OptionsWise how to invest sensibly

86 OptionsWise During the few weekends he can take a break, Dr Alfred enjoys taking his family on holidays. Every year Dr Alfred’s family goes on a skiing holiday and the trip has become a favourite tradition. During one of these ski trips, Dr Alfred looked at his teenage sons and realised how much they had grown while he had been busy working. He decided he wanted to reduce his working hours to spend more time with his family and pursue other interests. Dr Alfred’s practice is always busy and he has been earning a good income from it. Dr Alfred is interested in investing, but he has never had enough time to do it. He has previously delegated this job to his accountant and fund managers. However, Dr Alfred realises his earning capacity will peak in the next decade and he would like to take more control of his investments to ensure he is financially secure and prepared for his retirement. The performance of Dr Alfred’s super fund had been ordinary, and the global financial downturn in the past two years has seen his investment fund suffer. He is a prudent investor who is willing to take calculated risks. He is looking for an investment style that will afford him a consistent income and steady returns, without the complications that will distract him from his practice. Dr Alfred sets out to discover some alternative investment opportunities and speaks to his peers who take an active approach to their investments. Dr Alfred is attracted to the idea of using options as part of a portfolio to create an income stream and to have some certainty and control in his investments. He is introduced to Ed, a financial adviser. Ed’s first task is to help Dr Alfred invest the $200,000 cash he realised from his super fund portfolio. Dr Alfred would like to try to use options to buy shares. These are the portfolio building strategies available when buying shares: 1 Buy share with protective put 2 Buy call options to buy shares 3 Sell put options to buy shares

87 Building Portfolios 4 Buy shares and short put 5 Buy write 6 Synthetic long Let’s have a detailed look at the strategies. Strategy 1 Buy share with protective put This strategy is the most straightforward; buy the underlying shares but hedge the downside by buying put options. This strategy was elaborated under the hedging section. Buying a share with a protective put gives peace of mind with a limited downside and is the most riskbenign. If the share price rises after the purchase price, the investor will still gain but the insurance (put) bought will expire worthless and will make the purchase of shares more expensive. The breakeven price for the investor (the price of the underlying asset at which he starts to gain) is the purchase price of the share plus the cost spent on the premium. Underlying share price Profit and Loss $ + – 0 $ 2 1 Breakeven price 1 Investor buys share and enjoys unlimited upside 2 Also buys put to benefit from limited downside Diagram 15 Buying share with protective put

88 OptionsWise Strategy 2 Buy calls to buy shares This strategy yields the most benefits when the share price appreciates strongly. Buying call options gives the buyer the right to exercise the option as it becomes ITM. The buyer can purchase the underlying share at the lower strike price, whilst the share is trading at a much higher price on market. If the investor is very confident of the strong appreciation of a share, he can buy an OTM call, thus paying less for it now with the option of converting to a highly appreciated share later. The breakeven price for the investor who buys a call (in the event that he exercises the call to purchase the share) is the call strike plus the premium paid. Buying call options to buy shares has its trade-offs. Advantages of this strategy: • Allows the investor the opportunity to stall on spending the full amount of the share purchase price and the cash can be deposited in a high yielding bank account to earn interest. Underlying share price Call option price $ + – 0 $ 1 2 Breakeven price 1 Investor buys call option 2 Investor entitled to exercise to own underlying share if share price rises above breakeven price Diagram 16 Buying call options to buy shares

89 Building Portfolios • Investor need only commit a small initial outlay to have exposure to the underlying share. • Buys time for investor to make a decision later. He can change his mind and not purchase the share at expiry if circumstances have changed (in terms of the investor or the share). • Allows the investor the opportunity to exercise the option to buy the underlying share just before it goes ex-dividend, especially options with franking credits attached. • If the share price drops dramatically, only a small amount of capital is at risk. Disadvantages of this strategy: • Presents the possibility of losing the whole premium if the option expires OTM (if the share price fails to appreciate above the strike). • The buyer of the option is pitted against time, so the appreciation in share price needs to be greater than the erosion of time before the investor can benefit. A small appreciation in share price may not be enough to offset the erosion of time. • Buying a call to buy shares will increase the purchase price (strike price + call premium) if the call is ATM with the market price at the time of purchase. Strategy 3 Sell puts to buy shares If an investor thinks a share price will rise, he can buy a call. However, if he wants to receive cash instead of paying cash and accepts the possibility of not being successful in his objective to purchase the shares, he can sell puts on the underlying shares. This is depicted in diagram 17 on the next page. The desires of the writer can be managed using the strike of the put. An OTM short put option is a lower risk option. The investor has a lower chance of being assigned to purchase the shares and receives a lower amount of income from the premium. On

90 OptionsWise the other hand, a higher risk ITM short put position will return a higher premium and the investor has a higher chance of purchasing the shares. In addition, if assigned, the ITM put investor will usually purchase the shares at a higher strike/purchase price than the OTM put. The short put strategy has advantages and disadvantages. On one hand, the investor will receive an income from the put and he will pay a lower purchase price when assigned than if he bought the shares outright. He has time on his side, so it does not matter when he will be successful. Even if his objective is not achieved, he will still be better off with the receipt of the income. The only disadvantage of this strategy is that the right to purchase the share does not lie with the seller. It is quite common for the seller of a put to lose the opportunity to purchase shares that have Diagram 17 Selling put to buy shares 1 3 2 Underlying share price Put option price $ + – 0 $ 1 Investor has a long exposure to the underlying share 2 Receives income from the strategy 3 In compensation for a capped upside and no guarantee of share ownership

91 Building Portfolios appreciated strongly in value because he generally obtains the put to buy the shares when the shares are weak. This disadvantage can be overcome if an investor chooses not to embark on this strategy if a share is expected to fall sharply or rise sharply. In a sharp fall scenario, the investor should hold off selling the puts until the share price stabilises and establishes a support level from which it has a chance to rise. In a sharp rise scenario, an investor should sell a more ITM put or complement the short put strategy by buying a call, as he will have the right to buy the shares and the premium for the put will reduce his purchase price. This becomes a synthetic long strategy which is the sixth strategy touched on below. Investors who select the short put strategy have a number of obligations to fulfill and should put a number of risk management strategies in place. The seller is obligated to meet the ASX requirement to place a percentage of margins with the ACH as part of the deposit for the possible purchase. For a super fund or other non-super investors who are reserving the cash for the purchase of the underlying shares anyway, this requirement is not an issue. The margins will always be a fraction of the total potential exposure and will always be met with the reservation of cash. Reserved cash is normally parked in a bank account like a cash management account where it is on call 24 hours a day and yields a higher interest rate than a normal savings account. Cash reservation is a very important risk management tool and is often the difference between an investor who is in control and an investor who buckles under the pressure of a margin explosion when share prices fall. The seller of a put should make a cash reservation that is equal to the total potential exposure to the underlying share. This is calculated by multiplying the number of put contracts sold by the strike price of the put. There is no leverage in this strategy and the investor will be in control throughout the term of the option. This is the best defence for a seller of put options.

