others it creates a lower quality of life.
When faced with high-risk decisions (like investing), we tend to look back and choose the option that produced the least regret (or mental stress), even if it is known to return a lower level of satisfaction. On the other hand, another study found that regrets can produce favorable results and it’s not without benefits. Regrets can help us make sense of what went wrong and find a solution that may best overcome it.
There is a group of investors that have moved their investments to cash or fixed-interest products and perhaps even regret investing in the share market in the past two to three years. While wanting to participate in the “kicker” that shares can give them their past experiences are tearing them in the opposite direction.
However, if this group of investors subscribe to the finding that regrets can produce favorable results and may even allow them to grow from past experiences to considering other investing alternatives; then the combination of those scars (or past experiences) with the use of option strategies alongside their share portfolios, will help them move forward.
The use of options for a portfolio investor gives the investor the opportunity to consider his/her alternatives, buying time before spending a big chunk of capital and yet reduce the effect of a wrong decision and hence the emotions of regret.
The diagram below depicts the characteristics of a call option. It rises as the underlying share price rises, allowing the buyer to enjoy unlimited upside and yet limiting the maximum loss of this investment to the cost or premium paid.

Diagram 1: Buying call options to buy shares

The strategy of buying call options to buy shares gives investors the alternative of participating in the upside of a share price either with or without owning of the underlying share. If the underlying share price rises as expected after the purchase of the call option, the investor has the choice of either selling the call option for profit or exercising the call option to buy up the underlying share, to own it for the privilege of dividend or the advantage of harnessing further gain from the share without the time limit of an option contract.
Bank shares are favourites amongst many investors, especially with the dangling of a juicy dividend. Commonwealth Bank (CBA) will be the next big bank to go ex-dividend in mid-February 2011, with an expected dividend of $1.38 per share, yielding about 2.78% on the current share price of $49.50 (before franking credit).
An investor who on one hand wants to earn the dividend income and the capital appreciation from the share price and yet is still troubled by the slow recovery of the financial sector may not want to put a large chunk of capital at risk.
What if, with the use of options, the investor can spend just a small amount, say $2050 (before costs) to be entitled to the right to buy 1000 CBA shares at $49? Wouldn’t this option free the investor from the potential emotional drain of regretting, if the share price proves to be strong?
The price of $2050 is the premium for one contract of the January 2011 call option on CBA with the strike price of $49 (priced in November when CBA was at $49.50). The purchase of this call option entitles the investor to the right to exercise the contract to buy 1,000 CBA shares if it rises to and beyond $51.05 ($49 strike price plus $2.05 premium paid) anytime up to the January option expiry date of the 27th. The investor who exercises this right on the 27th of January will be in line for the $1.38 coming off (or ex’ed) from the share price in mid-February 2011. If the share price fails to rise as expected, only the small capital of $2,050 (plus cost) is spent.

Diagram 2: Buying CBA Jan 2011 $49 call options to buy shares

Without the use of options, the investor could either only stay out and forgo the possibility of income and profit; or jump in but spending (and risking) an immediate $49,500 capital. With options, the investor spends $2,050 to create more opportunities for himself; to either capital gain without owning of shares or owning shares and gaining from income and capital appreciation. The cost of this venture – $2050; potential upside – unlimited.

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