OptionsWise how to invest sensibly Wai-Yee Chen
OptionsWise how to invest sensibly Wai-Yee Chen
First published in Australia by Oex Publishers Pty Ltd copyright © Wai-Yee Chen www.optionswise.com.au All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior written permission of the publisher, nor be otherwise circulated in any form of binding or cover other than that in which it was published and without a similar condition being imposed on the subsequent purchaser. Every effort has been made to contact copyright holders. The publisher will be pleased to make good any omissions or rectify any mistakes brought to their attention. National Library of Australia Cataloguing-in-Publication entry Author: Chen, Wai-Yee. Title: Optionswise: how to invest sensibly/Wai-Yee Chen. ISBN: 9780980715101 (pbk.) Subjects: Finance, Personal. Saving and investment. Financial security Dewey Number: 332.02401 Distribution in Australia and New Zealand: Dennis Jones & Associates, Unit 1, 10 Melrich Road, Bayswater, Victoria 3153; www.dennisjones.com.au +61 03 9762 9100 Distribution in Singapore, Malaysia and Indonesia: MarketAsia Distributors (S) Pte Ltd 601 Sims Drive, #04-05 Pan-I Complex, Singapore 387382; www.marketasia.com.sg +65 67448483 Project Management Best Legenz www.bestlegenz.com.au Editor: Elizabeth Fenech Cover design: Best Legenz www.bestlegenz.com.au Internal design: Best Legenz www.bestlegenz.com.au Printed in Malaysia by Percetakan Anda Sdn. Bhd. Web design: Angusta Systems
To the person who said to me: “We can all still learn a new thing … at whatever age, yes, even at your age …” Thank you. You set me free to write this book, a new thing, at my age.
iv OptionsWise Contents Foreward vii Preface ix Introduction xii 1 Setting The Scene 1 Why use options? 1 The four OptionsWise investors 3 2 Foundation Building 7 Nine key concepts 8 3 Protecting Portfolios 23 Part A Hedging 23 Strategies 1 and 2 Buying and selling Index options 28 Strategies 3 and 4 Buying and selling specific share options 30 Strategy 5 Portfolio hedging 38 Strategy 6 Combination hedging 60 Summary of strategies 65 Summary of diagrams 65 Part B Non-Hedging 66 When is selling a call not a form of hedging 66
v Contents Summary of strategies 80 Summary of diagrams 80 4 Building Portfolios 81 Self managed super funds and options 82 Strategy 1 Buy share with protective put 87 Strategy 2 Buy calls to buy shares 88 Strategy 3 Sell puts to buy shares 89 Strategy 4 Buy shares and short put 98 Strategy 5 Buy write 98 Strategy 6 Synthetic long 100 Summary of strategies 118 Summary of diagrams 119 5 Optimising Returns, Managing Risks 121 Bull put spread 124 Combination strategies 136 Summary of strategies 147 Summary of diagrams 148 6 Managing Portfolios 149 Very profitable 150 Large paper losses 153 Due to be assigned 155 Exercised 159 Summary of portfolio management issues 165 7 Creating Certainty In An Uncertain World 167 Thin-slicing 167 Creating your own status quo strategies 171 Setting your own status quo rules of thumb 177
vi OptionsWise Fast and frugal 178 Epilogue 180 Acknowledgements 181 Glossary 183 References 193 Index 196 Author’s note 202 About the Author 204 About the book 206 About optionswise.com.au 208
vii Foreword Foreword Many people find out about exchange traded options from “free” seminars that claim they will make you rich. Alternatively they discover options by interacting with a financial adviser or broker who introduces them as a way of enhancing income returns from a share portfolio or as part of strategies to protect shares within a portfolio. Yet another way can be through friends who are involved in options and have had some good experiences. Options can be made to look very exciting and many people sign up for an options course or other products and services associated with them that can be the real reason for the “free” seminars. Or they get into strategies a broker or adviser or a friend suggests without really appreciating the risks and fees involved. Before embarking on trading options on such limited information, I urge anyone who is attracted to them to become very familiar with what they actually are and how they work. While options can be made to appear exotic and exciting, in their most practical form they are really an alternative way of trading shares. You can’t trade options and know nothing about shares. But you can through options invest or trade in some of the most prominent shares on the Australian stock market and enhance your returns or protect your investments. To do so successfully what can’t be emphasised enough is that you need to know what you are doing.
viii OptionsWise OptionsWise by Wai-Yee Chen will help you in this regard. In my view no-one should spend any money trading options without first gaining the sort of practical knowledge this book contains. If you invest some time doing this, you will quite likely find that people who claim options are risky will either be those who have never used them or who have traded options without the full and necessary knowledge that is required. Whether you are a direct share investor or invest in shares as a trustee of a self managed super fund, what you should gain from this book will go well beyond what any seminar or discussion you have with an adviser, broker or friend will give you. Once you have this, I believe you will understand that options are no more risky than investing in shares and can actually help make you a better share investor. John Wasiliev, Columnist Australian Financial Review November 2009
ix Preface Preface This book is written for: 1 Individuals who would like an income stream outside of their ordinary employment. Perhaps your job provides for your living expenses but is not fulfilling the future you dream about. Maybe you’ve considered “moonlighting” with a franchised café or restaurant, a mortgage-broking company or a web design business. Have you considered using options as a form of income? Like any other business, you need to start with knowledge and capital, then execute with discipline and follow up with good management. This book will provide you with knowledge, the first building block to success. It showcases good option portfolio management principles, which will help you build a sustainable, sensible income stream with the use of options. 2 Those with a good earning capacity who are looking to secure their future by making their money grow through prudent investing. Owning shares is one way to create wealth for the future. There are many choices involved in creating an investment portfolio. Should you choose a managed fund? Which manager should you select? Should you buy direct shares?
x OptionsWise How would you do it, on the Internet or through a full service broker? In your search for any financial solution, the first question you must ask yourself is, ‘Am I comfortable with this investment instrument?’ Most people invest in solutions their friends recommend or go ahead with a plan suggested by an investment adviser or financial planner. OptionsWise intends to give you the knowledge you require to feel comfortable about pursuing options strategies as a sensible way of securing your financial future. Understand that this book is not a magic pill, the answer lies in tailoring strategies for you, firstly by understanding them, then implementing and following through with them in a logical, disciplined manner. 3 Investors who have used options in the past, but experienced intermittent success or losses. Those who have used options but want a more systematic approach. Understanding how things went wrong for you is the key to knowing how to make them right. If you are searching for a more sustainable and sensible way of using options, this book is for you. 4 Those who believe shares are already difficult enough to understand and maintain, without complicating them with ever more options. You’re a busy person and don’t have the time or expertise to keep up with economic developments, financial markets and the ins-and-outs of companies and their CEOs. How will you understand options, with all their intricacies and fluctuations? OptionsWise unravels the complex DNA of options through the use of practical examples of everyday investors.