92 OptionsWise Eligible collateral In addition to cash, there are other, less ideal ways, from a risk management perspective, of meeting margin obligations. However, by offering eligible collateral, the investor has leverage and a better use of share values. This is a trade-off that investors need to be clear about. Margin requirements on any short option positions (calls or puts) can be met with cash or with the lodgment of other acceptable collateral. Most of the shares in the ASX/S&P 200 Index and some other specific shares are acceptable collateral and can be lodged with the ACH to meet margin requirements for the sale of any option positions. Some major stocks like banks, BHP and RIO can have up to 80 per cent of their value lodged as collateral. Most other eligible shares offer investors 70 per cent of their current market value for collateral cover. The ACH holds between 20 and 30 per cent of the market value of each share as a haircut. The list of acceptable collateral, with their respective haircuts, can be found on the ASX website. Lodgement of other shares as collateral can enhance the bullets in an investor’s armory, but if not managed carefully this can be a weapon that backfires. This “bullet” is one of the strengths of the use of options over a portfolio of shares—making use of the otherwise dormant value of a share portfolio. By lodging other shares as collateral, investors can earn an income stream, without having to wait for a dividend to be paid every six months. However, if an investor uses his share portfolio as collateral for his shortterm options in order to earn an income, he must first consider the dangers in exposing his short option obligations. There are many dangers in using a share portfolio to support the underlying buying obligations of a short put position. For example: haircut: a reduction in the market value of a share lodged as margin cover

93 Building Portfolios • The value of a share portfolio changes dynamically. This means the eligible collateral value that is derived from a portfolio of shares changes daily. The danger is doubled if the underlying share of the sold put option is also one of the shares in the portfolio. A fall in the underlying share would render a higher margin requirement on the put position, whilst the collateral value derived from the share (held in the portfolio) now yields a lesser value. An investor in this situation will experience a doubling effect of margin escalation in his option position. • The timing of buying the shares is not in the hands of the seller, so when he is assigned, the shares in his portfolio may have fallen (especially in a bear market where there is overall weakness in most shares). The sale of his shares, which may have been sufficient to fund the purchase at the time of the option trade, will no longer be enough. The investor will be short. This can be more easily grasped if one understands the concept of margin interval percentage and its effect on underlying shares. Margin interval percentage An option writer who uses his share portfolio to cover his short options can be caught short if there is an increase in margin interval percentage (MIP). A share is given a MIP by the ASX according to the amount of risk margin required for a short position. It is important to note that the MIP of any share can be changed by the ASX at any time and is effective immediately. Ad hoc changes within the designated quarterly review period can occur when a share is particularly volatile. During the peak of the global financial crisis in 2008, some shares fell 20 to 30 per cent in a day and this volatility played havoc with the MIPs of these shares. The margin escalation was margin interval percentage: measures the lowest and highest intra-day movement of a share in terms of percentage

94 OptionsWise catastrophic for traders who had covered their short put positions with other shares as well as for those who were not fully covered. Newcrest Mining (NCM) was one of the many shares that experienced a dramatic increase in MIPs at the peak of the credit crunch. In early July 2008, NCM was trading at around $29, with a MIP of 16 per cent. The MIP of NCM had a few increases in the months following, but by the third week of October 2008, NCM had fallen to around $17 and its MIP has increased to 36 per cent. While this change represents just a 20 per cent increase in the MIP, its resulting increase in risk margins is dramatic. A trader with a short six-month NCM put in July 2008 would have been required to cover a total risk margin payment of $1,600 per contract. By October 2008, after a $12 or 40 per cent fall on the share price, the risk margin on this short put position had widened to just under $16,000 per contract, due to the increase in MIP (and volatility). That’s an exponential increase of 900 per cent from the start of the trade in July, three months prior. This is leverage gone badly, and it works against the trader. But wait, there’s more. If this trader was also using the NCM shares he owned to meet the margin cover on the NCM short put position, he would have suffered a double whammy and been substantially short in October, due to the drop in the collateral value of his NCM shares as well as the increase in the demand for margin cover. This is how it happened. With a 30 per cent haircut on the share (at $29), 1,000 NCM shares lodged in July 2008 covered around $20,000 worth of margins, which was more than enough for the requirement of $1,600 for one short put. However, by late October of that year, with NCM stocks trading at around $17, these 1,000 shares had a collateral value of just $12,000, which was no longer sufficient to meet the margin requirement of $16,000 per short put position. What could a trader in this situation do? He could stump up more cash and fill the $4,000 shortage with other savings or he could

95 Building Portfolios lodge more shares to make up the cover. Most often, when there is general weakness in the overall market, a trader in this situation is either cash-strapped or has run out of cash reserves anyway. The pressure to cover the margin requirement is made more urgent as margin shortage must be covered within one business day, or in some cases, on the same day as the shortage occurs. Failing to cover the margin shortage may result in the position being closed off and the trader may be forced to realise a loss, possibly when the share is at its least valuable and most volatile. This is a situation every investor should avoid. This trader has lost control. These are some of the defence strategies for margin escalation for a short put position: i The best defence to counter the danger of margin escalation is full cash cover. This is sometimes more of a discipline issue than it is a financial one. Investors should only undertake gearing they are prepared for. The reservation of enough cash to purchase the underlying share in the event of it being assigned will always be more than sufficient to meet any margin escalation, as the maximum required would be the amount needed to purchase the underlying share. ii Lodge other shares (other than the one the put is shorted on) as collateral. Applying the diversification convention to collateral cover is good practice. Shares from other sectors may act as a counter-play in value. For example, resource and financial companies tend to have an inverse correlation. The drop in collateral value in one (resource share) can be compensated by the increase of another (bank share) in the portfolio. iii Create a limit for margin cover by hedging. Buy a put to protect a short put and limit the margin cover required. iv Close early if the short put becomes profitable. Despite the extra transaction costs required and the fact that investors

96 OptionsWise have to sacrifice a portion of the maximum profit already obtained when closing a short position, there will be occasions where it is still more prudent to close the short position early. Some of these occasions are: • If there is a long period before expiry and the premium has reduced to a fraction of the initial income earned. • If the share has appreciated strongly due to some positive announcement or pre ex-dividend and the premium is now a fraction of the initial income earned. The benefit of locking in a profit early outweighs the risk of holding on to a position even where one is obliged to pay cash, especially if it’s only a small outlay to lock in. Though this is a superior choice and should be a default strategy, it is often overlooked by investors. It is a common tendency to let stocks (and option positions) be, to go with the flow and not act, even when profits are available for the taking. These comments are common, “The share price is way above the strike, it’s not possible for the share to fall back to the strike,” and “I have earned almost all the income, there’s only one week left, I should be okay”. Whether or not an investor will be okay is not within his control and he has no say in whether the option will expire to his advantage. The outcome could go either way, unless the investor locks in his profits. The aversion trap This trap can be explained by a bias psychologists call the loss aversion bias. Kahneman and Tversky explain, “the aggravation that one experiences in losing a sum of money appears to be greater than the pleasure associated with gaining the same amount.”12 A loss is twice as painful as a gain. For option sellers, this sense of not being able to let go is very real and intensely felt. This is because the option has been earning the seller a regular income and forking out money to close out (or

