From this brief outline of the operation of a put option, it is quite easy to grasp what occurs in the case of a call option. As a matter of fact, call options are much more frequently entered upon by the public than are put options, for the same reason that the public are far more frequently Bulls than Bears. Perhaps it is the optimism of human nature that accounts for this, or perhaps it is the fact that to buy is more natural than to sell, especially when the operator has got nothing to sell. Whatever may be the explanation, some of those who are frequently Bulls themselves regard with horror anything in the nature of a Bear transaction. They buy what they do not want without turning a hair, whilst denouncing as a speculator, dangerous to himself and the community, one who sells what he has not got. They may exercise their judgment in selecting stocks and shares that will rise, but consider it heinous to select those which are likely to fall. In fact, to some minds such selection is tantamount to knocking down the price, to the severe loss of those who hold the securities. We are always hearing of the wicked Bears, but never of the wicked Bulls. In a hazy kind of way, indeed, the Bull with his optimism is supposed to perform a public service. These ideas are perhaps not very sound, but they are at all events natural. All that, however, is a subject for the metaphysician; it suffices here to remark that just as Bull operators are more popular than Bear operators, so are call options more popular than put options. In the case of the call option, the one who buys it thinks the price will rise, and for that reason purchases the right to buy the stock at the existing price some time hence. If he is right he can, when the option period expires, sell the stock at a higher price than that at which he can call it. If he is wrong, and the stock falls, he has only to sacrifice the money he has paid for his call option. However far it may have fallen, he loses no more.
In the case of the option for the put-and-call, the operator buys the right either to sell or buy the certain amount of stock at a certain price on a certain future date. Such options are generally arranged in stocks of a widely fluctuating nature, and the operation partakes more of a gamble, a mere betting upon chance, than do either put options or call options. In these cases the operator has at least an opinion or a belief upon which he lays out his money: in the one case he thinks the stock will fall, and in the other case that it will rise. But in the case of the put-and-call, the only opinion he has is that it will move somehow; he does not know or care which way it moves, provided it moves far enough to show a profit over the amount he has paid for the option. The only question involved is as to whether the price will move widely enough.
If, when Consols are 73, he pays 1 per cent. for a put-and-call option on £10,000 for the end of next month and they rise 2, he can sell them for £7,500; exercise his call, which, with the price he has paid for the option, cost £7,400; and pocket the profit of £100 less the commission of £12 10_s._ which he pays his broker. If during the option period Consols fall 2, then he exercises that part of his option which enables him to put them upon the jobber, and pockets a similar profit less the similar commission which he pays his broker. If Consols during the period of the option do not move sufficiently either way to make it profitable for him to exercise his double option, then he loses the £100 he has paid for it and the broker's commission.
The price at which the operator has the option to buy or sell at the end of the option period is the price at which the stock stands at the time the option is bought. Of course, special arrangements may sometimes be made, but that is the rule. Such being the case, the price payable for an option to call is always exactly the same as the price for an option to put, and the price for a put-and-call option is always double the amount. At first sight it might appear strange that this is so. The jobber, when confronted with the name of any one stock, might be imagined as demanding a much higher price for the call than for the put, if he is of opinion that the price will rise. As a matter of fact, however, if the jobber were really of that opinion, the price of the stock would immediately be put up. In other words, current prices are an exact expression of market opinion. There is no more reason why a jobber should make the price of a call option in any one stock higher than the price of a put option than there is for his going into the market and buying heavily. If he did, the price would rise; he does not because he thinks that the price is at a fair level, and being at a fair level, is just as likely to fall as to rise. As the price is the basis of the option operation, he charges exactly the same for taking the chance of its rising as of its falling. It is no more reasonable to ask why the jobber does not make the price of the call option higher than the price of the put option than it is to ask why he does not go buying; and it is no more reasonable to ask why he does not make the price of a put option higher than the price of a call option than to ask why he does not go selling. The market invariably puts the price of a stock at the exact level which it thinks it is worth, which means that, in the market's opinion, it is just as likely to rise as to fall, and for that reason the price for a put option is the same as that for a call option.
