• New Shares Issued: When company options are exercised, new shares are created and sold to the option holder. This increases the total number of shares in the market.
• Cash Inflow for the Company: The company receives the exercise price, adding more cash to its assets.
• Shareholder Dilution: As new shares are issued, existing shareholders own a smaller percentage of the company. This is known as dilution.

Impact on Shareholders

When a lot of company options are “in the money” (the exercise price is below the current market price), there’s a good chance they will be exercised. This can dilute the ownership of existing shareholders but also bring additional capital into the company.

Heres a Simplified Example
Imagine you are an investor interested in XYZ Mining, a company listed on the ASX. You decide to buy options to purchase shares in XYZ Mining. Here’s how it works step-by-step:

Purchasing Options: You buy options on the market to purchase 1,000 shares of XYZ Mining at $5 each (the exercise price). You pay $1 per option, making your initial investment $1,000 (1,000 options x $1).

• Market Price Rises: After two years, XYZ Mining announces a significant mineral discovery, and the market price of its shares rises to $10 each.
• Exercising the Options: Since the market price ($10) is now higher than the exercise price ($5), you decide to exercise your options. You buy 1,000 shares at $5 each, costing you a total of $5,000.

Profit Calculation:

• Initial Investment (Option Purchase): 1,000 options x $1 = $1,000
• Cost to Exercise Options: 1,000 shares x $5 = $5,000
• Total Investment: $1,000 (options purchase) + $5,000 (exercise cost) = $6,000
• Market Value of Shares: 1,000 shares x $10 = $10,000
• Profit: $10,000 (market value) – $6,000 (total investment) = $4,000

Selling the Shares: You now own 1,000 shares of XYZ Mining. If you sell these shares at the current market price of $10 each, you will make $10,000, resulting in a net profit of $4,000.

Key Points to Consider

• Initial Investment: Your initial investment included the cost of purchasing the options ($1,000) plus the cost to exercise the options ($5,000), totaling $6,000.
• Potential for High Returns: By exercising the options and selling the shares, you capitalized on the increased share price, making a substantial profit.
• Limited Risk: If the share price had not risen above the exercise price, your maximum loss would be limited to your initial investment of $1,000 for the options.

Comparison: Buying Shares Directly

Let’s compare this to what would have happened if you had bought the shares directly instead of purchasing options.

• Initial Investment: Suppose you invested the same $1,000 directly into XYZ Mining shares when the price was $5 per share. You would have been able to buy 200 shares ($1,000 / $5 per share).
• Market Price Rises: After two years, the market price of XYZ Mining shares rises to $10 each.
• Value of Shares: Your 200 shares would now be worth $2,000 (200 shares x $10).

Profit Calculation:

• Initial Investment: $1,000
• Market Value of Shares: $2,000
• Profit: $2,000 (market value) – $1,000 (initial investment) = $1,000•

Return Comparison

• Options Investment: A $1,000 investment in options resulted in a $4,000 profit, a 400% return on your total investment of $1,000 in options plus $5,000 to exercise them.
• Shares Investment: A $1,000 direct investment in shares resulted in a $1,000 profit, a 100% return on your initial $1,000 investment.

Conclusion

Investing in company options allowed you to achieve a 400% return with a total investment of $6,000 ($1,000 for options plus $5,000 to exercise). In contrast, to make a similar $4,000 profit by directly buying shares, you would have needed an initial investment of $2,000 (200 shares at $5 each), doubling your initial investment compared to the options strategy.

By choosing options, you leveraged a smaller initial investment for potentially higher returns, demonstrating the power of options in enhancing investment performance.

Cautionary Risks
While the potential returns from investing in options can be highly attractive, it’s important to be aware of the risks.

• High Volatility: The value of options can be extremely volatile, and small changes in the underlying share price can result in large changes in the option’s value.
• Total Loss: If the share price does not rise above the exercise price before the options expire, the options will become worthless, and you could lose your entire initial investment.
• Leverage Risk: The leverage provided by options can amplify both gains and losses. While you can achieve higher returns with a smaller investment, the risks are also significantly higher.

Investing in options requires careful consideration and an understanding of the risks involved. Always consider your risk tolerance and investment strategy before engaging in options trading.