97 Building Portfolios buy back) the position later seems like the seller is giving up the money he earned. This can feel like a loss. The emotion associated with this “loss” can seem very intense compared to the forgone gain (of a profit which is not locked in). Remember this trap when you next encounter the opportunity to close early for profit, especially if it’s a substantial one. This strategy of closing early to lock in profits is a conservative one and is recommended because it is common for stocks to peak during the life of the option only to fall back to, or even below, the strike of the put at expiry. Let’s recap the features of buying calls versus selling puts. Option strategies Buy call Sell (short) put Pre-qualifying conditions Large increase expected Need to act soon Moderate to steady increase expected Time is not an issue Receipt of dividend income No, unless investor exercises to buy shares before ex-dividend date No, unless assigned to buy shares before ex-dividend date Purchase of shares Has the choice to exercise to buy underlying shares No choice, but willing to buy underlying shares Cash flow Pays Receives cash Margin requirement No strings attached Need to put up margins, which change daily with share price Purchase price Increases purchase price of shares with premium paid Reduces purchase price with premium, if assigned to buy Maximum loss Limited to premium paid Unlimited, until share reaches zero At expiry Profitable if ITM, need to sell to realise profits, otherwise exercise to buy shares Profitable if OTM, but no need to act, expires worthless Table 16 Summary of buying call and selling put

98 OptionsWise Strategy 4 Buy shares and short put This is a variation of the short put strategy. It involves the simultaneous buying of shares and selling of puts. Buying some shares will guarantee ownership and if the put expires worthless, it will reduce the purchase price of the shares. This is depicted in diagram 18 on the next page. Strategy 5 Buy write Buy write is a strategy that involves buying shares and simultaneously selling or writing call options over the underlying shares. This strategy has the advantage of reducing the purchase price of the shares (if not assigned on the call option at expiry) and providing mild protection from a moderate fall in the share price (to the purchase price deducting the premium received). For these benefits, the investor is willing to forgo upside beyond what he will sell his shares for (if assigned when the option is ITM). This upside cap he places on the shares is the strike price of call option plus the premium received. This is depicted in diagram 19 on the next page. The buy write strategy will work successfully in an environment where the underlying share is mildly positive. It is particularly powerful when used around a share that is about to go exdividend. The buy write strategy works well for an investor who wants a dividend play, where he buys the underlying share for the dividend (which is more attractive if it is a high dividend and fully franked share) and sells a call to lock in an upside sale price at which he is willing to sell his shares. He would at least sell an ATM call, if not an ITM call. The expiry date of the option is selected to be after the dividend date. This strategy gives the investor some certainty of reward and risk as well as an idea of the length of time he needs to allocate resources to a particular strategy.

99 Building Portfolios 1 Underlying share price $ $ + – 0 Profit and Loss 1 Lower purchase price than if the shares had been bought outright Diagram 18 Buying shares and selling puts 1 3 2 Underlying share price $ $ + – 0 Profit and Loss 1 Strategy guarantees share ownership 2 Upside capped 3 Lowers purchase price and provides mild downside protection Diagram 19 Buying shares and writing call options

100 OptionsWise The disadvantage of this strategy is that the downside protection is mild. If the underlying share falls sharply after ex-dividend or if there is an unexpected sharp fall in the share price due to negative news, the investor is not protected beyond the breakeven price of the purchase price of the share minus the premium received. In order to use these option strategies successfully, it is important that the relevant pre-qualifying conditions are met. Investors should avoid the temptation to use one strategy as a blanket cover for all shares and market conditions. Strategies are not magic pills, certain conditions need to be met and risks need to be managed in order to use them successfully. One of the considerations of the buy write strategy that investors must be aware of is the margin requirements. Following the buy write trade, there is a two day window in which the margin requirement on the sale of the call option must be covered by means other than the underlying shares, such as cash or other eligible shares. This is because the investor does not own the underlying shares until they are settled on the third business day after the trade and the shares can only be used as collateral on the fourth business day. Strategy 6 Synthetic long The synthetic long is the strategy to be used when the investor is very bullish or positive about the underlying shares. This strategy involves the simultaneous buying of calls and selling of puts, for either a debit or credit net income depending on the desires of the investor. It replicates the position of a shareholder without requiring the investor to own the share. A synthetic long investor experiences a similar exposure to a shareholder, but he does not have the rights to dividends or voting. This is depicted in diagram 20 on the next page. There are two ways in which an investor can use this strategy. In the first scenario, the investor wants to buy the underlying share as it is expected to appreciate strongly, but in order to have leverage,

101 Building Portfolios he buys a call option to delay the purchase of the share, perhaps until it is near to the ex-dividend date. The investor can exercise his rights at any time and can defer spending cash and also defer the decision to purchase the shares. In order to defray some of the cost of buying the call, the investor sells a put option, but it will most likely be OTM as he hopes for it to expire worthless. The put option is a cost saving or cash flow consideration. The alternative is for the investor to buy the underlying shares by selling the put, as it is likely to be ATM or ITM. Just in case he misses out if the share price rises strongly, he also buys a call to guarantee his purchase. The call is most likely OTM to keep this insurance cost low. This strategy will only work when there is a strong appreciation in the share price. 1 or 2 Underlying share price $ $ + – 0 Profit and Loss 1 Breakeven point (purchase price of underlying shares) is higher than price of buying shares outright if the investor paid for constructing the strategy (net debit premium) 2 The breakeven point is lower than the price of buying shares outright if the investor has received a net credit income Diagram 20 Synthetic long

102 OptionsWise If the share price drops, it would be a very costly mistake for the investor to use the synthetic long strategy. In this instance, the investor will lose money on the call option he bought, as it will expire worthless or lose value because of the simultaneous drop in the share price and the erosion of time. Should the share price fall below the put strike price, the investor’s position will worsen, as he will also be obligated to buy the underlying share at the strike price which is now higher than the market price or the price at the time of entering into the strategy (of a net debit synthetic long). The investor will end up buying a “losing” share (on paper). To reduce the risk of this occurring, a split can be achieved by selling the put option OTM, at a lower strike (to reduce the investor’s risk of buying the share at a high price). In addition, a higher strike on the call can be purchased to lower costs and give the investor exposure to the stock just in case it rises too strongly. It will also give the investor another chance at buying the share if he cannot exercise to buy the share at the lower put strike. A trader with a bullish view can put a more aggressive version of this strategy into place by choosing ITM strikes, higher on the put and lower on the call. In this case, the purpose of the ITM put is to defray cost while the ITM call (with a higher Delta) allows for greater appreciation of the stock. This way, there is a higher likelihood of setting this trade up as a credit at the start and receiving income while at the same time getting an unlimited upside potential. An aggressive trader who uses this strategy is likely to be looking for a double whammy on a share with a positive uptrend. He will be hoping to gain from the depreciation of the put and the appreciation of the call when the share rises. This high-risk trader is using this strategy for leverage, to take a view without much cash outlay. He is unlikely to reserve the cash required to buy up the shares in the event of being assigned on the put option.

103 Building Portfolios Rather than waiting to be assigned, this trader would be more likely to close out the put position by buying it back before he is assigned, or, if already assigned, he will most likely sell the assigned shares instead of holding on to them. For the portfolio investor who uses this strategy to purchase shares when the market trend is bullish, a key risk mitigation strategy is the choice of the put strike. The put strike should be set at the price at which the investor wants to buy the underlying shares. Hence, the put strike tends to be low, while the call, a safeguard in case the share price rises dramatically, tends to have a high strike price to keep costs down. Both put and call tend to be at OTM strikes. The investor is sacrificing some income upfront by purchasing a call to lower the risk of not being able to buy the share from the put, should the underlying share appreciate strongly. If the share does appreciate, the investor can exercise the call option to buy the underlying share using the cash he reserved for this purpose. The synthetic long can be an effective strategy for purchasing shares, but the investor needs to be clear in his intentions and operating strategy. Even though the split strike strategies can somewhat reduce the risk involved, the synthetic long strategy is not suitable for a conservative investor as it presents no downside protection. Let’s take a look at how Dr Alfred used these option strategies to buy shares for his super fund. Dr Alfred’s portfolio building strategy There are two shares Dr Alfred is eyeing to buy for his superfund; Woolworths Limited (WOW) and National Australia Bank (NAB). Before he can decide on a suitable option strategy for the shares, Dr Alfred must establish his expectation of their performance over the next six to twelve months. Dr Alfred discusses this at length with his adviser Ed and they conclude the following.