What determines the price of an option is not, therefore, the likelihood in the mind of any one person of its rising or of its falling, but the probability of its moving widely in either direction. The price payable for an option on stocks which fluctuate widely is much higher than upon those which are steady, moving within very narrow limits. For instance, whereas 10_s._ per cent. has been mentioned as an ordinary price for an option on Consols, the price for an option on some American railroad shares would be £4 or £5. As the price of the option depends upon the extent, not the nature, of the fluctuation, it is naturally affected also by the duration of the period over which the option extends. The longer the period, of course, the higher the price. The Stock Exchange Committee does not recognise any bargain, option or otherwise, which extends for more than two accounts beyond the one in which it is begun, which would mean about six weeks at the most; the law of the Stock Exchange evidently aiming at prompt settlement of transactions. The fact, however, that options for longer periods are not officially recognised by no means implies that they are not carried out. Options for three months are quite common, and it may be said that the periods for which options are entered into extend from a day to six months.
In the case of day-to-day options, it is taken for granted that the period ends exactly a quarter of an hour before the official closing time of the Stock Exchange, which is half past three o'clock. In the case of options for other periods, it is taken for granted that the period ends with the account in which they fall due, or rather a quarter of an hour before, with the idea of allowing time for making final arrangements. An option may be arranged in January for, say, the end of March account, in which case the period would expire at a quarter to one on the Contango day at the end of that account, the account actually ending at one o'clock. When the time expires, the giver of money for the option has to declare whether he will exercise it or not. If he exercises a call option, he has then to pay the money and receive the shares. If he exercises a put option, he has then to deliver the shares and receive the money. Except in very peculiar circumstances, the option dealer, the taker of the money for the option, will know, when the term arrives, whether it will be exercised or not by merely comparing the existing market price with the option price. A call is not likely to be exercised if the shares can be bought much more cheaply in the market, nor is a put likely to be exercised if the shares can be sold at a much higher price in the market.
The giver of the money for an option may, of course, operate against it, securing his profit, as it were, at any time during the currency of the option period. If, early in January, he has bought a call of De Beers at 19 for the end of February, he need not wait until the end of February to sell the shares which he has the right of calling, although, of course, he cannot obtain delivery of the shares until that time. When he has bought the option early in January, he watches the market in case De Beers should rise to a point which would make it profitable for him to sell in view of the option which he has bought. Or he makes up his mind as to what price he will sell at, and instructs his broker, who will then watch the market for him. If, early in February, De Beers rise to 20, and he thinks they will go no higher, he sells them, knowing that under his option he will get them at 19 at the end of the month. There is, however, the mid-February settlement to be negotiated, and our operator is obviously in the position of having sold shares which he is not yet in a position to deliver. He must carry them over at the making-up price. This means that if they have risen to, say 21, he must pay the difference between that and the price at which he has sold. This puts him into the position of having sold at 21, so that his profit when he exercises his option will include, not only the £1 per share profit at which he aimed when he sold, but also the £1 difference which he has to pay at the intervening settlement. It is obvious, however, that one who operates on his option in this way must be prepared to meet the differences and expenses that arise in connection with any settlements that intervene between the time at which he has bought or sold against his option and the time when that option is exercised or, as it is called, declared. If he merely operates within the account at the end of which the option expires, he requires no capital at all except the money he pays for the option, but if settlements have to be negotiated, he may require considerable capital to go on with. Even where settlements intervene, the operator requires capital only to meet the differences and expenses connected with those settlements; he does not have to pay for stock he buys against his option; the matter being arranged by the broker handing over the net amount due to the operator when the option is declared. The broker takes his remuneration in the form of commission on the shares over which his client obtains the option, whether he exercises it or not.
These operations in options may become exceedingly complicated, an adroit operator backed by his option taking advantage in various ways of the fluctuations of the market. Sometimes in buying his option he arranges for what is called the call-of-more or the put-of-more, which really means the call or put of as much again; or he may arrange for the call or put of twice more or three times more.
It may easily be imagined that the existence of option dealing has sometimes a palpable effect upon market quotations, and, especially on Contango day or on its near approach, considerable fluctuations are often brought about by the buying and selling of those operators who have not been able during the currency of the period to buy or sell stocks to advantage. Stocks must be bought to satisfy call options, or stocks that have been put upon an unwilling purchaser must be cleared out, and these transactions naturally affect prices.