xi Preface It has been simply crafted so that even those with the most basic financial experience can relate to, and understand, this invaluable financial tool. OptionsWise has devised an investment plan for you, one that is simple and easy to follow, with trading rules that will provide you with the ability to make good snap investment decisions. Take up the challenge to learn something new and take control of your financial future. 5 Individuals who are trustees of self managed super funds. Your retirement destiny is in your hands. A share portfolio enhanced with option strategies is a legitimate way of boosting returns within and outside of a super fund. OptionsWise contains the key to unlocking your wealth.
xii OptionsWise Introduction “Retirees lose nest eggs through options trading,” reads the headline of the local paper. “How unfair! How could this happen?” you ask. The answer is, it has happened too easily. Options trading, like other investments, is a calculated risk, but nevertheless one that can go wrong for unsuspecting users. Options, a form of derivative, are no longer the only culprits responsible for losing investors’ money. Since the beginning of the global financial crisis, investors have lost savings in the lowest risk investment options, including deposits with financial institutions and investments in once-solid businesses and brand names. So why should investors consider options when they are reputed to be risky? All investments present some element of risk. The key to minimizing that risk is to understand options, and you don’t need to be a professional investor to do so. As Australia and the rest of the world slowly climb out of the global financial crisis, options can be used by savvy investors to grow wealth, even in the depressed financial market. How does this work? Low growth and low interest rates mean returns on regular investments are low. This book contains options strategies that can boost, or enhance, these low returns, so you can make the most of your money.
xiii Introduction The use of options can mean the difference between huge losses and limited downside, the difference between low interest income and an income stream. An investor who can use options successfully in a challenging environment such as the one we face today, will be experienced with a powerful tool in a more conducive investment climate. The use of options as part of an overall portfolio strategy can provide protection, certainty and a consistent income stream, in any market conditions. The key to using options successfully is not in investment knowledge and strategies alone, it is also dependent on the goals and behaviours of investors themselves. OptionsWise can provide an investment plan for readers, but options users must have the discipline to stick to that plan. In reading this book, you will not only discover a better way of managing your share investments during these unusual economic times, you will also discover ways to better manage yourself as an investor. I hope you enjoy reading OptionsWise as much as I have enjoyed writing it.
xiv OptionsWise
1 1 Setting The Scene I nvestors often tell me it’s difficult enough trying to figure out which shares to buy and when to buy or sell them, without complicating matters further by throwing options into the mix. I advise my clients that they cannot afford not to explore options, particularly in an investment climate where interest rates and returns from share investments alone are low and stock market volatility is high. Why Use Options? In his book, Nudge: Improving Decisions About Health, Wealth and Happiness, Dr Richard H. Thaler, a well known theorist in behavioural finance and an economics professor says, “In economics (and in ordinary life), a basic principle is that you can never be made worse off by having more options, because you can always turn them down.”1 Options are not as complicated as you might think and we use them in many areas of our everyday lives. Consider parents who put deposits down to waitlist their child in a few reputable private schools to ensure their offspring gets into the best one when they turn five. Some parents choose to begin this process when their child is born; others do so at 20 weeks of gestation when the gender of the child is known.
2 OptionsWise Why do parents do this? Because they prefer the option of turning a place down when offered, to not having a place for their child at a school that they favour. Hence, parents with foresight buy, or pay for, the option of choice. Another example of buying options can be found in the work environment, where a man who is his family’s sole bread-winner takes out income protection insurance to provide for his family should he die or become injured. If the man is never injured during his working life, the policy will lapse and the premiums he has paid during the life of the policy will be sunk costs. However, if he becomes injured while working, he can exercise his right on the policy to receive a monthly income benefit for the rest of his working life. Both the above scenarios involve the risk of making an investment without a guaranteed return, but the safety net provided by having options in the event of future unknowns far outweighs their cost. While most people actively seek out safety nets in their dayto-day business, few choose to secure their financial assets in the same way. For example, most Australian adults own a car and pay for car insurance. So why do we choose to insure a $20,000 car but don’t insure our self managed super funds worth hundreds of thousands of dollars? Those who can see the benefits in investing a small amount of money to protect a significant asset, such as a motor vehicle, should recognise the need to protect the funds that will allow them to live a comfortable retirement. Financial options Share investors use financial options that can be separated into two fundamental types; those issued by individual companies, called company options, and those issued by the Australian Securities Exchange (ASX), called exchange traded options (ETO), the latter type is the subject of this book. Options are a powerful investment tool, as investors can be sellers of options rather than just buyers (think of yourself as being the
3 Setting the Scene school that received the waitlist deposits and the insurance company that sold the insurance policy and received the premiums). Aside from shares, financial options are also commonly used in real estate. Think about a property seller who, instead of selling his property outright, sells an option to his property for an income. A buyer of this option will only exercise his right to buy if the property has appreciated in value, otherwise the buyer will let the option lapse and walk away, whilst the seller made an income from his property without having sold it. On the flip side, if the property has appreciated in value, the buyer will exercise the option to buy the property at a reduced price. The seller will have sold his property at the sale price plus the income from selling the option. Both seller and buyer are better off. This is the basic tenet of the strategies in this book. Being a seller of financial options will set investors up for a better financial outcome. In order to apply the strategies in this book successfully, you must first understand the risks inherent in options strategies and then plan for those risks to occur, even though they may never do so. The OptionsWise strategies will give you certainty and control in your share portfolio. A disciplined investor who uses the options strategies in this book can enjoy a sustainable income stream from a sensible investment. The Four OptionsWise investors In the following chapters, you will be introduced to four investors; Will, George, Dr Alfred and Simon. These investors are key characters that utilise option concepts and strategies according to their investment needs. The four investors will demonstrate how Australian Securities Exchange: the primary stock exchange for Australian shares. It regulates companies listed on its exchange and is a public listed company itself exchange traded options: options with standardised features issued by the ASX. There are three types of ETOs; equity options, Index options and low exercise price options
4 OptionsWise they make financial decisions and what action should or should not be undertaken in each individual situation. It is not the objective of this book to cover all the possible option strategies, instead the intent is to show the reader how four different investors identify the strategies appropriate to their objectives and their views of the overall share market and individual stocks. Strategies are broken down and explained according to how they meet the expectations of the investors. You will find each of the four characters very different in their personal background, training, emotional response, investment experience, tolerance to risk and decision-making processes. Each has different expectations and objectives when using options and a step-by-step approach is used to demonstrate how each investor decides on their strategies. The book also suggests a follow-up strategy for use after this initial implementation. You will discover that not all the strategies achieve the investor’s objectives, nor do they all go according to plan. This happens in life, when your money is on the line and your decisions have real consequences. All four of the investors suffer from mental traps that are common to investors and it is interesting to see how they react when worst case scenarios eventuate. I hope you will be able to identify with some aspects of at least one of the investors and that the financial strategies will come alive to you as you see their practical application. Your great advantage over the characters is that you have the chance to observe and learn from their experiences and avoid the traps they succumb to. Will Still working after 60, Will started work young and built a life for himself. As a result of his age and experience, Will guards his assets carefully and invests in a conservative manner. Will’s investment personality of balanced to conservative most befits the German meaning of his name, which is “strenuous guardian”.
