Option Basics

• An option contract gives the buyer the right, but not the obligation, to "exercise" the contract by buying (call option) or selling (put option) the underlying stock at a "strike price" on or before the "expiry date." The "premium" is the trading price of the contract. Each contract "multiplier" is 100. Therefore, if the premium is $1, the investor pays $100 to buy one contract.
  
  

Issuing New Shares

• Companies may need to raise capital for any number of reasons. A biotechnology company may need it for clinical trials, a technology company for entering new markets. Raising debt capital may be expensive when interest rates are high or rising. A better option may be to issue new shares. However, this dilutes existing stockholders' holdings as a proportion of the company's outstanding shares. It also reduces per share valuations, such as earnings per share and book value per share, which can lead to a lower share price.
  
  

Impact on Put Options

• As the share price drops, the premiums on the put options rise. Options that were "out of the money" may become "in the money." Put options are "in the money" when the strike price is higher than the market price; otherwise, they are "out of the money." For example, if a new share issue lowers the market price from $22 to $19, the put options with a $20 strike price become in-the-money. The option holder can sell these options at a profit because the premiums will be higher. He can exercise the contracts and make a profit of about $100, minus commission charges. He may also wait for the price to stabilize at a lower level before trading or exercising his put options.
  
  

Tips

• It may be too late to profit from these price changes once a company makes a new share issue announcement. There is usually an immediate reaction in the markets to possible share dilution. However, a savvy investor will realize that sudden market price changes can present attractive buying opportunities. The price may move higher if the fundamentals are sound. Call options may then provide an attractive return since their premiums rise with the share price.