CHAPTER X THE WARES OF THE MARKET
It has been seen that the Stock Exchange is a market, of which the wares are stocks and shares. There is some considerable difference, however, between stocks and shares, and there are various kinds of stocks and various kinds of shares. It may be interesting and profitable to inquire into the distinctions, to examine, in fact, with some detail the wares of the market. A stockholder is frequently called a shareholder even by the most precise, but, strictly speaking, the terms are not synonymous; stocks are not shares. Stock is calculated by quantity and shares by number; stock is capital in a lump, while shares are capital divided into equal parts; although the unit of stock is usually £100, any quantity, such as £218 13_s._ 1_d._ worth, can, in the case of leading stocks, be bought, whilst shares, which are usually of the denomination of £1, £5, or £10, are indivisible, and can be dealt in only in multiples of their nominal value.
All the various kinds of securities--including both stocks and shares--can conveniently be divided into three main classes according to the manner in which they are passed from owner to owner. There are inscribed stocks, registered securities, and securities to bearer; and this classification has been adopted by the Stock Exchange itself in drawing up those of its rules which relate to the settlement of bargains, each of the three classes having its own set of rules.
Let us take first the class known as inscribed stocks, and we may reasonably do this, for to this particular class belong the premier securities--Consols, the other British Funds, Corporation stocks, and Colonial Government securities. The holder of inscribed stocks may have a bank receipt, but he has no certificate of his holding; his name is inscribed as the legal owner in a register kept for the purpose at the Bank of England, or some other bank or office. Such stock cannot, therefore, be transferred from seller to buyer by the mere delivery of documents, for there are no documents to deliver. To illustrate the method of transferring inscribed stock, let us see how Consols, for instance, are passed from a holder to the person to whom he has sold them. A ticket, on a form supplied by the Bank of England, is issued by the broker acting for the purchaser, and passed in the way explained in describing the settlement. But in the case of inscribed stock the ticket contains an additional item--the name and address of the ultimate seller who is going to transfer the stock. This, of course, is filled in when the ticket reaches the seller's broker. The ticket is taken by the selling broker to the Transfer Office at the Bank, where the particulars are copied into the Register. The transferor--identified by his broker, who attends for the purpose--or his representative appointed by a power of attorney, then has to sign the register in the presence of a clerk of the Bank, who witnesses the signature, and also has to sign a receipt for the purchase money. This receipt sets out simply that the transferor has received a certain sum, being the consideration for so much interest or share in such and such a stock which he has transferred to the transferee. The receipt is subsequently handed over to the buying broker for his client. The handing of this Bank receipt to the buyer of the stock is, then, the recognised method of delivering inscribed stocks--the seller who delivers the receipt before the appointed time on Settling day is entitled to demand payment of the purchase price. It will be seen that in transferring stock in this way the purchaser himself takes little part; but on the receipt there is a special note recommending transferees, as a protection against fraud, to accept the stock by signing their names in the Register at the Bank. The use of this is that the signature can be verified when any future transfer is made and when dividend warrants are signed.
With the next class of securities, registered stocks and shares, by far the greatest number of Stock Exchange dealings are concerned. In this class are included nearly the whole of the securities issued by the joint stock companies. The distinctive features of a registered security are that it is transferable only by a separate conveyance or transfer, and that no holder has a legal title to the security until his name has been registered as the holder in the books of the company. On the registration of the holder, the company issues a certificate as evidence of his title in the manner described in a previous chapter.
Stocks which are neither inscribed nor registered frequently take the form of bonds to bearer. A large number of foreign loans are issued in this form, as also are a large number of the stocks of the American railroads. These bonds to bearer pass from hand to hand in exchange for money after the manner of bank-notes. They are a very convenient form of security, but, at the same time, somewhat dangerous, as in case of loss or destruction the holder has, of course, no means of proving that he is the rightful owner. In this they resemble bank-notes, but they differ from them in the fact that their currency is recognised in only a narrow circle, and in that they, of course, bear interest. The Government or the company which issues them has no means of knowing in whose hands these bonds may be at the moment, and therefore it cannot remit the interest payments as they become due. It is left for the holder to apply for these payments, and this he does by presenting one of the large number of coupons attached to each bond, each bearing the date of one payment. Besides the coupons there is often attached to the bond a "talon," enabling the holder to demand a fresh set of coupons when his supply is in due course exhausted.