104 OptionsWise Woolworths is, and will continue to be, a defensive share and is expected to weather the financial storm better than other shares. WOW is likely to remain stable in the months to come. Dr Alfred hopes to pick up NAB shares as they have been hit hard by the financial crisis and there is a chance that bank shares have hit a bottom, especially since NAB has fallen 40 per cent from its peak. In order to determine which option strategies are most appropriate for Dr Alfred, he must consider dividend amounts and ex-dividend dates. It is predicted that WOW will go ex-dividend in early September with 48 cents. NAB is not expected to go ex-dividend until November. At the current price of $26.20 for WOW, the expected yield on WOW is 1.8 per cent (48 cents/$26.20). Hence, the option strategy for WOW should incorporate the opportunity to receive the dividend in order to further boost portfolio income. If these shares are bought after they go ex-dividend, the investor will have to wait another six months before the next payment. The best way to ensure the entitlement to the dividend is by owning the shares. The next best way to increase the chance of purchasing shares is to sell ITM puts. The benefit is that the investor can be assigned anytime before expiry, especially if the put goes deeper ITM (if the share falls further) and will receive a higher premium for the ITM put. Of course, there is no guarantee that one will be able to purchase shares using this strategy because the right to exercise shares belongs to the buyer. As the dividend on WOW is only 1.8 per cent, Dr Alfred is willing to take a risk with the purchase. He will sell an ITM put for a higher premium to compensate for the dividend if he is not assigned to buy the shares. The NAB dividends are not due until mid-November, so Dr Alfred can take his time. He has no immediate need to own the

105 Building Portfolios shares, but he wants to ensure he has some insurance towards owning them. He decides to buy an October call. This gives him the right to exercise his call in October and he will be entitled to the dividend in November. This strategy will only work if the NAB shares appreciate strongly and it is then worthwhile to exercise the ITM call. To help him defray the cost of the purchase, Dr Alfred will sell puts ATM, affording him another chance to purchase the shares and earn some income at the same time. To purchase WOW and NAB, Dr Alfred will sell ITM puts in WOW for the expiry month of August and buy October expiry calls in NAB with a bullish view. In addition, he will sell NAB puts for October expiry to lower the cost of the calls and to gain the opportunity to purchase the shares. Strategy planning for WOW shares Option strategy Selling ITM puts Pre-qualifying condition Bullish Receipt of dividend income No, if not assigned before ex-date. Yes, if assigned before ex-date. 1.8 per cent for six months Purchase of shares Possibility, investor only gains the opportunity to, not the right to Cash flow Positive, from higher intrinsic value and built-in dividend Margins requirement Yes Purchase price (if assigned) Lower than current price (current price - premium received) Maximum loss Unlimited At expiry If ITM, buy shares If OTM, maximum profit from premium Table 16 Selling ITM puts

106 OptionsWise By selling ITM puts in August, Dr Alfred not only increases his chance of purchasing shares, he also pushes buying to the last possible date, 27 August, the August expiry date (if not assigned earlier). The delay in spending cash increases the interest earned (3 per cent, or 0.25 per cent per month) on the cash in the cash management accounts, yet he is still entitled to earn the 48 cent dividend in early September, if assigned. What if Dr Alfred wants to increase the premium income by selling September puts? Firstly, for options of the same strike price, a put for a closer month (which is August) will stand a better chance of being assigned than one for a later month (September or beyond). Secondly, by selling September puts, Dr Alfred runs the risk of being assigned to buy the shares only after the shares have gone ex-dividend. This may be magnified by the fact that share prices fall to adjust for the ex-dividend and if the fall is more than the dividend amount, put prices increase accordingly as does the risk of assignment. In this scenario, Dr Alfred would not achieve his purpose of earning the dividend income. Below are the prices for some of the WOW put options for the August expiry at WOW current price of $26.20. Security Code* Description Price Premium per contract Delta WOWJV7 August 2009 $26 put $0.42 $420 -0.41 WOWJX7 August 2009 $26.50 put $0.65 $650 -0.57 WOWJI7 August 2009 $27 put $1.00 $1,000 -0.72 Table 17 Premiums for selected WOW puts * The ASX stock code of the underlying company makes up the first three letters of the security code and the last three letter-numeral combination denotes the particular option series. Each option series (across shares) has a unique security code.

107 Building Portfolios Cash Flow Dr Alfred has decided to sell the ITM $27 put. For a $100,000 allocation of cash to the purchase of WOW shares, he can sell a maximum of three contracts ($100,000/$27 per share = 3,703 shares, rounded down to 3). The premium income from this sale is $3,000 (before costs). Margins Margins will be required for this short put position. As Dr Alfred will be reserving the full amount of cash required for this trade, the margins will always be met until the option expires. However, it is still good practice for the investor to be aware of the amount of margins required for each trade before execution (this will be the actual amount debited from his bank account held with the stock broking firm he is trading with) to meet the margin requirement. Margins can be estimated using the ASX website where they are featured under the tab marked “Margin Estimator” or on the OptionsWise website Margin/Risk Analyser page. The margins requirement estimated for the sale of three WOW August 2009 puts valued at $27 is around $5,600. This total margin of $5,600 is made up of the premium margin of $3,000 (which he already received) and a risk margin of $2,600. The amount of $2,600 will be debited from Dr Alfred’s bank account and, together with the $3,000 already earned, will be used to fund the margins. This total margin figure changes every day. When the WOW shares go up, the premium and risk margins on the short put will go down and Dr Alfred’s bank account will be credited with excess margins. If the WOW shares drop the following day, this will render the margins in shortage and Dr Alfred’s bank account will be debited. This is an automatic process that takes place daily and is administered by Dr Alfred’s broking firm.

