With all the fundamental and technical information providing a positive outlook for both gold and silver, many investors are either unaware of company options or scared off by the inherent risk factors. Many elect to take the warrant/ETO route and are wiped out on premiums and time decay despite making a reasonably accurate call. Long-dated company options provide a balance of time value and leverage with negligible risk of a near-term 100% wipeout.

What is a company option?

A company option provides the buyer with the right but not the obligation to convert the option into a fully paid share at some time in the future. 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. 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.

An example of a long-dated option is the RMSO (December 2007 expiry, 20c exercise price). In a recent ASX listing Ramelius Resources issued shares at 20c with 1 RMSO for every 2 shares issued. The company issued approximately 16m shares and 8m new options, whilst seed investor's options are escrowed for 12 months. The options are listed in financial publications as Opt07 below the fully paid shares.

ADVANTAGES OF LONG-DATED 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

• 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.

HOW COMPANY OPTIONS PERFORM

Example 1: ZXCO (December 2006 expiry, 20c exercise)

ZXC's 20c shares upon listing are trading at 15c, with the ZXCO's at 8c. The options were issued on 1 for 2 ratio, and post listing retail investors are down 5% on their original investment. Shortly after listing ZXC drills a major intersection of 80m at 12 g/t gold and the fully paid shares are now trading at 45c. The ZXCO's are now effectively worth 25c minimum taking into consideration intrinsic value (45c-20c). With a December 2006 expiry there is still considerable time value remaining, and combined with a relatively tight issue the ZXCO's are attracting 32c-33c. For those that purchased $10,000 worth of fully paid shares in the IPO the options alone have returned $8,000, whilst those that purchased on market have made a 300% return. A purchase of the fully paid shares at 15c would have returned a respectable 200%. ZXC is a well-managed company with a tight structure and a suite of prospective properties. The board consists of those at the helm of gold companies who were gobbled up by South African raiders. ZXC has a loyal shareholder base.

Example 2: NFIO (December 2006 expiry, 20c exercise)

NFI has transformed itself from a technology company into a gold explorer. In 1997 NFI were a small gold producer and were doing reasonably well until the RBA gold sales and dwindling sentiment forced it to shut down operations and conserve cash. In early 2000 NFI decided to issue a press release saying that, "In light of a lack of investor interest in the mining sector, NFI has elected to make a number of investments in the technology arena with the aim of enhancing shareholder wealth". After the bubble had burst the company ran out of money and was forced to issue significant amounts of paper to survive. NFI realised that gold was again in fashion and dusted off some old leases and put together a glossy prospectus. The capital structure, which had blown out like a current account deficit, had to be tightened and as a result shareholders saw their investment shrink even further. Those close to the company issued themselves copious amounts of stock at cheap prices, and as a result of a strong market the public chipped in at 20c and NFI was back in business. On day one the shares opened at 11c, after trading as low as 9c. The NFIO's were trading at 1.5c as only a handful of brave buyers stepped up to the plate. NFI's share price settled at 7c, with the NFIO's trading at 1c. Those that took up the 20c issue were down 62.5% on their original investment.

Example 3: BNMO's (June 2003, 20c expiry)

BNM is trading at 22c, whilst the BNMO's are 1.6c buyer. The options expire next month and the time premium has been effectively removed. BNM is in need of cash and has mounted a major drilling program and JV negotiations. The results are well received and the share price moves to 27c, whilst the options are now trading at 5c. With limited time to expiry buyers remain cautious as to the ability of BNM to hold 27c and the options continue to trade below intrinsic value. With limited liquidity in the stock there are no apparent arbitrage opportunities.

Example 4: WTFO (January 2008, 30c expiry)

WTF through previous success acquired a number of producing gold mines, and issued new shares at 35c, along with 1 for 2 attaching free option). The Directors believed that WTF should differentiate itself from a host of other new issues and price them accordingly. The shares listed at 40c with the WTFO's trading at 22c. (10c intrinsic value + time value/quality of issue). The POG continues to climb and interest in small producers increases and a speculative bubble is eventually formed. WTF's share price rockets on a major gold discovery in Indonesia and despite calls of another "Bre-X" the find stacks up under the JORC code and WTF is trading at $7.50. The WTFO's are trading at $6.70 based on an illiquid market and the fact those that were still holding them from the issue were prepared to sell them at any price, even if it was well below intrinsic value.

ASX LISTED LONG-DATED OPTIONS

The table below lists those companies with options that expire from 2005. (PM and mineral companies only).

**Abelle Options (ABXO) has been omitted due to a takeover from Harmony, whilst Spinifex options have not been included due to a pending merger with Gallery Gold.**

VALUING COMPANY OPTIONS

Whilst a formula would lend great assistance the fact remains that there are a vast array of variables that affect the pricing of company options. These include,

• Exercise Price and time to expiry. Exercise prices can vary greatly although 20c is the most common.
• Number of fully paid shares and options on issue.
• Quality of management and company assets.
• Loyalty of shareholder base.
• Liquidity of both the fully paid shares and options.
• Resource market sentiment.
• Specific company fundamentals, i.e. production and drilling programs.

MY VALUATION MODEL

When assessing long-dated company options I tend to recommend those where the company's fully paid shares are holding their ground around or below their issue price, have a tight structure, strong management and are exposed to a commodity where the risk/reward is attractive. In terms of ratios I would consider those in the range of 0.15-0.25 to be extremely undervalued, with fair value approaching 0.45. (Exercise price 20c).

Ideally the number of options on issue would be below 20m. Those with the lower ratios tend to have low share prices and a significant number of shares and options on issue.

In terms of assessment I have provided two groups where reasonable comparisons can be undertaken

Group 1: Malachite (MARO), Ramelius (RMSO), Midas (MDSO), Central Asia (CGXO), Independence (IGO), Alkane (ALKOB), Gateway (GMLO), Jackson (JAKO), Oroya (OROOA), Resolute (RSGO), Macmin Silver (MMNOA)

Group 2: Aust Mag (ANMO), Apollo (AOOO), De Grey (DEGO), Diamond (DDV), Exco (EXSO), Gippsland (GIPO), Gold Aura (GOAO), Helix (HLXO), Jervois (JRVO), Jindalee (JRLO), Mawson (MWEOA), Monarch (MRSO), Sylvania (SLVO), Universal (URLO),Vulcan (VCNO), WA Metals (WMEOA), Yilgarn (YGLO)

Group 3: Afminex (AFMOC), AKD (AKDO), Kanowna (KLSO), Conquest (CQTOC), Hillcrest (HLLOA), Aztec (AZRO), Yamarna (YAMO), Quantum (QURO,QUROB), Legend (LEGO), Rusina (RMLO, RMLOA)

Long-dated options offer exceptional leverage to a broader based PM rally along with the opportunity to benefit from individual company achievements. During the Nasdaq bubble some long-dated options were able to increase 20-40 fold, and whilst a return to similar conditions could be some time away, substantial profits still exist for those prepared to carry to undertake their own due diligence.

Tony Locantro
locantro@iinet.net.au

7 April 2003