Although, for the purposes of Stock Exchange dealing and settlement, securities may be thus divided into three great divisions, from the point of view of the dealer in the market and of the outside investor and speculator, there are many more interesting divisions, dependent, generally speaking, upon the nature and rank of the security. At the top of the list come the trustee stocks, which are the securities in which the law of the land permits a trustee to invest the moneys he holds in trust without incurring liability for any loss that may occur. Roughly speaking, these include the Government securities of the United Kingdom and of India; certain Colonial Government securities; the stocks of the Banks of England and of Ireland; London Corporation and County stocks; the inscribed stock of any borough or county having a population exceeding 50,000; the stocks of the British railway companies ranking before their ordinary stocks, provided a dividend of 3 per cent. has been paid on the ordinary stock for at least ten years; various Indian railway stocks, the interest on which is guaranteed by the Secretary of State; the stocks of the water companies ranking in front of the ordinary stock, provided that stock has received a dividend of not less than 5 per cent. for at least ten years; and so on. These, of course, may all be regarded as securities of the highest class--as what are termed gilt-edged investments.
Ranking next to them, perhaps, are the first debenture stocks of the railway and other companies which do not come within the Trustee Act. Such a statement as this is naturally only general. Some debenture stocks of industrial and mining companies are far less sound and secure than the shares of the lowest rank of some well-established undertakings. There are mortgage debentures and debentures which carry no right of mortgage, and there are, in the case of many companies, mortgage debentures of various classes, one class carrying a first mortgage, another a second, and so on. Mortgage debentures are secured by a specific charge on certain properties definitely scheduled, and in case of default in the interest payment the Court will appoint a Receiver in respect of such properties for the protection of the mortgage debenture holders. Debentures which are not mortgage debentures are secured by a floating charge over the properties and assets of the company, and in the case of its default they rank as ordinary creditors, being entitled to proceed against the company and levy execution. The mortgage debenture and debenture stocks of a company are frequently described as its fixed charge stocks, because not only does the interest never vary in rate, but has to be paid whatever the profits of the company. In fact, debenture holders, being creditors and not shareholders, receive interest and not dividend.
These debenture stocks, like the loans issued by Governments and Municipal Corporations, may be redeemable at a specified date or after it. The approach of the redemption date naturally affects the market price. If a stock at present quoted at 95 is redeemable ten years hence at 100, the tendency of the price is, of course, to rise to the 100, and one who buys the stock at 95, in calculating what it will yield him, takes into account, of course, not only the annual interest, but the fact that he must receive, as it were, a bonus of £5 when the company buys the stock on the date of redemption. Similarly, if the stock is bought at a higher price than that at which it is redeemable at some future date, the buyer must regard the yield which it gives him as so much less, for when the date arrives he must take for the stock less than he gave for it. Some stocks are irredeemable, which means, of course, that they go on bearing the rate of interest for ever. The holder of the stock may sell it and thus get rid of the arrangement, but the company or corporation is saddled with the debt and the obligation of paying the fixed rate of interest upon it for all time. This may prove inconvenient and unprofitable if the borrower can obtain loans at a lower rate, but the only way to get rid of the burden is to make some arrangement acceptable to the stockholders. Certain of the Government stocks are redeemable at a comparatively early date, Consols themselves being redeemable in 1923, but only at the option of the Government.
Although debentures are called fixed charge stocks, partly because their rate of interest is fixed, and partly because it is a charge on the income of the company before any consideration can be entered into as to what profits there are to be divided among the shareholders, the rate of dividend on certain classes of mere shares which rank after the debentures is also fixed. A company may issue 4 per cent. or 5 per cent. preference shares, and their claim upon the profits, as their name implies, is preferential to that of the ordinary shares, which rank after them. They must receive their 4 per cent. or 5 per cent., as the case may be, out of the profits, and the ordinary shareholders have to look for their dividend to any profits that remain. At the same time, whereas debenture holders are entitled to their interest as a right, and may proceed for it legally as for a debt, the shareholders, even preference shareholders, go without their dividend if there are no profits--and there is an end of it.