108 OptionsWise Dr Alfred is emailed daily reports that keep him up-to-date on his financial position. He is not required to act until the expiry date, unless he chooses to close his position early or is assigned by the buyer. At Expiry If WOW closes under $27 at expiry, Dr Alfred will have been successful in his strategy to purchase 3,000 WOW shares. He will be able to do this at the discounted price of $26 ($27 strike - $1 premium) and a few days later, he will be entitled to the 48 cent dividend. If WOW closes above $27, Dr Alfred will not have been successful in the purchase of the WOW shares. He can either choose to go through with the purchase on market (at the prevailing price) or choose to buy a different share with the $3,000 income earned. In order to circumvent the second scenario, where the share has appreciated above the $27 strike and Dr Alfred is disappointed because he cannot buy the shares, he can act in one of two ways. He can initiate the buy write strategy, or he can commence a variation on the first strategy; buy some shares now and simultaneously short put on the balance. If he uses the buy write strategy, Dr Alfred’s cash flow will be negative to begin with. Buying 3,000 WOW shares at $26.20 each will cost $78,600 (gross). If Dr Alfred chooses the call level of $27.50 in September 2009, he will be receiving about 20 cents for each contract. With three contracts, he will be receiving $600 and reducing the purchase costs to $78,000. Dr Alfred’s maximum gain using this strategy is capped at $1.50 per share ($27.50 call strike + 0.20 premium - $26.20 purchase price) at a return of 5.7 per cent before dividend. Adding the dividend will bring the return to 7.5 per cent (return of 5.7 per cent + dividend of 1.8 per cent) in two months or 45 per cent in

109 Building Portfolios one year. This scenario will only eventuate if WOW is strong and appreciates above $27.50 at September expiry. If the sale of shares is not possible, Dr Alfred will have successfully used the buy write strategy to purchase 3,000 WOW shares at $26 (after the receipt of a 20 cent premium income on each share) instead of the market price of $26.20. Option strategy Buy write Pre-qualifying condition Mildly bullish Receipt of dividend income Yes, locked in Purchase of shares Yes, at current market price Cash flow Negative Margins requirement Yes, for two days after purchase No, after settlement and lodgment of shares Purchase price Lower than current market price (current price - premium received) Maximum loss Unlimited At expiry If call ITM, sell shares If call OTM, lowered entry price Table 18 Buy Write The third possibility, of buying shares and shorting puts at the same time, is explained below. Dr Alfred is willing to spend $26,200 now to purchase 1,000 shares and simultaneously sell two August $27 puts for $1.00. He is cash flow negative at the start with a cost of $24,200 (purchase of 1,000 shares * $26.20 each - $2,000 premium for two contracts of puts). Margins will be required on the two short put contracts. Dr Alfred is guaranteed only $480 worth of dividend.

110 OptionsWise At Expiry If WOW finishes above $27 at August expiry, Dr Alfred will have successfully purchased 1,000 (still 2,000 short) shares in WOW at a price of $24.20 (the purchase price is lowered by the $2,000 premium income received). If WOW finishes below $27 at August expiry, Dr Alfred will be buying 2,000 more WOW shares at $26 ($27 strike - $1 premium). His overall purchase price for 3,000 WOW shares will be $26.07 (1,000 * $26.20 + 2,000 * $26), slightly higher than if he had bought all 3,000 from the short puts, but lower than if he had purchased all 3,000 outright. The choice of strategy depends on Dr Alfred’s cash flow requirements at the beginning of the strategy (that is, if he is willing to spend the cash upfront or if he prefers to wait), how much he desires the underlying shares and if he wants to cap the upside from the shares. The three possible strategies in the purchase of 3,000 WOW shares are summarised in table 19. Strategy Initial cash flow Share purchase price Upside cap Dividend Sell three ITM August 2009 $27 puts $3,000 cr $26 No, if assigned. Yes, capped to premium if not assigned Only if assigned Buy write three September 2009 $27.50 calls $78,000 dr $26 $27.70 per share Yes Buy 1,000 shares and sell two August 2009 $27 puts $24,200 dr $24.20 for 1,000 or $26.07 for 3,000 None Yes, for 1,000. Maybe, for balance of 2,000 shares Table 19 Comparison of three share purchasing strategies

111 Building Portfolios Strategy planning for NAB shares The first objective Dr Alfred will try to achieve with the NAB shares is to delay buying the shares, however, he does want a foot in the door in case the shares appreciate strongly from the current price. Deferring is important for two reasons, firstly, because it means there will be no dividend payment until November (which is four months away) and secondly, because he can change his mind about NAB in four months’ time. Dr Alfred remembers reading a quote by Ronald Howard in which he says an option affords us at least the possibility of adjusting our decisions in the light of experience13 and the opportunity to gain information before acting.14 This is exactly what Dr Alfred intends to do. With the use of options, he can limit his cash spend on the strategy and retain the option of re-considering at a later date. NAB’s current share price is $22.50 and the following table shows the premiums of its October 2009 puts. Dr Alfred chooses this month to study because he wants to buy the NAB shares before they go ex-dividend in November. Security code Description Price Premium per contract Delta NABYB7 October 2009 $22 put $0.85 $850 -0.38 NABYD7 October 2009 $22.50 put $1.10 $1,100 -0.45 NABYF7 October 2009 $23 put $1.35 $1,350 -0.52 Table 20 Premiums for selected NAB October puts Dr Alfred intends to sell the $22.50 ATM puts to give himself close to a 50 per cent chance of acquiring the shares (Delta of -0.45). At $22.50 and an allocation of $100,000 to NAB, he can only sell a maximum of four contracts ($100,000 reserves/$22.50).

112 OptionsWise However, if he is considering purchasing calls to ensure he gets the shares, he will have to cater for that as well. Table 21 shows the premiums for selected NAB October 2009 calls. Security code Description Price Premium per contract Delta NABYB7 October 2009 $22.50 call $1.20 $1,200 0.56 NABYD7 October 2009 $23 call $0.95 $950 0.49 NABYF7 October 2009 $23.50 call $0.70 $700 0.42 Table 21 Premiums for selected NAB October 2009 calls With premiums for the OTM $23.50 call at 70 cents, buying these will enable him to achieve a credit at the start if he sells two ATM $22.50 puts and buys two OTM $23.50 calls. This will be under his cash level of $100,000. The split strike synthetic long will require a cash reservation of $92,000 ($22.50 put strike * 2 contracts * 1,000 SPC + $23.50 call strike * 2 contracts * 1,000 SPC) in his super fund bank account. Cash Flow Sell two October 2009 $22.50 puts for the credit of $2,200 ($1.10 * two contracts) and Buy two October 2009 $23.50 calls for the debit of $1,400 ($0.70 * two contracts) for Net credit of $800 (before costs) Margins will be required for the two contracts of $22.50 puts.

113 Building Portfolios At Expiry If NAB closes above $22.50 (equivalent to the put strike sold) at expiry, Dr Alfred will not have been successful in buying the shares from the puts, as they would expire worthless. However, if the share price is above $23.50, it will be worthwhile for Dr Alfred to exercise the call option to buy the 2,000 NAB shares at a breakeven price of $22.70 ($23.50 strike on bought call - $0.80 net credit premium). If NAB closes under $22.50 at expiry, Dr Alfred will be buying 2,000 shares from the assignment of the put options at the purchase price of $21.70 ($22.50 - $0.80). The $23.50 calls will expire worthless. If this eventuated, Dr Alfred would have been partially successful, because he would have purchased 2,000 shares out of the intended 4,000. The synthetic long scenario can vary depending on the strike rates and the cash flow at the start of the trade. Assuming that Dr Alfred had implemented an ATM synthetic long, the trade would have cost him 10 cents per contract at the start (receiving $1.10 from $22.50 put and paying $1.20 for $22.50 call). At expiry, if NAB closed above $22.50, Dr Alfred could exercise the call to buy 2,000 shares at $22.60 (+0.10). If it closed below $22.50, then Dr Alfred would be assigned to buy 2,000 shares at $22.60 (+0.10) from his exposure in the put. Either way, Dr Alfred would have been partially successful in his quest to purchase the shares, with a cost of $100 for the ATM synthetic long strategy. The application of this strategy seemed quite benign in terms of risk. It also seems effective, with a cost of $100 guaranteeing partial success for Dr Alfred in the purchase of shares. For the synthetic long strategy to succeed, especially for more conservative investors, three important elements need to exist—the prequalifying expected bullish trend on the underlying share, full cash cover and an investor eager to buy the underlying shares.

