Call and Put options

There are two types of options - "call" and "put". A call option entitles the holder to buy a certain quantity of a specific gilt at a fixed price any time during a specific period.

So, for example, it might entitle you to buy R1-million worth of Eskom 11 percent 2006 stock. This is an IOU from Eskom which will be repaid in the year 2008 and in the meantime will pay 11 percent per annum at any time during the next two weeks.

Conversely, a put option on the same stock would entitle you to sell that stock any time during the next two weeks at a fixed price (known as the "strike" price).

If you believed interest rates were going to fall over the next two weeks, you could buy a call option with a strike price at the current market price. If you were right and interest rates fell, you could "call" your option and buy the stock at the strike price, knowing it could immediately be sold and net you a profit.

As soon as an option can be exercised at a profit, it is said to be "in-the-money". An "out-of-the-money" option has no value except the possibility that it will become "in-the-money" before it expires.

Options represent a right to call or put stock during a specific period, and that right costs money. In general, the longer the duration of the option, the higher the price - because the greater the probability that it will trade "in-the-money". A one-week option on Gilts with a face value of R1-million would cost R2 500.

A two-week option would cost R3 500 and a three-month option R10 000. This money simply buys you the option - if you choose not to exercise it you will lose the purchase price (i.e. R2 500, R3 500 or R10 000, depending on which you bought).

In other word, the most you can lose in the options market is the money you used to buy the option. This is preferable to the futures market where losses can be much greater.

How much can you make?

The potential returns from buying the correct option at the right time can be substantial. Over the past year, in any two-week period, stock prices have moved at least R10 000. If interest rates move in your favour, it is possible to make three to four hundred percent on the cost of buying the option.

If you buy a call option valid for three months and pay R10 000 for it, interest rates must fall by at least 0,25 percent before you break even. Therefore, each 0,25 percent rise nets you R10 000 profit. You are participating in the increase in value of the underlying gilt stock .


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