Maximising Leverage to Gold/Silver

Whilst the major "brand name" gold producers in Australia have attained significant and at this stage sustainable share price re-ratings, the following stages of the cycle will involve the search for higher leverage. One of my preferred sources of leverage is the listed company option. These offer greater leverage potential than fully paid shares, without the near-term risk of 100% losses that prevail in futures and warrants.

When companies look at raising fresh capital a number of options are open to them in terms of new equity, debt financing, debt facilities or a combination of all three. One area of capital raising that has been instrumental in creating excellent leverage to the performance of a fully paid share has been the listed company option.

The option gives the buyer the right, but not the obligation to convert their option into a fully paid share at a future date, which is pre-determined when the option is issued. The main features of a listed company option include, the underlying security, the exercise price, the exercise date and the class of option, which is normally American or European. American options provide the holder with the opportunity to convert their option into a fully paid share at an anytime up until expiry, whilst European options can only be exercised at expiry. Both European and American options are actively traded on the ASX and their role as an investment tool is gaining a wider acceptance.

Listed company options are normally issued at zero or minimal cost to shareholders and investors as an incentive to participate in a placement of fully paid shares. The term "free attaching options" is often included in company announcements along with the terms associated with the option. A company may elect to conduct an option issue to holders without placing additional shares and these normally incur a nominal charge per option, but have similar conditions to those options issued at zero cost to the investor.

The listed company options will normally appear in the financial section following the price of the fully paid share. They will also be assigned their own ASX code, which in the majority of cases will end in O, OA, or OB. For example the company options in Macmin Ltd have an ASX code of MMNOA (MMN is Macmin's ASX code). The options have a 12c exercise price, and expire in September 2005. The options are listed in the Australian under the Macmin share price as opt05. This identifies it as an option with a 2005 expiry date. Investors should converse themselves with option terms available in Shares Magazine or from their investment advisor. Some companies may have more than one option on issue, and they will each have a separate code, and terms attached to each option.

Another instrument is the contributing share, which is similar to an option in terms of leverage potential, but will involve the requirement of holders to pay incremental payments to continue to hold the right to convert it to a fully paid share. Many are issued at a low entry price, and may involve a number of small payments over time, before a final pre-determined amount is paid to fully convert it into a fully paid share. These are normally listed as ctg, below a company's fully paid shares and again they are freely tradable however investors should have a working knowledge of the terms and conditions associated with the contributing share. After a payment or call is made, the contributing shares code will normally change to reflect the new conditions.

Factors that affect the pricing of a company option

Whilst the Black and Scholes formula for pricing derivatives and options created strong interest during the mid-late 1990's, in terms of pricing company options a number of factors will come into play that go beyond the application of any formula.

Performance of the underlying security

The performance of an option is linked to the underlying share the holder has the right to convert into a fully paid share. For example a company XYZ is trading at 20c, and the March 2003 options are trading at 6c (XYZO). There is a significant gold discovery and the shares move to 35c on heavy volume. The option is now "in the money" and as an intrinsic value of 15c. (35c-20c to convert the option to a fully paid share). The option price will include intrinsic value and time value, which forms the basis of the premium an investor has to pay to purchase the option. In this example the option is trading at 22c, where 7c is the time value of the option. Investors should note that time value is at its greatest level when an option is "at the money". This means the share price is trading at the exercise price. XYZ options have increased 16c and have increased 266%, whilst the fully paid shares have increased 15c or 75%.

In another example the price of GHJ is trading at 35c, and the GHJO's are trading at 25c, as interest in the stock is high as the market is speculating on a positive outcome to the company's development. The options are January 2002 expiry with a 20c exercise price, meaning the options are 15c in the money with 10c of time value applied (being the premium).

The company then announces to the ASX that their joint venture partner has withdrawn funding from their major project, and the company has difficulties in servicing short-term debt. The market reacts to the news, and the shares fall to 12c. The GHJO's fall to 1.5c as investors digest the news and reassess the company's potential. The options effectively do not have a considerable amount of time value left and are heavily discounted as a result. In this example the share price has fallen 57%, whilst the option price has slid 94%.