5 Setting the Scene George George, in his early thirties, is a high salaried IT professional who feels on top of the world. He believes he can do anything and likes to pursue new opportunities. His name means “fire” and his investment personality is aggressive. He sees options as a way to get rich, quick. Dr Alfred Dr Alfred is a considered family man in his late forties who runs a busy medical practice. Dr Alfred is a prudent investor, not afraid to take risks but always preferring to take calculated ones. In addition to the income he is generating from his medical practice, he wants to ensure he is investing his self managed super fund wisely so that he and his wife can retire to a comfortable lifestyle and he can reduce his work hours to pursue other interests. His practice is currently his priority, so Dr Alfred’s options criteria is to have a share portfolio that builds wealth for him in a sustainable and sensible manner over the next 10 years without the volatility and short term emotional swings that will take his attention and concentration away from his job. His adviser, Ed, is given the task to fulfill these requirements. Simon Simon is an early-retired businessman who sold his successful printing and design business to a zealous conglomerate who more than compensated for his 20 years of hard labour and costly family time. After enjoying some time with his family and paying off all his outstanding financial obligations, Simon has set aside a sum of money to invest in a small business. Simon has spent months researching and has decided on investing with options and he is going to run his investments like he did his business with the same disciplines and principles he had employed.
6 OptionsWise
7 2 Foundation Building Options are financial contracts entered into by two parties. One is a buyer, the other is a seller. The buyer pays a premium and the seller receives the premium. The buyer pays for the privilege to either call upon or put, the underlying asset or share. The seller is paid for the commitment he or she makes to either sell or buy the underlying asset when required by the buyer of the option. This is the basic principle each investor must understand before he or she can delve into the finer workings of options trading. As I help my five-year-old daughter learn the letters of the alphabet, then watch as she begins to sound out words, I appreciate the importance of grasping solid basics, like knowing the letters of the alphabet back-to-front, when learning a new skill, like reading. There is also much to be said for rote learning, which involves repeating the sight words every day until the sounds stick, alphabets begin to form words, and a confident reader is born. This process is time consuming; it takes an average kindergarten child two terms to master the skill of sounding out words before they start to read confidently. While the work in those two terms may seem drawn-out, it will set them up for the lifelong joy of reading. It is worth the effort. premium: the price of an option contact call upon: to buy put: to sell
8 OptionsWise I suggest you learn some of the following concepts by rote if you have to, in order to get started. Nine Key Concepts 1 Options have no value on their own Options are derivatives, which means they have no inherent value on their own. Their value is derived from the worth of the underlying asset that they represent. This derived value is their intrinsic value. The value of the underlying asset (or the lack of it) is often the largest determinant of the value of options. 2 Options do not last forever Time value is the other important component of option value or price. Options have a limited life span, not different to a life insurance policy, which expires upon the death of the insured. The life of ETOs are standardised by the ASX, most are monthly and some are quarterly. These phrases can often be heard in our everyday lives, “Time is money”; “If only I had more time”; “I need to buy more time”. Time is a desirable commodity with very real value. Why do we need more time? So we can do more? Many of us “buy” more time by subcontracting out the tasks we need to do but can’t or don’t do due to a lack of time (for me, this is gardening, though I must admit time is not the only obstacle). Likewise, in options, time is valuable. The longer you want an option for, the more you pay for it. When dealing with options, time really is money. Option buyers want more time so their options have more time to increase in value. The beauty of financial options is you can actually buy the commodity called time. The longer you want it, the more you pay for it. If you pay less, you buy a shorter time. So, time value is the next important component of option pricing. The longer an option is, the higher its value will be.
