And then you will get the value of an option!  Sounds tough doesn't it?  However let me remind you that the options game is very risky.  All you own is the option.  You do not own the property.  Once the period expires and you haven't exercised your option then anything you paid for the option is lost.  An option is a bit of paper and it only comes to value when you exercise it (assuming that it is worthwhile).

 

So bear with me.  If you want to get good at this you have to apply those 4 steps above so you can be sure you will make some money. 

 

So lets take the example of an option of £110k in 5 years on a property worth £100k today. 

 

Lets say I think the property will be worth £150k in 5 years. Then the profit is:

 

£110k - £150k = £40k

 

Then deduct fees of buying the property and selling the property say £5k.  So the profit is:

 

£40k - £5k = £35k

 

Then you have to discount that £35k profit in the future in today's terms.  I am going to assume an inflation rate of 3%.  To do this you need a scientific calculator to do this (you can get one in my package) and perform the calculation:

 

(1-0.03)⁵ = 0.85873

 

So a £35k profit in 5 years time is actually worth:

 

0.85873 x £35k = £30,055

 

Now you have to apply a risk multiplier to this.  As this £30,055 is not money in the bank and in no way guaranteed.  So you have to multiply this by a suitable percentage.

 

Now if you are looking to me for this percentage then you would be mistaken!  This is your call.

 

Lets just say you was 100% sure of this profit.  Then an asking price for the option of anything less than £30,055 would mean you would profit. 

 

If you were less than 100% sure then you have to decide what you want to pay for it.  Whatever you paid for it you would deduct from the £30,055 and this would give you the profit from the option.

 

Now if I were getting in to this game I would be extremely pessimistic.  Only pay for an option what you are prepared to lose.  It is a form of gambling in a strange kind of way unless you get a really long period where the volatility is evened out and the exercise price is within the long term average or lower.

 

If you paid 10% of the expected profit for an option you could not argue that was an unfair bid.  So in the above example a fee of £3,005 (10% of £30,055) for the option would be a fair price if I thought the property would be worth £150k in 5 years time.

 

The good thing is you can exercise your option anytime within those 5 years.  So if there was a mini boom after 1 year you could make around £35k less the price paid for the option.  Not bad for shuffling a few bits of paper about.

 

However most options in the UK are not just plain options.  We have a thing called lease options.  I will tell you about those in the next blog.....

 

Posted on: 17th Sep 2009

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