Many preference shares, however, are cumulative preference shares, which means that if the profits in any year are insufficient to provide their dividend, the stipulated rate must be made up out of succeeding profits before the ordinary shareholders can receive anything. In the case of preference shares which are not cumulative, each year is complete in itself. They may be entitled to 4 per cent., but if the profits of the year suffice to pay only 3 per cent., that is all they get. Even if the profits of the next year are so good as to enable the payment of the full 4 per cent. dividend on the preference shares, and 2 per cent. or even 5 per cent. on the ordinary shares, the preference shares receive only their 4 per cent., because they are not cumulative. If they were cumulative, they would receive 5 per cent. to make up for the 1 per cent. lacking in the preceding year, and the ordinary dividend would be reduced accordingly. Of course, there may be first, second, and third preference shares, cumulative or non-cumulative, just as there can be different series of debentures, one ranking after another.
It will be seen that while the dividend on preference shares is more certain than that on the ordinary shares of a company, it is at the same time limited, whereas the dividend on the ordinary shares is only limited by the profit-earning capacity of the company. In the case of a well-established and prosperous concern, therefore, the price of the ordinary shares may be very much higher than the price of the preference shares ranking before them. In such a company the preference shares may receive a certain 4 per cent., while the ordinary shares may receive 10 per cent., which, although by no means so certain, may be certain enough for all practical purposes. In the case of many companies, of course, the dividend on the ordinary shares varies considerably year by year, and the price of the shares accordingly fluctuates widely.
Some companies, in order to meet this, have divided their ordinary shares into two new classes, one called preferred ordinary, bearing a fixed rate of dividend, and the other called deferred ordinary, taking what remains for division. In fact, the preferred ordinary bears the same relation to the deferred ordinary as preference shares bear to ordinary shares. Suppose a company has paid a dividend on its ordinary shares or stock averaging over a number of years 6 per cent. In one year it may have paid 4-1/4 per cent., in another year 8 per cent. This ordinary stock with its fluctuating dividend is divided into two parts. Each holder of £100 worth of stock receives £50 worth of preferred ordinary, entitled to a fixed dividend of 6 per cent., and £50 of deferred ordinary, entitled to the remainder. Thus in the year when the company paid 4-1/4 per cent., a dividend of 6 per cent. would be paid on the preferred ordinary and a dividend of 2-1/2 per cent. on the deferred ordinary--this making an average of 4-1/4 per cent. on the whole. In a year when a company pays 8 per cent., the preferred ordinary still receives 6 per cent. and the deferred ordinary 10 per cent. Instead of the stock being thus divided, the same object is attained by its duplication or watering. For each £100 of ordinary stock is issued a nominal £100 of preferred ordinary and a nominal £100 of deferred ordinary. In the case of the 4-1/4 per cent. dividend, the preferred ordinary would receive its fixed 3 per cent., and the deferred ordinary the remaining 1-1/4 per cent. Of course, this stock-splitting or stock-watering enables the holder of the original stock to dispose, if he chooses, of either the more speculative or the more stable security.
Even this list of Government loans, home and foreign, of trustee stocks, of mortgage debentures, of debentures, of cumulative preference shares, of preference shares, of ordinary shares, of preferred ordinary and deferred ordinary, by no means exhausts the various kinds of wares dealt with in the market. For instance, there are founders' shares, which are usually issued at the time of the flotation of a company to those specially interested in its promotion. Their peculiarity is that they usually participate with the ordinary shares in any profits remaining after a certain rate of dividend has been paid upon those ordinary shares. There may be 100,000 ordinary shares of one pound each and 100 founders' shares also of one pound each. It may be stipulated that the founders' shares participate equally with the ordinary shares after the latter have received a 7 per cent. dividend. Suppose the divisible profits amount to £20,000, the ordinary shares take their 7 per cent., which amounts to £7,000, and the remaining £13,000 has to be divided equally between the ordinary shares and the founders' shares. The 100,000 ordinary shares receive a further £6,500, raising their dividend to 13-1/2 per cent., and the 100 founders' shares receive the other £6,500, making their dividend 6,500 per cent. Had the company earned only £7,000, that would have sufficed to pay only the dividend on the ordinary shares, and the founders' shares would have received nothing.