9 Foundation Building One other important concept to remember in relation to time is that the life of an option is not linear. Its time value depreciates in a log manner and approximately two weeks before an option is due to expire, its value deteriorates quickly and exponentially. Diagram 1 Relationship between the price of a one year option and time As a result of having a set lifespan, after an option’s expiry date, it will cease to exist, whether it has intrinsic value or not. The buyer will cease to have rights and the seller will be free of his or her obligations. If the option has value at the end of its useful life, it should be exercised, or sold off by the buyer, who will gain from it, whereas if it has no value at the end of its useful life, that will be to the benefit of the seller. This is akin to the insurance company that sold the income protection insurance policy to the father. If he is 1 As time increases 2 Time value component of option price decreases exponentially $ 0 + – Option price 12 months Time 1 2
10 OptionsWise never injured during work, at age 65 or when he retires, whichever is earlier, the policy will lapse or expire and the insurer will have happily pocketed all of the premium paid. 3 There are only two types of options They are calls and puts. The distinction between the two is in the way they change in value or price in relation to the change in value of the underlying asset or share. This is the important concept that you need to learn by rote in options—the value of call options increase when the underlying share rises in value, whilst the value of put options increase when the underlying share falls in value. These are depicted in diagrams 2 and 3 on the next page. It’s also important to understand that the relationship between call and put option values and the underlying asset value is always derived from the perspective of the buyer of the option. Buy a call if a share rises and buy a put if a share falls. However, as you read this book, you will find that many of the strategies discussed are about taking advantage of being a seller, or writer, of options to create a consistent flow of income for yourself as a portfolio investor. Hence it’s important to understand options from the perspective of a buyer, as it will give you, especially as a seller, the ability to plan the best defense or risk management strategy by anticipating your opponent’s behaviour in a particular scenario. Being prepared is your best defence. 4 Let’s strike a deal, at a price Options are contractual obligations between buyers and sellers and to be of value, or to be valid, both parties need to agree on a contract price. The strike price of the option is the price at which the parties strike a deal, independent of the prevailing market price. The term “strike price” is used interchangeably with “exercise price”, as this will also be the price at which buyers will exercise, if
11 Foundation Building Put option price Underlying share price 1 As share falls 2 Put option price increases Put down 2 1 Diagram 3 Price of put option goes up as underlying share falls in value 1 As share rises 2 Call option price increases Call option price Underlying share price 1 2 Call up Diagram 2 Price of call option goes up as underlying share rises in value $ $ + – 0 $ + – 0 $
12 OptionsWise they choose to do so. It helps to remember that in this contractual relationship, the balance of power is on the buyer’s side. It is the same as that of the policy holder of an insurance policy who holds the right to exercise it when the conditions are met. The insurance company, the seller, can only react to the buyer’s actions. The strike price is important because we study it to ascertain whether or not an option is valuable, and whether the buyer can exercise, or sell it for a profit. The buyer of a contract, whether it’s a call or a put, will only exercise it if it is in the money (ITM), a specific term used in options for being valuable. This is the inherent right of an option contract; the buyer of a call has the right to exercise to buy and the buyer of put has the right to exercise to sell the underlying asset, at the strike price of the contract. When will the buyer of a call option want to exercise his rights to buy the underlying asset? When the underlying asset value moves above the strike price of the call option plus the premium paid, the breakeven price. As calls increase in value when the underlying asset appreciates, call options are ITM (read “in the money” mentally, it will help the concept stick in your mind) when the market price of the underlying asset is higher than the strike price. The buyer of the call will gain from calling in (or buying) the underlying asset at the lower strike price (after recovering what he has paid for it). This is depicted in diagram 4 on page 14. When will the buyer of a put option want to exercise his rights to sell the underlying asset? When the underlying asset value moves below the strike price of the put option, including the premium paid (breakeven price). Put options are ITM when the value of the underlying asset moves below the strike price after deducting the premium paid. This is easier to be conceptualised if you think from the perspective of the buyer of the put having to sell an asset at the strike price to
13 Foundation Building the other party. The put buyer will only do so if the “sale” price (which is the strike price after deducting the premium paid) is higher than the market price of the underlying asset. This is depicted in diagram 5 on the next page. Two other terms that are often used are out of the money (OTM), which means there is no advantage for the buyer to exercise as the option is low in value, and at the money (ATM) which is of no benefit either way as the strike is the same as the market price. 5 Options thrive on uncertainties Uncertainties create possibilities and possibilities can create value. Life and health insurers create value for their businesses from uncertainties in human life. In an uncertain environment, options have more chances to increase in value. For calls, uncertainties increase the chance of the underlying asset rising to the highest possible positive value during its life. Similarly, for puts, uncertainties increase the chance of the underlying asset falling to zero. The technical term used to describe this movement is volatility. Volatility is a measure of uncertainties in both the movement and direction of the underlying asset. Volatility is also linked to velocity; the greater the velocity of the volatility, the greater the impact it will have on option pricing (it pushes the value of options up). The volatility of the underlying asset is an important factor in option pricing. The measure of volatility is one variable where different market participants can have a different measure and one may have an advantage over another through more accurate pricing of the option. There are various methods practitioners use to measure volatility. The method that uses past prices is called historical volatility. This is where the closing prices of the underlying share over a set period of time are recorded and used to measure the range of its price movements. The other method, called implied volatility, is where the price movement of the share over a set period is observed
14 OptionsWise Put option price Put ITM Breakeven price $5 1 2 3 Underlying share price ATM Put strike price $ + – 0 $ 1 As share falls below the strike price of $5 2 And falls below the breakeven price, which is the strike price minus the premium paid 3 The $5 strike put option gets more valuable and becomes ITM Diagram 5 Buyer of a $5 strike put option Diagram 4 Buyer of a $5 strike call option $5 $10 Breakeven price Call ITM Underlying share price ATM Call strike price 1 2 1 As share rises above the strike price of $5 2 And moves above the breakeven price, which is the strike price plus the premium paid 3 The $5 strike call option gets more valuable and becomes ITM Call option price $ + – 0 $ 3