The leverage of the company option in both directions makes them a high risk/high reward investment tool that is mainly suited to more experienced and risk adverse investors.

Time Decay

As an option nears expiry the time value decreases, and if an option is in the money it will trade near its intrinsic value. For example RTY is trading at 23c, and the RTYO's (20c options) are 3 weeks from expiry. The RTYO's are trading at 3.4c, whereby there is 3c intrinsic value, and 0.04c of time value applied.

ASD is trading at 8c, with the ASDO's (20c option) trading at 0.001c. The options have 1 month to expiry, and it is expected that the ASDO's will expire worthless. There is one small buyer on the screen at 0.001c who is taking a punt that the gold price may rally strongly over the next few days and believes if ASD's share price moves, the options may increase to 0.002c (a 100% return). The sellers are holders that see little opportunity and wish to sell their options to realise some capital from their investment.

With company's now electing for lower exercise prices and longer dated options, the time decay issues will take a number of years to have a bearing on how the option reacts to the pricing of the underlying security.

Supply and Demand

A number of listed company options will trade at either significant premiums or discount to other companies based on the supply/demand imbalances for each option. The imbalances that arise from time to time will have an overriding impact over any pricing model. For example: The Black and Scholes formula. One of the other aspects to consider is that in order for some sellers to complete their selling a number of price steps must be taken out to satisfy the order. In the reverse situation when there is a large buy order the option price may temporarily move out of kilter with the fully paid shares. This activity can often result in a snowball effect as other speculators enter the fray.

ADVANATAGES OF LISTED COMPANY OPTIONS

• For a small capital outlay investors and speculators can attain leverage to the performance of a fully paid share. In some cases leverage of up to 1 million options is available for a fraction of the cost of purchasing 1 million fully paid shares.
• Long dated company options can provide investors with the opportunity to purchase having a guide from the company on developments that may be 2-3 years away and have a similar exposure to those holding the fully paid shares.
• With the options tradable on the ASX, there is a choice to either hold till near expiry or buy and sell within the life of the option.
• Options are often issued to investors at zero or minimal cost, usually as an incentive to partake in a placement of fully paid shares.
• During periods of speculative boom, the option price will react very strongly on a percentage basis in comparison to the fully paid share. Options trading can be very volatile and as liquid as the fully paid shares.
• Volume in options can often indicate activity in the company is gathering momentum and can often lead a rally in the fully paid shares.
• A number of companies with shorter-dated options have elected to extend the options for holders at a nominal fee, which in some cases can save them from a 100% loss on their investment.
• Option issues and contributing shares is a valuable tool not only for the investor but also those companies seeking to raise additional capital. This affect is greatly enhanced if the options can remain in the money for an extended period of time to attract investors to inject much needed capital into the company.

DISADVANTAGES OF COMPANY OPTIONS

• Company options are a wasting asset meaning in the majority of cases they will expire worthless.
• Share reconstructions can have a negative impact on the exercise price of options. For example a company that consolidates its structure on a 1 for 10 basis with a 20c option will have the expiry price blow out to $2.00.
• Companies that have a number of options series available to investors may suffer as a result of higher levels of interest in the series that provides the most liquidity. Positive announcements may only have a minor affect on the fully paid share price, as speculators seek leverage through options.
• Entry and exit can be difficult during quiet times due to liquidity levels, and overall investor sentiment to the particular sector. In some cases the option price may fluctuate greatly to allow for moderate buying and selling.
• Negative movements in the company's share price are magnified in the company option. Investors should be prepared for significant rewards and be able to work their way through difficult market conditions.
• A company that has a shorter-dated option series on issue may need to raise additional capital and as a result another option series may be issued. The shorter-dated option may suffer a further drain on liquidity to the disadvantage of holders.

LONG DATED GOLD/SILVER COMPANY OPTIONS (2004+)

* The following table is a quick guide only. Full terms of options (expiry date, exercise price, and conditions) can be accessed through Shares Magazine or your advisor