OPTION DEALING
There is a class of business, in which some freely indulge on the Stock
Exchange, which, if transacted cautiously, results in the limitation of
losses, whilst providing full scope for Bull and Bear proclivities and a
great deal of fascination for the skilful operator. This class of
business is called option dealing, and although it is not practised to
nearly the same extent as is ordinary speculative buying and selling,
perhaps because of its intricacies, the fact that it is full of
fascination attracts to it many staunch votaries. There are some jobbers
in each market who lay themselves out specially to do option business.
Options are of three kinds. In the case of the put option, the operator
buys the right to sell so much stock on a certain day at a certain
price; in the case of a call option, the operator buys the right to buy
so much stock on a certain day at a certain price; and in the case of a
double option, or a put-and-call option, the operator buys the right
either to buy or sell so much stock on a certain day at a certain price.
For instance, let us suppose an operator believes that the price of
Consols, at the moment 91, is not justified. He thinks it will fall. He
decides to indulge in a put option. He buys the right to sell £10,000
worth of the stock at the end of next month at the present price of 73.
Believing that it will have fallen by that time, he sees the chance of
buying it for less and making a profit by selling it at 73. For the
option, the right to sell, he would probably have to pay about 10_s._
per cent. If at the end of next month, when the option has to be
declared, Consols have fallen to 71, he can obtain his £10,000 worth for
£7,100, and exercise his option to sell them for £7,300, thus making a
profit of £200 less the £50 he paid for the option and the broker's
commission of about £12 10_s._ The utmost he could lose by the
transaction would be the £50 plus commission paid for the option, which
he would, of course, not have exercised if the price movement had not
been such as to produce a profit. However much the stock might have
risen against him, he could not lose more than that £50 plus commission.
If in his belief that Consols would fall he had sold them as an ordinary
Bear, not taking advantage of the option system, there would, of course,
have been no limit to the possible loss, which would have been measured
by the extent of the rise of the stock. If it had risen 2 instead of
fallen 2, he would have lost, not £50, but £200 besides expenses.
From this brief outline of the operation of a put option, it is quite
easy to grasp what occurs in the case of a call option. As a matter of
fact, call options are much more frequently entered upon by the public
than are put options, for the same reason that the public are far more
frequently Bulls than Bears. Perhaps it is the optimism of human nature
that accounts for this, or perhaps it is the fact that to buy is more
natural than to sell, especially when the operator has got nothing to
sell. Whatever may be the explanation, some of those who are frequently
Bulls themselves regard with horror anything in the nature of a Bear
transaction. They buy what they do not want without turning a hair,
whilst denouncing as a speculator, dangerous to himself and the
community, one who sells what he has not got. They may exercise their
judgment in selecting stocks and shares that will rise, but consider it
heinous to select those which are likely to fall. In fact, to some minds
such selection is tantamount to knocking down the price, to the severe
loss of those who hold the securities. We are always hearing of the
wicked Bears, but never of the wicked Bulls. In a hazy kind of way,
indeed, the Bull with his optimism is supposed to perform a public
service. These ideas are perhaps not very sound, but they are at all
events natural. All that, however, is a subject for the metaphysician;
it suffices here to remark that just as Bull operators are more popular
than Bear operators, so are call options more popular than put options.
In the case of the call option, the one who buys it thinks the price
will rise, and for that reason purchases the right to buy the stock at
the existing price some time hence. If he is right he can, when the
option period expires, sell the stock at a higher price than that at
which he can call it. If he is wrong, and the stock falls, he has only
to sacrifice the money he has paid for his call option. However far it
may have fallen, he loses no more.
In the case of the option for the put-and-call, the operator buys the
right either to sell or buy the certain amount of stock at a certain
price on a certain future date. Such options are generally arranged in
stocks of a widely fluctuating nature, and the operation partakes more
of a gamble, a mere betting upon chance, than do either put options or
call options. In these cases the operator has at least an opinion or a
belief upon which he lays out his money: in the one case he thinks the
stock will fall, and in the other case that it will rise. But in the
case of the put-and-call, the only opinion he has is that it will move
somehow; he does not know or care which way it moves, provided it moves
far enough to show a profit over the amount he has paid for the option.
The only question involved is as to whether the price will move widely
enough.
If, when Consols are 73, he pays 1 per cent. for a put-and-call option
on £10,000 for the end of next month and they rise 2, he can sell them
for £7,500; exercise his call, which, with the price he has paid for the
option, cost £7,400; and pocket the profit of £100 less the commission
of £12 10_s._ which he pays his broker. If during the option period
Consols fall 2, then he exercises that part of his option which enables
him to put them upon the jobber, and pockets a similar profit less the
similar commission which he pays his broker. If Consols during the
period of the option do not move sufficiently either way to make it
profitable for him to exercise his double option, then he loses the £100
he has paid for it and the broker's commission.