15 Foundation Building or predicted by monitoring the market prices of the options. For example, implied volatility can be calculated by taking the average of the bid and offer spread of an option quote during trading hours. Volatility is an important determinant of option pricing, as an increase in volatility causes an increase in the value of option. Volatility will be a friend of the buyer as, without a change in the underlying value of the share and all other variables, volatility increases the value of an option. On the other hand, it will have an adverse effect on a seller or writer of the options. 6 Dividends and interest rates matter too Dividends and interest rates have a relatively small impact on option pricing, whilst franking credits, which are attached to some dividends, have no impact on option pricing. Franking credits are tax credits paid to shareholders as 30 per cent tax has been paid on the dividend income by the issuing company. It has the effect of reducing the tax liability or enhancing the after tax income of the shareholder, but options do not cater for tax effects. Share prices that trade cumdividend generally rise as they include the upcoming dividend payment. Hence, once a share trades ex-dividend, its call option prices reduce in value whilst put options increase in value. However, in practice, these adjustments are normally anticipated prior to the ex-date. spread: the difference between the buying and selling rate dividends: the amount paid out of company profits to shareholders interest rate: the rate charged or paid for the use of borrowed money, expressed as an annual percentage of the principal cum: with something—for example, shares bought cumdividend entitle the purchaser to the rights to the dividend earned ex: without something—for example, shares bought exdividend do not entitle the purchaser to dividends. This right remains with the seller
16 OptionsWise The impact of dividend and its ex-date are crucial when we examine early exercises of options, that is, when the buyer of the option exercises his right to the option contract before the expiry date. This will be discussed in more detail in the section below and throughout the book as part of the investor’s defence for various strategies. The fluctuation in interest rates has only a small impact on option pricing in a low interest rate environment where there are only small changes in either direction. However, the change in interest rates is more of a consideration in a high interest rate and leveraged environment, where an increase in interest rates will cause the purchase of the underlying share outright with gearing to be more expensive, and render the purchase of call options to gain the same exposure to the underlying share more compelling. Hence, an increase in interest rates has the effect of increasing the value of call options and decreasing the value of put options. 7 How are options priced? There are two basic popular methods of pricing options, the Binomial Tree and the Black-Scholes Model. The first is a tree constructed with one branch leading up and the other leading down to trace the possible paths that an underlying share may travel in a specified period of time. The price of an option is determined by assigning the probabilities of each of the paths it may take, based on the option’s volatility. A tree can have many nodes from which the up branch and the down branch can extend, depending on the number of time intervals, such as, for example, the number of months in its lifespan. The option price is calculated Ex-date: the date on which shares change trading from ‘cum’ to ‘ex’ status leverage: gearing, the use of borrowed funds to supplement an investor’s money when acquiring an asset. The higher the leverage, the higher the use of debt
17 Foundation Building backwards from the furthest time period (Dec 2009, Node 1 in the tree (Diagram 6), taking into consideration the share price, the strike price, the stock’s volatility and if there are dividends at each time interval. The option price at Node 3 is arrived at from the probabilities of 1 and 2 and the option price for today (Oct 2009), which is Node 6, is then arrived at from the probabilities of 3 and 5. The Black-Scholes Model is a complex mathematical formula used to calculate the theoretical price of options. Though early Black-Scholes Models did not cater for the impact of dividends, the formulas were later revised to include them. Option prices can be calculated with or without dividends. However, readers should keep in mind that all option prices in the OptionsWise book and online applications include Diagram 6 Binomial Tree º º º º º º Probability that share price will rise Probability that share price will drop If share goes up, what will the options price be? If share goes down, what will the options price be? Dec 2009 Dec 2009 Nov 2009 Dec 2009 Nov 2009 Oct 2009 %+ %+ %+ %– %– %– Option price ? Share price? TODAY 1 5 6 4 3 2
18 OptionsWise dividends and their expected ex-dates in the calculations. The price of an option is calculated using the Black-Scholes Model from six inputs. These inputs are the underlying share price, strike or exercise price, expiry date, volatility, dividend and interest rates. The relationship between the underlying share price and the strike price of the option determines the intrinsic value. For a call, this is the higher underlying share price minus the strike price and for a put, the strike price minus the lower underlying share price. The option’s expiry date determines time value, which is the number of days to the expiry date. The percentage of the range of the share price movements over a certain period determines the volatility and the dividend amount expected to be ex’ed during the life of the option. The overnight cash rate makes up the interest rate component. It’s not important for investors to know how to calculate theoretical option prices using this formula, or to even know what this formula is, but it is important for investors to understand how a change in any of these six variables affects the theoretical prices of options. Theoretical prices of options calculated from these models and their variations can be obtained from the Internet, including on the ASX website (www.asx.com.au), which provides an option price calculator and option prices that are either on 20 minute delays or at theoretical prices. Theoretical prices can be obtained relatively easily, but they are not always close to the live, or “real”, market prices. The unavailability of live prices for option series that are not near to the market price of the underlying share or near to the current expiry date is the bane of option investors. Market makers who provide live option bids and offer quotes are not obligated to provide prices for all market makers: companies that trade in options to provide liquidity in the market
19 Foundation Building option series. Those who have access to trading systems can request live quotes, others often have to call their investment advisers or contend with the theoretical prices available on websites. This gap in the market is one of the services the OptionsWise website (www.optionswise.com.au) provides. The site supplies option investors with theoretical prices that are “refined”, or very close to, the live prices. This is made possible by allowing investors to calculate implied volatility from available live option prices and applying that live volatility to refine theoretical prices. The OptionsWise website does not just calculate option prices, it goes one step further in helping investors evaluate the risk and reward of strategies by allowing “what-if” scenarios to be explored to help investors prepare for possible risks before they occur. The risk and reward analysis tools on the website help investors achieve the balance they require in their investment objectives and prepares them for risks, however remote they may seem. www.optionswise.com.au is an essential planning tool for any option portfolio investor. 8 When will you exercise or get assigned? Understanding when an option contract is to be exercised (by the buyer) or assigned (on the seller) is important. This is not just from the perspective of the buyer, who will gain by exercising, it is also important from the sellers’ perspective, as this point presents a risk management issue. As the option buyer has the upper hand, sellers need to be prepared when assignment is imminent and have the skills to manage this risk up-front. There are two kinds of possible assignments; they can either occur at any time or only on expiry of the option. Most options over shares are American options, and can be assigned anytime. Index options and low exercise price options (which are not covered in this book) are European options and are only exercisable at expiry.