114 OptionsWise Without all these elements, this strategy has the potential to go very wrong. Option strategy Synthetic long Pre-qualifying condition Bullish Receipt of dividend income No, unless put is assigned or call is exercised before ex-date Purchase of shares Yes, if call is exercised or put option is assigned Margins requirement Yes, on put options only, premiums on calls do not reduce overall requirement Cash flow Can be positive or negative, depending on how much calls cost and puts pay. Generally, if puts are ITM, the investor has a higher chance of buying shares and being cash flow positive Purchase price Can be higher or lower than current price, depending on whether the net premium is in debit or credit Maximum loss Unlimited after breakeven point (strike price minus credit or plus debit) At expiry If put ITM, buy shares If call ITM, exercise to buy shares Table 22 Synthetic long When the synthetic long goes wrong In order to demonstrate the dangers of the synthetic long, I will take you back to mid-2008 when NAB had just fallen 40 per cent from its high of over $44 to $26.50. Bob is a non-super fund client of Ed’s. He is an aggressive investor and uses options for leverage and short term trading. Bob believes that after such a steep fall in NAB’s share price, there

115 Building Portfolios is much potential for it to recover at least half, if not all, of its former value. Bob is experienced in the use of options and has successfully run his options portfolio for many years with the advice and assistance of Ed. He is familiar with the use of the synthetic long strategy, where he can get exposure to an underlying share without spending the cash to buy the share. Bob used this strategy successfully when shares were trending up. To execute this synthetic long strategy, Bob sells a six month put option on NAB at a strike of $24 (relatively low risk at $2.50 OTM from the prevailing share price) and buys a six month call option at $30. He manages to execute the combinations with just a 1 cent debit per contract (he received $1,280 from the short put and paid $1,270 for the long call). This seems like an effective low cost (almost free) exposure to the recovery of NAB shares. The margin on this trade is $2,670 per contract and Bob’s cash covers the margins from his capital. Three months into this six month trade, NAB is not performing according to Bob’s expectations and actually drops another 26 per cent after Bob has executed his positions (this is a total of a 66 per cent drop from NAB’s last peak). NAB is now trading at around $19. Bob’s synthetic long has gone wrong. The strategy has been hit both ways; the long (bought) $30 call option is now worth only $30 per contract (Bob paid $1,270 for it), whilst the premium on the short $24 put position has gone up substantially to $5,000 per contract (Bob sold it for $1,280). The put is now very deep ITM; increasing by one dollar for each dollar the NAB share price drops and has a very high risk of being assigned early. The short put is assigned at the depth of the fall and Bob ends up buying NAB shares at $5 per share higher than the market price. How did this synthetic long go so wrong? Firstly, the prequalifying conditions failed to eventuate. Secondly, Bob fell into

116 OptionsWise a trap that is common to investors at the time of the trade. Let’s examine this trap carefully. The framing trap People routinely frame events in order to see what they wish to see. Bob misjudged the conditions surrounding the fall in the NAB shares and this affected his choice of option strategy. The main reason Bob chose to pursue the NAB shares was because their value had dropped significantly compared to other shares across different sectors. At the time, NAB was 40 per cent below its peak and was nearly 80 per cent worse off than the ASX/ S&P200 Index. Bob may have been correct in his view, but incorrect in his timing, or perhaps the manner in which he framed the issue was completely askew. Shares that have fallen the most may not necessarily be the quickest to recover. They may not even recover when the rest of the market does, as we have seen with the once “blue chip” companies that have gone into administration or been delisted since the global financial crisis. It is quite a common phenomenon for an investor or trader to assess the purchase of a share from the perspective of how much it may have fallen and conclude that there must be value in it or that he should buy it while it is cheap. AMP shares were $20 when they were first floated, or listed, on the share market in 1998. By this token, some may believe the price of AMP shares is destined to head back to this point. In fact, AMP has been trading for more than 10 years and not only that it has not returned to the $20 mark, it is currently trading at around $5 per share. The danger of this mental framing is that it can cause investors to overlook other more pertinent issues to an investment evaluation (like the company’s underlying fundamentals, earnings and profits) that are crucial to the assessment of whether they should be bought in the first place.

117 Building Portfolios Investors have been known to angle their assessments according to the outcomes they expect and, as a result, they fail to see the potential pitfalls and downsides of their decision. This is also one major reason why some investors don’t implement protection like buying puts or reserving the cash required for the possible purchase of a short put position. They have framed the situation in such a way that they can only see the potential upside and they become blind to the potential danger. Professor Amos Tversky, one of the world’s leading researchers of human decision-making, says, “Peoples’ choices depend on the framing of the problem, the method of elicitation, and the context of choice.”15 Alternative descriptions of the same problem can lead to different decisions. In his work, Tversky finds that doctors are more likely to recommend a particular operation when told that ninty out of one hundred patients who have undergone the surgery are alive, than if they are told that ten of the one hundred are dead, even though the two statements are exactly the same.16 As an investor, you must consider whether you choose to keep your eyes on the potential for income and overlook the potential for an unlimited loss on a naked short position. Options traders need to assess investment decisions from different angles and consider not just the rewards, but also the risks involved in a strategy. If Bob had assessed the NAB shares more thoroughly by asking, “How much more downside is there?” rather than, “How much have the shares fallen?” perhaps he would have chosen to buy a put to limit potential downside, rather than buying a call with a short put. Interestingly, Bob could have formed his view by relying on professional advice or reports. It is important for investors to know that the framing trap is not limited to everyday investors, professional advisers can also get caught in the web of perspective.

118 OptionsWise Summary of strategies Option strategies Pre-qualifying criteria Buying shares and buying puts Peace of mind is essential and share ownership is guaranteed Buy calls Wants a small outlay now to limit maximum loss. Share ownership not guaranteed until call is exercised Selling puts Wants to receive income and the opportunity to buy shares. Accepts the possibility of not being successful in share ownership Buy shares and short put Wants to ensure ownership of at least some shares Buy write Wants to receive upcoming dividend and is willing to cap upside and sell shares Synthetic longs Wants to receive income and the opportunity to buy shares, but wants more upside exposure and leverage. Only suitable for super funds if cash is reserved for both the put and call underlying exposure, to avoid the temptation of leveraging Table 23

119 Building Portfolios Summary of diagrams Profit and Loss $ + – 0 Underlying share price $ Underlying share price $ $ + – 0 Profit and Loss Put option price – $ + 0 Underlying share price $ Underlying share price $ $ + – 0 Profit and Loss Call option price $ + – 0 Underlying share price $ Profit and Loss $ + – 0 Underlying share price $ Protective buy Buy call Buy write Synthetic long Sell put Buy shares and short put