The price at which the operator has the option to buy or sell at the end
of the option period is the price at which the stock stands at the time
the option is bought. Of course, special arrangements may sometimes be
made, but that is the rule. Such being the case, the price payable for
an option to call is always exactly the same as the price for an option
to put, and the price for a put-and-call option is always double the
amount. At first sight it might appear strange that this is so. The
jobber, when confronted with the name of any one stock, might be
imagined as demanding a much higher price for the call than for the put,
if he is of opinion that the price will rise. As a matter of fact,
however, if the jobber were really of that opinion, the price of the
stock would immediately be put up. In other words, current prices are an
exact expression of market opinion. There is no more reason why a jobber
should make the price of a call option in any one stock higher than the
price of a put option than there is for his going into the market and
buying heavily. If he did, the price would rise; he does not because he
thinks that the price is at a fair level, and being at a fair level, is
just as likely to fall as to rise. As the price is the basis of the
option operation, he charges exactly the same for taking the chance of
its rising as of its falling. It is no more reasonable to ask why the
jobber does not make the price of the call option higher than the price
of the put option than it is to ask why he does not go buying; and it is
no more reasonable to ask why he does not make the price of a put option
higher than the price of a call option than to ask why he does not go
selling. The market invariably puts the price of a stock at the exact
level which it thinks it is worth, which means that, in the market's
opinion, it is just as likely to rise as to fall, and for that reason
the price for a put option is the same as that for a call option.
What determines the price of an option is not, therefore, the likelihood
in the mind of any one person of its rising or of its falling, but the
probability of its moving widely in either direction. The price payable
for an option on stocks which fluctuate widely is much higher than upon
those which are steady, moving within very narrow limits. For instance,
whereas 10_s._ per cent. has been mentioned as an ordinary price for an
option on Consols, the price for an option on some American railroad
shares would be £4 or £5. As the price of the option depends upon the
extent, not the nature, of the fluctuation, it is naturally affected
also by the duration of the period over which the option extends. The
longer the period, of course, the higher the price. The Stock Exchange
Committee does not recognise any bargain, option or otherwise, which
extends for more than two accounts beyond the one in which it is begun,
which would mean about six weeks at the most; the law of the Stock
Exchange evidently aiming at prompt settlement of transactions. The
fact, however, that options for longer periods are not officially
recognised by no means implies that they are not carried out. Options
for three months are quite common, and it may be said that the periods
for which options are entered into extend from a day to six months.
In the case of day-to-day options, it is taken for granted that the
period ends exactly a quarter of an hour before the official closing
time of the Stock Exchange, which is half past three o'clock. In the
case of options for other periods, it is taken for granted that the
period ends with the account in which they fall due, or rather a quarter
of an hour before, with the idea of allowing time for making final
arrangements. An option may be arranged in January for, say, the end of
March account, in which case the period would expire at a quarter to one
on the Contango day at the end of that account, the account actually
ending at one o'clock. When the time expires, the giver of money for the
option has to declare whether he will exercise it or not. If he
exercises a call option, he has then to pay the money and receive the
shares. If he exercises a put option, he has then to deliver the shares
and receive the money. Except in very peculiar circumstances, the option
dealer, the taker of the money for the option, will know, when the term
arrives, whether it will be exercised or not by merely comparing the
existing market price with the option price. A call is not likely to be
exercised if the shares can be bought much more cheaply in the market,
nor is a put likely to be exercised if the shares can be sold at a much
higher price in the market.
The giver of the money for an option may, of course, operate against it,
securing his profit, as it were, at any time during the currency of the
option period. If, early in January, he has bought a call of De Beers at
19 for the end of February, he need not wait until the end of February
to sell the shares which he has the right of calling, although, of
course, he cannot obtain delivery of the shares until that time. When he
has bought the option early in January, he watches the market in case De
Beers should rise to a point which would make it profitable for him to
sell in view of the option which he has bought. Or he makes up his mind
as to what price he will sell at, and instructs his broker, who will
then watch the market for him. If, early in February, De Beers rise to
20, and he thinks they will go no higher, he sells them, knowing that
under his option he will get them at 19 at the end of the month. There
is, however, the mid-February settlement to be negotiated, and our
operator is obviously in the position of having sold shares which he is
not yet in a position to deliver. He must carry them over at the
making-up price. This means that if they have risen to, say 21, he must
pay the difference between that and the price at which he has sold. This
puts him into the position of having sold at 21, so that his profit when
he exercises his option will include, not only the £1 per share profit
at which he aimed when he sold, but also the £1 difference which he has
to pay at the intervening settlement. It is obvious, however, that one
who operates on his option in this way must be prepared to meet the
differences and expenses that arise in connection with any settlements
that intervene between the time at which he has bought or sold against
his option and the time when that option is exercised or, as it is
called, declared. If he merely operates within the account at the end of
which the option expires, he requires no capital at all except the money
he pays for the option, but if settlements have to be negotiated, he may
require considerable capital to go on with. Even where settlements
intervene, the operator requires capital only to meet the differences
and expenses connected with those settlements; he does not have to pay
for stock he buys against his option; the matter being arranged by the
broker handing over the net amount due to the operator when the option
is declared. The broker takes his remuneration in the form of commission
on the shares over which his client obtains the option, whether he
exercises it or not.
These operations in options may become exceedingly complicated, an
adroit operator backed by his option taking advantage in various ways of
the fluctuations of the market. Sometimes in buying his option he
arranges for what is called the call-of-more or the put-of-more, which
really means the call or put of as much again; or he may arrange for the
call or put of twice more or three times more.
It may easily be imagined that the existence of option dealing has
sometimes a palpable effect upon market quotations, and, especially on
Contango day or on its near approach, considerable fluctuations are
often brought about by the buying and selling of those operators who
have not been able during the currency of the period to buy or sell
stocks to advantage. Stocks must be bought to satisfy call options, or
stocks that have been put upon an unwilling purchaser must be cleared
out, and these transactions naturally affect prices.