20 OptionsWise In general, from a seller’s perspective, ITM options (calls and puts) have a high risk of being assigned, as buyers are only likely to exercise their rights when they are valuable. An ITM call has a high risk of being assigned when the market price of the underlying share is high and an ITM put has a high risk of being assigned when the market price of the underlying share is low. Assignments are managed by the ASX and they are allocated on a random basis to all opened positions for the series exercised by the buyer. An option position (except for Index option positions) closed before expiry will avoid the risk of assignment. Dividends and their ex-dates are big determinants of early assignments. The buyer of a call option would be inclined to exercise an ITM option, especially the day before the ex-dividend date, to gain from buying the underlying share at the lower strike price and earning the dividend income. The buyer of a put option covered by an underlying share would be inclined to exercise the put to sell the underlying share at the higher strike price after the ex-dividend date if the underlying share falls below the strike price. 9 Who trades in options? In addition to the normal options players like professional and retail investors, traders and hedgers, there is a group of players called market makers. Market makers are recognized institutions who trade in securities, such as options, to provide liquidity in the market. One big difference between the option market and the equities (share) market is that live prices (bids and offers) are not always available for all options, unlike in the equities market where there are generally buyers and sellers in the queue wanting to trade. liquidity: the state of having assets either in cash or readily convertible into cash. A liquid market is one in which there is enough activity to satisfy both buyers and sellers
21 Foundation Building To provide liquidity for the option market, the ASX has enlisted the use of companies to make a market their business by providing bids and offering quotes. These companies make profits from the bid and offer spread and through arbitrage opportunities between the option and equities market. You will find that live quotes for option series (calls and puts) that are ATM and near to the current traded price and those at and near to the expiry month, more readily available. The further out they are in terms of strikes to the current price and in terms of time, the harder it is to get live prices. This can be explained by the way market makers are enlisted to quote. Market makers are regulated and monitored by the ASX and they are required to quote live prices within the maximum allowable spread (between bid and offer) in any of three ways— either on a continuous basis (displaying prices all the time), or only upon quote request by brokers or a combination of the two. They have an obligation to quote live prices 60 per cent of the time on the first two categories and only 50 per cent of the time when they quote on the third. This is why there are times when the bid and offer columns on certain option series are blank (without live prices) or where the bid and offer quotes column display the same bid and offer prices (which is the theoretical price), depending on how prices are displayed on various websites or systems. If live prices are not displayed or available, investors can request a quote from their stockbroker who will in turn make a request to the market makers. Even when live prices are not quoted, market makers will trade at a price determined by them. This is based on existing market conditions, liquidity, past or expected demand and supply of the underlying share or the market makers’ own observation of the volatility of the underlying share or certain expected impending news that may affect the price of the underlying share. This price may be different from the theoretical price. This is the price that
22 OptionsWise the market maker for that particular share is willing to trade at, regardless of where the theoretical price is. Hence, in order to maintain integrity, competitiveness and price tension in the provision of live option prices for market participants to trade in, the ASX usually appoints more than one market maker for each share, especially the larger market capitalised ones. For investors, this reinforces the point that whatever price one bases his strategies on, whether it be theoretical, on a 20-minute delay or refined theoretical, at the end of the day, the true price of the option is the price at which the market makers or other available participants are willing to trade at. All other prices can only be a guide. Overall, the existence of market makers gives option investors and traders alike the confidence to buy or sell any option they wish during trading hours, at a price that is agreeable to both parties. Summary of concepts: • Types—There are only two types of options, calls and puts • Underlying assets—Calls and puts have an inverse relationship to the value of the underlying asset • Option price—The main determinants of the price of options are intrinsic value, time value and volatility. • Live option prices are not always readily available, check OptionsWise website • Strike—Strike price is important in determining if an option is ITM (valuable) • Exercise—Early exercise is assigned randomly • Action—An investor can sell or write to initiate, open or start a trade
23 3 Protecting Portfolios Options can be a double-edged sword that can arm you or harm you. Options can be used to protect investors against a loss in portfolio value. They can also be used as an aggressive leveraging tool. To demonstrate the distinct difference between the two uses, this chapter is divided into two parts. Part A explores hedging strategies whilst Part B demonstrates how some of those same strategies can cease to be protective tools when misused or employed inappropriately. PART A HEDGING Hedging is the most benign use of options and is one weapon that non-option portfolio investors are not privy to. Options are used for hedging by a variety of investors, from the most risk averse to the most risk tolerant. So what is hedging? Hedging can be compared to taking out an insurance policy. Experience in life tells us that unfortunate events do occur, most often without warning. For peace of mind, we pay for insurance. As in everyday life, unpredictable and unforeseen events can affect investments. Sometimes the share market behaves in a way investors don’t anticipate. Perhaps it is disrupted by the outbreak of war or bird flu. Occasionally, intangible events like a change in hedging: a risk minimisation strategy that protects investors against losses
24 OptionsWise government monetary policies or a crisis in collaterised debt obligations cause the share market to lose billions of dollars. Risk-averse investors try to protect their portfolio of shares from such fluctuations in the market. More aggressive investors could use hedging to protect them against the market rising, to counteract their short positions as they may have bet on the market falling. Hedging is simply protection against losses and is useful for all investor types. The use of options is more prevalent in everyday investments than most people are aware. Options are used in capital guaranteed funds, which are marketed to conservative or risk-averse investors. Often the capital guarantee, or protection, offered by fund managers is available through the purchase of put options packaged as part of the fund. The more risk tolerant investor uses options in borrowings and some margin lenders package options together and sell them as protected loans. Options can be used by share investors in a direct share portfolio as well as in managed funds (in the case of Australian shares). Individuals who invest in a direct share portfolio generally have more flexibility than those who choose managed funds as they have a wider choice of protection and more control in terms of how, how long and how much they want to hedge. For a managed fund investor, undertaking hedging outside of the fund may be confined to the use of an Index option. collaterised debt obligations: securities that are exposed to the credit risk of a number of corporate borrowers short positions (shorting): strategy that involves selling shares then buying them back later, at a cheaper price capital guaranteed funds: a managed investment where the original capital invested and interest earned (if any) are locked in and not subject to market fluctuations margin lenders: companies that lend money to investors based on the value of their share portfolio protected loans: Lender buys put options on shares. Investors pay higher interest rate in compensation for not losing more than the loan amount
