Let us look at this example in more detail.

Suppose an investor has £1,000 to invest and believes that HSBC shares are going to rise from their current price of say 800p per share.

He has two alternatives;

  • Buy HSBC shares outright, or

  • Buy a call option on HSBC shares

    In the first case, with £1,000 to invest, he could purchase 125 shares (i.e. 125 shares at 800p per share costs £1,000).

    In the second case he could buy a Call Option on 4,000 shares since the cost of each option is only 25p per share (i.e. 4,000 options at 25p per option costs £1,000). In this case he pays £1,000 as the option premium to an option seller for the right to buy 4,000 HSBC shares at 800p on the agreed option expiry date.

    Now suppose the price of HSBC shares rises to 900p.

    If he had bought the shares outright then his profit would be £125 (i.e. 125 shares times the rise in the share price of 100p is £125).

    If he had bought the options however the profit would be £3,000 (i.e. exercising the option to buy 4,000 shares for 800p each and then selling these shares immediately for 900p each would make a profit of £4,000 less the £1,000 in premium that he paid for the options leaves £3,000).

    Some points worth noting:

  • The profit on the option is many times higher than on the share purchase. This effect is called gearing.

  • The share price must rise by at least the cost of the option for the option strategy to make a net profit. In this case the shares must rise by at least 25p before a net profit is made.

  • If the share price falls, even by a small amount, then the option strategy would produce a loss of the entire investment. The loss on the purchase of the shares however would just be equal to the fall in the share price.