120 OptionsWise

121 5 Optimising Returns, Managing Risks No share portfolio was spared in the tsunami that was the 2008- 2009 global financial crisis (GFC). The wave swept across the world and saw share markets flounder in the white wash. Some shares lost more than 40 per cent of their value in one day while highly respected corporate companies were completely wiped off the financial landscape. Two financial years later, the Australian share market is still 40 per cent away from its last high since the outbreak of the historic crisis in July 2007. Many investors feel that they have been hung out to dry by finance experts who didn’t warn them of the impending disaster. Most have seen their portfolios shrink in size and are wary of getting back into the investment game. Simon is one of the lucky few investors who had invested only a small portion of his money in shares during the GFC. Simon sold his printing and design business to a corporation about one and a half years ago. With the proceeds of the sale, Simon paid off his mortgage, put money aside for his retirement and living expenses, then took his family on a round-the-world holiday. He chose to take the trip because he realised his daughters would be leaving home in a few years and he wanted to spend some quality time with them to “redeem” some of the time he lost while building up his business. Since the trip, Simon has been looking for businesses in which he can invest with some money he set aside from the sale. He knows

122 OptionsWise he had been lucky with timing so far; he sold his business when the global economy was still roaring, the share market was bullish and spending was high. He was also fortunate that he had stayed away from the share market before the onset of the GFC when he was getting back into a routine and researching business investments. Simon is willing to invest $500,000 into a business that will keep him mentally stimulated into his retirement and will utilise the skills and discipline he has honed in his own business. Simon is not new to investing in the share market. Throughout his years in business, Simon invested in shares, dabbled in options and traded CFDs. However, the investments were always more of a hobby than a serious business pursuit. Simon would simply invest when he had some free cash and put yields back into his business when necessary. Now that Simon has more time and a sum of money earmarked for investment, he would like to approach a business that will generate an income stream and return a profit at the end of the financial year. He has researched many avenues, such as owning a café and selling goods or services on the Internet, but none of these options interest him. During his research, Simon comes across the concept of using options as a tool to generate income. He finds this idea interesting. His previous experience with options involved buying them for short-term trades to get exposure to the market with a small amount of money, or buying them for a punt. The idea of selling options for income; taking advantage of time erosion, determining the income upfront and having a risk management plan for the positions and the monitoring all seem a bit foreign to Simon in terms of an investment, but are familiar to him as a businessman. He has always sought contracts and watched his expenses and risks in his business. He knows it was the constant discipline in seeking new business and the discipline of keeping expenses in check that delivered him a healthy company, which provided

123 Optimising Returns, Managing Risks him with a comfortable sum for retirement. Simon decides he is going to invest in shares with the use of options. He will utilise the Optimiser on the OptionsWise website to help him “seek new business” and he will work with his financial adviser to “watch the expenses” and manage business risks. In 2008, Simon sees the All Ordinaries Index plunge. He decides his future risk management strategy will be to determine the potential downside of any trade before looking at the upside. He knows that if he can manage his risks successfully, his capital will not be eroded by losses on the stock market and the more he can maintain his capital, the more he increases the opportunity to grow it. Market conditions have somewhat improved since the trough of March 2009, where the ASX/S&P 200 Index plunged to 3,120 points. The market has recovered about 20 per cent since the low point when Simon was preparing to invest. Simon is expecting the share market to move in a range in the next few months as market participants continue to digest company reports and economic indicators to gauge the state of the global economy. Simon realises that the Australian share market will not return to a bullish outlook any time soon, as interest rates are low and companies, licking their wounds in the aftermath of the downturn, will experience low or negative growth. He may have to contend with a market that will move in a range in the short- to medium-term and investing may involve low returns in a high-risk environment. Simon believes options will give him the flexibility to generate some reasonable returns whilst capping his downside. With the market situation in mind, Simon will employ option strategies over shares that are fundamentally sound to generate an income stream. Though owning a portfolio of shares is not his ultimate objective, buying and selling shares will form part range: sideways, neither up or down strongly

124 OptionsWise of Simon’s overall share and option strategy to generate income. Downside protection will be key for him to preserve capital and reduce risk and he intends to work his capital hard without undertaking leverage. Below are some strategies Simon could employ to implement his objectives. Pre-qualifying conditions Strategies Strong uptrend Buy call, sell ITM put, synthetic long Bullish, uptrending Sell ATM/OTM put, bull put spread, protective buy Mildly uptrending Sell OTM put, buy write, buy share and sell collar Neutral, in a range Combination strategies Table 24 Summary of Strategies The methods we will be focusing on in this chapter will be the bull put spread and combination strategies. Bull Put Spread This strategy entails the selling of a put option and the simultaneous buying of a lower strike put for protection. The gap, or the spread, between the two puts (the higher one sold and the lower one bought) is the investor’s maximum loss (before costs). The strike of the short (sold) put is the level of the investor’s obligation to buy the shares, whilst the long (bought) put is the level at which the investor bought protection, with the right to sell the shares. Hence the investor will not lose more than the difference, or spread, between the long and short put strikes. This spread is normally at a net credit premium as the premium from the higher short put strike will be higher than the lower long

125 Optimising Returns, Managing Risks put strike. In embarking on a spread, the investor is forgoing some credit premium in return for limited losses. Margins will be required for a put spread but are lower than a non-protected (naked) short put. The maximum margins for a spread are limited to the price gap between the two strikes. An investor who embarks on this strategy has a set income determined (net credit received upfront), downside protection (to the spread) and maximum margins locked in (to the spread). Margin escalation can be a big trap for writers of options, so putting a spread on a short put creates certainty of margin cover throughout the life of an option strategy. Creating a spread not only limits downside and avoids margin escalation, it also limits the amount of resources needed for the strategy. For a naked short put position to be fully covered, cash needs to be reserved for the potential opportunity to buy the shares at the put strike. However, once a spread is created for a short put position, the investor also holds the right to sell the underlying shares at the long put strike. As the difference between the buying price (short put strike) and the selling price (long put strike) is the investor’s maximum exposure, he only needs to reserve capital covering the spread to be fully protected. This is an advantage for an investor because it reduces the amount of capital to be allocated to the spread, even though it limits the amount of income received. Hence, return on a spread is high and risk is low. The “leg-in” trap Investors should be aware of the pitfalls of executing any protected spread strategy (that is, selling an option protected by the buying of another option of the same share, at the same time). The major pitfall is the temptation to leg-in this combo trade. It is tempting to sell the put first and wait for the share to rise (as hoped for), before buying the put (thereby lowering the cost outlay), but this action

126 OptionsWise is flawed for two reasons. Firstly, it can be as simple as forgetting to buy the put, especially as the share rises. The investor who is on top of his financial situation may be less inclined to buy the put if the share has risen, as this cost now feels like “giving-back”. On the other hand, if the share has dropped, the investor will be anxious to buy protection, but he will find that the put will cost him even more than before and this will make the decision to buy the put more of a challenge. It’s difficult to follow through with the second leg retrospectively, regardless of which direction the share moves in following the first transaction (the short put). There is also a bigger loss at stake if an investor succumbs to the temptation to leg-in. If he fails to buy the put altogether, the investor could unwittingly go from having a maximum downside certainty to flirting with unlimited loss (a potential abyss). His risk profile would increase dramatically as a result. Hence, though it may be tempting to save costs by legging-in or doing away with protection retrospectively, the risk is not worth the cost savings. It is more prudent to calculate one’s maximum loss at the outset and have peace of mind in knowing one can afford the worst-case scenario, then sit back and enjoy the possible upside. This is sensible investing. A summary of the naked put strategy versus a put spread is tabulated below. Attributes Short naked put Put spread Net income received Higher Lower, paying for protection Potential for margin explosion? Yes No. Maximum margins determined at the start Maximum loss determined? No. Unlimited to maximum of zero Yes. Maximum to the spread Costs Lower. One transaction Double. Two transactions Table 25 Attributes of naked put versus put spread