25 Protecting Portfolios Let’s have a closer look at the practical use of hedging with options by following Will’s experience. Will Will is a well-liked, experienced accountant, who has been practising for more than 30 years. He has spent the last 20 years building his own firm from a one man show to a consultancy with five full time accountants, 10 support staff and 200 clients. Will often recounts his humble beginnings to the apprentices who come through his door, describing how his parents migrated to Australia when he was three years old and how his father struggled to start a local corner store. He often mentions how he has worked hard since primary school when he helped his dad stack shelves and deliver groceries to neighbourhood customers. In Year 7, Will’s dad entrusted him with the store’s cash register and he was renown for being very quick and accurate with calculations. Will is a good mentor to the young, budding accountants and often advises his apprentices to “work hard, save smart and invest well”. The stock market has intrigued Will since he was a young working adult. His interest in the stock market piqued during the mining boom in the late sixties, but Will is very cautious and understands how hard it is to make money, so he would not jump into investing without due consideration. He sat on the sidelines watching the Poseidon bubble burst in 1970 and the bull market peak and burst in the 1980s. After years of studying the stock market, Will finally felt comfortable enough to invest when the Australian government began the privatisation process. He seized the opportunity to buy Commonwealth Bank of Australia shares through their initial Public Listing Offer in 1991. Will withdrew his first big cheque of $10,800 from his interest Index option: an option that derives its value from an Index. It cannot be exercised early and can only be settled in cash on expiry bull market: a rising market
26 OptionsWise bearing account to buy 2,000 Commonwealth Bank shares. That initial plunge saw Will on the road to a lifetime of investing and as his accounting business became more successful and his savings increased, Will invested more capital into the stock market. At the end of 2007, after almost two decades of investing, Will was sitting on a portfolio of $2.5 million worth of mostly blue chip shares, thanks to the privatisation process. He has come out of the tech bust fairly unscathed, as he resisted investing in high PE stocks, but Will did see his portfolio shrink on paper when markets tumbled during the Asian crisis. Will regards himself as a long-term investor who holds stocks and franking credits for their good dividend yield. Will takes profit on his stocks only occasionally if they prove to be too tempting or to reinvest into other stocks. Will is an accumulator and does not sell stocks unless they present fundamental negative changes. Like most investors, Will enjoyed very good double-digit returns on his stocks in the five-year bull run, which started in 2002. However, being an astute investor and a cautious accountant, as 2007 rolled on, he became more wary of the latest developments in the U.S. housing sector and sub-prime mortgages. He followed the developments of the credit-induced crisis in the US closely. One of the headlines that caught Will’s attention in late 2007 was the collapse of two of Bear Stearns’ hedge funds. Bear Stearns was one of the largest investment banks in the world and its share price once traded above 100USD. Negative returns on funds are ordinarily bad enough for a company’s reputation and business, but a full-blown collapse is a sign of great distress in the market. Soon, the distress that was rife in America traveled to the United Kingdom. Everyday Britons began queuing in front of Britain’s largest mortgage lender in Northern Rock to withdraw their deposits. After that, central banks around the world began price to earnings (PE) ratio: measures the number of times the market price covers the earnings of a share
27 Protecting Portfolios hurriedly injecting hundreds of billions of dollars into financial systems. In his years of investing, Will had never seen central banks so desperate to act, or give money away. The developments did not sit well with him. At this stage, Will’s portfolio was still sitting on good paper profits, though they were less impressive than before. However, a further downturn would reduce his paper profits even more. Will knew he should sell his shares in order to lock in his profits while he still could, but as an accountant, he was painfully aware of the potentially huge tax bill he would receive at the end of the financial year if he did so. Connor, one of Will’s apprentices, started working full-time for Will two years ago. With Will’s encouragement, Connor became a keen young investor and had started investing while still at University, using money earned from tutoring and contributions from his parents. During one of Will and Connor’s regular afternoon mentoring sessions, conversation drifted to the state of the US housing and financial market. Connor revealed that he had been introduced to an options course through a friend and had started using options to protect his portfolio. He had actually gained from the falling share prices, without selling his shares. Will was intrigued by this alternative way to gain from falling share prices, without selling his shares and without incurring capital gains tax (CGT). He got the information about the options course from Connor and spent the rest of the day conducting his own research. Will logged on to the ASX website and downloaded all the tutorials he could find on the basics of options, particularly hedging. He spent the next three months studying, attending courses and speaking with advisers who offered their expertise on option strategies. Will also used the applications on the OptionsWise capital gains tax: income tax calculated on the realised capital gains when assets are sold
28 OptionsWise website for estimates of option prices, an understanding of how certain strategies work in relation to required margins cover, usage of capital and the risk and reward evaluations of strategies. He is now ready to begin. Over the course of his research, Will learned six hedging strategies: 1 Buying (long) index put 2 Selling (short) index call 3 Buying specific share (protective) put 4 Selling specific share (covered) call 5 Portfolio hedging 6 Combination hedging Strategies 1 and 2 Buying or selling Index options Using these strategies for an investor will create a blanket cover. It doesn’t matter if the shares he or she holds drop, as long as the shares that make up the Index drop, the investor is covered. The Index that protects a portfolio of Australian shares is the ASX/S&P 200 Index, the ASX Code for which is XJO. The ASX/ S&P 200 Index consists of the top 200 listed Australian shares by market capitalisation. Market capitalisation is the value of a company as set by the stock market. This is calculated by multiplying the number of shares on issue for a company by the listed share price. The ASX/S&P 200 is the Index institutional investors use to benchmark the performance of their portfolios and is also where Index options derive their value. The Index represents almost 80 per cent of the market capitalisation of the Australian share market. There are two other Indices that have options issued over them. They are the ASX/S&P 50 Index (XFL) and the ASX/S&P A-REIT Index (XPJ). Taking XJO options as a blanket cover can be advantageous, and not just because it can be cheaper than having many specific
29 Protecting Portfolios covers. XJO options can be useful for an investor who is unsure of the performance of the individual shares that make up his portfolio or one who holds stocks outside of the top 200 listed shares, as there will be no specific equity options available for him to hedge. The purchase of the XJO options in these cases will provide some downside cushion for the overall portfolio. Index vs. share There are differences between hedging with the use of Indices and hedging with specific share options, commonly called equity options. These options have different properties and there are differences in how they function and are administered. These are tabulated below. Features Index Equities (specific shares) Expiry day Third Thursday of the month Last Thursday of the month Exercise style European (only at expiry) American (any time during option period) Settlement on exercise Cash only (pay or receive) Specific underlying share (buy or sell) Strikes Expressed in points Expressed in dollars Premiums Expressed in points. Multiplied by $10 per point to arrive at dollars Expressed in dollars Options Choices Three Indices only - XJO, XFL, XPJ More than 100 shares Table 1 Differences of index versus equity options
30 OptionsWise Strategies 3 and 4 Buying or selling specific share options Specific cover is useful for an investor who wants to protect particular shares in his portfolio. In this scenario, the investor is protected so long as the shares he holds fall, even if the overall Index rises. For an investor considering hedging with specific shares, he needs to decide which type he will use (call or put) and how he will invest (buy or sell). Call vs. put Let’s re-visit the call and put diagram. Remember from your earlier reading that a call appreciates if the underlying share price rises and a put appreciates if the underlying share price falls. If an investor thinks there is more potential bad news coming from the US housing sector, which will drive the share market down, he should invest in a put. Diagram 7 Protective put—Buying a put to limit losses from shares $ + – 0 1 3 2 Profit and Loss Underlying share price $ 1 Investor holds shares 2 Expects underlying share price to fall 3 Buys put options for protection 4 Put option increases in price and protects investor from loss of value in shares 4
