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Shares A Beginners Guide to Making Money Contents

11 Getting Into Top Gear

When you have gained experience and made some money on the stock market you may decide to be really brave and go for bigger and quicker profits. You can do this by what is known in stock market jargon as gearing.

In financial terms, this works on the same principle as the gears on a bicycle or any other piece of machinery - a small movement at one end makes a larger movement at the other.

There are several ways in which you can jump on to this bandwagon - but beware it can move fast and if you fall off you can get a nasty bump.

Traded options

A call option gives you the right to buy a share at a fixed price and within a fixed period. You use it if you think the shares will go up before the option expires.

For example, Lucky Day shares may be standing at 250p in the market. You pay 20p for a three months' call on them. This gives you the option to buy Lucky Day shares at 250p at any time during the next three months.

If the shares rise to 290p, you will make a profit of 20p a share (40p less the 20p you paid for the option). So you will have doubled your money - your outlay is 20p for the option (not 250p the price of the shares).

But if the share price stays at 250p or falls below this figure, the option will be worthless, and you will have lost all your money.

How does this compare with the ordinary investor, who buys Lucky Day shares at the market price? If he pays 250p for them and they rise to 290p, he will make 40p per share, but on a much larger stake. Far from doubling his original investment, he will make a mere 16%.

If the shares show another 20p rise, he will have increased his investment by 24%. But the lucky option holder would have trebled his money.

Moreover, if the shares fall badly, the option holder cannot lose more than his original stake - which in this case is 20p per share.

On the other hand the investor who buys the actual shares could lose considerably more on each share -though he is unlikely to lose all his money.

Before you become too enthusiastic however, be warned that this is an extremely volatile and sophisticated market. There is a substantial gambling aspect within it. Just as gamblers on coffee and tea futures are not interested in coffee or tea (except for a cup full now and again to steady their nerves) and would be upset if a lorry started unloading tea chests outside their office, so buyers and sellers of options are interested only in the price of the options and not in the related shares. Most options contracts are never exercised, but are sold before the expiry date.

The investor has the choice of several striking prices, all with their relative premium prices.

In the case of our example share, Lucky Day, the striking prices might be 230, 250 and 270. You stand to make more money if you go for the highest price, simply because the option price is lower. But you are taking a greater risk, because if the shares do not reach that figure,your option will be valueless.

Example of traded option prices

Options are dealt with in units called contracts, each of which usually represents 1,000 shares. A buyer of 10 contracts would therefore be dealing in 10,000 shares.

You also have a choice of expiry dates, set at three, six or nine-month intervals into the future.

There are also put options which work in reverse and give you the right to sell shares. But anyone buying a put option must have very strong nerves. It is not so easy to become a jeremiah - most people are naturally optimistic.

Besides, your profit is limited with a put option because a share cannot fall below zero. Also, most shares in which options are traded are from large companies which are unlikely to become completely worthless.

A traded option can be bought or sold through a stockbroker at any time before its expiry date, after which it is worthless. Stockbrokers' charges can be high and they are not keen to deal in single 1,000 share lots.

It is essential to study this market for some time before parting with your money. Prices on the London Traded Options Market are quoted in the Financial Times and on-line.

Warrants

Share warrants are similar to options in so far as they give a right to buy the shares at a future date without an obligation to do so. They offer a future interest in a share for a relatively small investment.

However, they are issued by the company and it is the company and not another investor who delivers the actual shares (in the form of newly issued shares) - when the warrant is exercised.

Share warrants have a much longer life than share options, ranging from three to ten years or longer with an average of around six years. But like ordinary shares they can be traded on the Stock Exchange.

Gearing is the main attraction. But remember, this can work in reverse in a falling market with the result that prices fall further and faster than those of the underlying ordinary shares.

Only a few large companies have issued share warrants; they are more popular with investment trust companies.

The spread between the buying and the selling rate can be high and you need to employ a stockbroker with specialist knowledge of the market.

Nil and partly paid shares

New share offers and rights issues often come on the market in nil or partly paid form. How the effects of gearing can make these a good investment opportunity is explained under the heading rights issues.

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Last updated 19 January 2008.