31 Protecting Portfolios Now, what should an investor do if he doesn’t want to pay for protection and would prefer to earn an income and have protection at the same time? The reverse of a put is a call, so he should sell a call, covered by holding the underlying shares, in order to earn an income. Hence, to hedge against a specific share price falling, an investor can buy put options or sell call options on the underlying share. The buyer of protective put options pays for the privilege of limiting downside to his shares whilst benefiting from the unlimited upside from a share price. On the other hand, the seller of call options enjoys the privilege of receiving an income upfront at the expense of forgoing further upside from the appreciation of the share and the obligation to sell the underlying share, but at the same time accepting a limited downside protection. There are trade-offs in both. Which is better? $ + – 0 Profit and Loss 1 5 4 3 2 Underlying share price $ Diagram 8 Covered call—Investor sells call to protect from falling share price 1 Investor holds shares 2 Sells call and upside gains are capped 3 Investor receives premium income 4 Strategy offers limited protection 5 Investor is exposed to unlimited loss to a maximum of zero
32 OptionsWise In order to use either of these two strategies successfully, the investor first needs to ensure the pre-qualifying conditions for the respective strategies are met. See Table 2 below. Buy put Sell call Large drop expected Moderate weakness expected Cash flow is not a concern Cash flow is important Holds underlying share Holds underlying share Wants to hold on to underlying share Willing to sell underlying share Table 2 Pre-qualifying conditions of buying put versus selling call for hedging For the buyer of a protective put, if the underlying share (which he owns) is expected to fall sharply, the increase in the intrinsic value will compensate for the erosion of time value on the put and the loss in value of the share price. For a small outlay, a buyer can limit the downside from his shares and have unlimited protection whilst the underlying share falls in value. The maximum he will lose from this protection is the premium he has paid. A small outlay, which is potentially a small loss, protects the investor against a potentially huge loss in the value of his shares. However, predicting a huge fall in a share price within the specified option time frame is no easy task. It’s not uncommon for the investor’s expectation to eventuate after the expiry of the option. This is what normally happens to similar protective policies like warranties on products. Often products get spoilt once the warranty period runs out. On the other hand, the seller of a call option only expects the underlying share price to weaken moderately from the current peak. Selling a call option when the share price is high is like harnessing the highest value for the shares and locking them in. As time value is on the seller’s side, even if the share does not fall from the current
33 Protecting Portfolios peak, he will still gain from the option he has sold because of the loss of time value. If the investor’s expectation was wrong and the stock actually punches through the peak and reaches for another new high above its breakeven selling price (which is the call strike price plus the premium received), then the investor would have lost the opportunity to get a higher price for his shares. In the reverse situation, if the share falls sharply, selling a call option would not be an effective hedging strategy, as once the share falls through its breakeven protective price (which is the share price at the time of selling the calls minus the premium received), the investor will no longer be hedged against further losses (remember this strategy is only suitable for moderate weakness). A conventional way of calculating the breakeven protective price is to deduct the premium received from the purchase price. In this book, we will be deducting the call premium from the market price of the share at the time of selling the call. The advantage of using this method is that it allows an investor the opportunity to evaluate the call writing decision compared to one that is not hedged (without the option strategy). It also allows the investor to make a quick decision by basing his evaluation on the current price (we may not always have the cost price of a share at hand or remember what it is). To use the covered call strategy successfully, the pre-qualifying condition is for the underlying share price to refrain from moving up or down drastically. In addition to noting these pre-qualifying conditions, investors should be aware that selling a call option involves some risks that should be dealt with. When the pre-qualifying conditions are met and risks are managed up front, the covered call strategy is a very breakeven protective price: the price where the option strategy no longer protects the investor and places the investor in a similar position to a non-hedged position or investor
34 OptionsWise powerful income-generating tool for a portfolio investor. We will examine the risk management issues in the section below. Risks of hedging When an investor buys a put option for protection, there are “no strings attached” to the underlying share. The option will not cost him any more than the premium he has paid. If it was not called to usefulness (as the share did not fall in value over the life of the option contract), he would have lost the premium he paid only. However, if the share did fall, the put option would be ITM and he could sell the option for a profit. Alternatively, if he chooses to do so, the investor has the right to exercise the ITM put option to sell his shares at the strike price (which will be higher than the prevailing market price). On the other hand, when an investor sells a call for protection, there are obligations he needs to adhere to. Firstly, the covered call investor commits himself to delivering or selling the underlying shares should the buyer of the contract decide to exercise. This can occur at expiry or any time before expiry if the call option is ITM, that is, the underlying share is trading above the call strike price. The deeper the shares are ITM or the closer they are to expiry, the higher the risk of the calls being assigned. Another event that heightens the risk of early assignment is when the underlying share is close to going ex-dividend. The buyer of the call option contract would like to buy the underlying share before it goes ex-dividend in order to have access to the dividend and franking credit (especially if it is a high dividend and franking credit paying share). To reduce the risk of being assigned early to deliver his shares, a covered call investor should avoid selling calls ITM and at the month of the share going ex-dividend. More importantly, if an investor does not intend to sell his shares, he should avoid this strategy altogether though the income potential can be tempting. The best defence for the risk of early assignment is to be fully covered during
35 Protecting Portfolios the life of the option. To be fully covered, it is good discipline for the investor to check the number of shares per contract (SPC) of the particular option series before executing the trade. The general SPC convention for options is for 1,000 underlying shares per option contract, but this can vary from share to share and even for the same share from month to month. ASX will undertake adjustments either to a company’s strike price and/or its contract size (SPC) when the company undergoes corporate actions, like mergers and acquisitions, or capital management, like rights or bonus issues. Share purchase plans (SPP) can be used by companies to raise more money from their existing shareholders by offering them discounts or incentives to buy extra shares. In the first half of 2009, many companies undertook the sale of additional shares to existing shareholders at a discounted price through SPPs and rights issue to re-capitalise their balance sheet strength after the GFC. Investors who did not participate in the capital raising (by taking up their entitlement to the additional new shares) would have found themselves under-covered in some situations, as the SPC and strike prices of those companies went through adjustments. Even whilst an investor is in the covered call position, he still needs to be aware if he is fully covered until the option expires. Rio Tinto was involved in capital raising through renounceable rights issue (where rights are tradable on the market) in June 2009, and this is a case in point. The rights issue offered shareholders 21 new shares for every 40 existing shares at a subscription price of $28.29 per new ordinary share. RIO, which closed at $73.23 was adjusted after it traded ex-rights to a price of $57.8857 the rights issue: undertaken by listed companies to raise additional capital by issuing new shares to shareholders in proportion to their existing shareholding. Rights can be tradable on the market (if they are renounceable) for shareholders who do not wish to take up or pay for additional shares in the company. Rights that at are not tradable (nonrenounceable) will be lost if not taken up