127 Optimising Returns, Managing Risks The lesson here is an investor should avoid the temptation of legging-in a combo trade and stick with the plan to execute them together. Simon’s bull put spread strategy Simon has selected a few sectors that he identifies as suitable for investment in the current uncertain market conditions. He chooses sectors that have revenue resilience in the face of low or negative growth and difficult business conditions. Simon’s selections include consumer staples like groceries, energy and healthcare companies, where demand is ongoing and is not affected by the rise and fall of the general economy. He also chooses the telecommunications sector, where usage or demand will be sustainable in a low growth environment. Simon also selects the gold sector, as it has traditionally been a hedge in a portfolio for inflation, weak US dollar or political or financial uncertainties. In the healthcare sector, there are four listed healthcare stocks with ETOs listed on the Australian share market; Sonic Healthcare (SHL. ASX), RedMed Inc. (RMD. ASX), Cochlear Limited (COH. ASX) and CSL Limited (CSL. ASX). Out of the four, CSL’s options offer the best liquidity and its share price has been languishing in the last few months. In addition, Simon likes the exposure to the plasma industry that CSL provides. Simon believes he can use the bull put spread to take advantage of its current weakness. CSL last traded at $30.30. Simon is considering either selling an ATM put of $30 or employing the bull put spread strategy and limiting his maximum loss to $2 a share. As this is his first trade, he has taken great pains to work out the possible scenarios of both strategies before making a decision. Let’s first have a look at the premiums for the August series, with CSL’s share price at $30.30. The premiums per contract at table 26 are arrived at by multiplying the option theoretical prices by the SPC of 1000 shares.

128 OptionsWise CSL August 2009 expiry put strikes Theoretical price Premiums per contract Delta $28 0.085 $85 -0.06 $28.50 0.095 $95 -0.11 $29 0.155 $155 -0.18 $29.50 0.275 $275 -0.29 $30 0.42 $420 -0.41 Table 26 Premiums for selected CSL August 2009 puts Selling one contract of the August 2009 $30 put will give Simon an income of $420 (before costs) and requires a cash reservation of $30,000, with no downside protection. The margin required for this short position is $2,305 (more on this calculation to follow). Based on margins-cover only, that is, with unlimited downside loss and the potential for margin escalation, the return on this strategy is 18.2 per cent ($420/$2,305) at the outset. For a full cash cover investor like a super fund, the return drops to 1.4 per cent ($420/$30,000), but has the best form of risk management. To sell a put with a $2 spread between the strikes of $30 and $28, Simon will be receiving a net income of $335 ($420-$85), with a cash reservation of $2,000 per contract and a maximum loss of $2,000. The margin required at the start is $1,412 (more on this later). The return on the spread is 23.7 per cent ($335/$1,412) at the outset. As Simon will be reserving the maximum loss for the spread, his return is 16.75 per cent ($335/$2,000) with a maximum loss of $2,000 before costs for each contract. This is the scenario; 18.2 per cent return for no downside protection and returns falling as margin increases or 16.75 per cent return for a maximum loss of $2,000, without further margin topup. Simon is leaning towards using the put spread strategy, but before he makes a final decision, he wants to evaluate one more

129 Optimising Returns, Managing Risks issue. He would like to have a sense of how the margin cover would change should CSL shares fall to $25 (about 17.5 per cent down from the current level). Margin Evaluation—understanding risk margins Naked put Firstly, selling one contract of the August 2009 $30 put will require a total margin of $2,305 (estimated from the ASX margin estimator). The breakdown for this total margin is $420 for premium and $1,885 ($2,305 - $420) for risk. This is based on CSL’s last traded price of $30.30. Short August 2009 $30 put Margin requirement Premium margin at $30.30 -$420 Risk margin down ($27.57) -$1,885 Total margin -$2,305 Table 27 Margins for shorting 1 contract of 2009 $30 put This margin is arrived at from the MIP of CSL at 9 per cent. At $30.30, the MID is $2.73 (9 per cent of $30.30). Being a short put, the risk is on the share price falling and the worst probable scenario for this position is if the share price falls to an intra-day low of $27.57 ($30.30 - $2.73). If CSL is at the price of $27.57, the option price of the $30 August 2009 put will increase from $420 per contract to $2,305 and this will affect the total margin required to cover the probability of risk. The risk margin will be the total margin of $2,305 minus the premium margin of $420, which comes to $1,885 per contract. This will be the margin payment required for the short put (as the $420 premium received will meet part of the total margins requirement of $2,305). This margin requirement will fluctuate daily according to the last closing price of CSL, as it rises, margins fall and if it falls, margins rise.

130 OptionsWise If CSL were to fall to $25, the $30 short put would be $5 ITM and with minimal time value, the $30 put option would be priced at around $5 (its intrinsic value). The total margin cover required will increase by more than 200 per cent to $7,250 (from $2,305). Unless the short position has been fully covered by cash reserves of $30,000, where the increase in margins is well within the cash reserved, margin escalation can create cash flow problems for the investor. How did margin escalation occur? Applying the MIP of nine per cent to the $25 price of CSL, the MID is $2.25. With the share price at $25, the worst case for the $30 short put would be if the share price falls to an intra-day low of $22.75 ($25 - $2.25). If CSL is at the probable price of $22.75, the price of the $30 August 2009 put will increase from $5,000 to $7,250. Hence, if CSL is at $25, the risk margin will increase from $1,885 to $2,250 ($7,250 total margin - $5,000 premium margin). For a 17.5 per cent drop on the share price, the total margin required has increased by 214 per cent! Short August 2009 $30 put Margin requirement CSL at the price of $30.30 CSL at the price of $25 Premium margin -$420 -$5,000 Risk margin down -$1,885 -$2,250 Total margin -$2,305 -$7,250 Difference in total margin after CSL plunges $5 -$4,945 (214 per cent increase) Table 28 Potential margin escalation on shorting a naked August 2009 $30 put This scenario analysis highlights the fact that shorting the naked put does not provide certainty of downside protection or cap margin

131 Optimising Returns, Managing Risks requirements. As share price falls, margin cover increases and as it gets deeper ITM, margin increases more substantially (at intrinsic value on premium margin). If MIP is increased simultaneously (by the ACH) as a result of increased volatility on the underlying share, risk margin will also increase at a higher rate. Put spread When a put at the $28 strike is bought to protect a naked short put at $30, the margins required for the spread are reduced from $2,305 to $1,412. If CSL falls to the intra-day 9 per cent low of $27.57, the option price for the August $28 put rises to $808 per contract. As this is a long put position, the higher premium for the $28 put offsets the risk margin required on the short $30 put of -$1,885. The net risk margin payment for the put spread (a short put protected by Profit and Loss 1 2 Underlying share price $ $ + – 0 1 Investor receives income for selling put 2 Breakeven point is the put strike minus premium received 3 Investor faces unlimited losses and potential of margin escalation if share falls beyond breakeven point Diagram 21 Shorting put naked 3

132 OptionsWise a long put) is reduced to $1,077. Likewise, the premium margin received is reduced from $420 to $335 (due to the cost of the long put). The total margin required for the spread is the lesser amount of $1,412. CSL at $30.30 Option series Net margin requirement Aug09 $30 put Aug09 $28 put Action Short Long Premium margin -$420 $85 -$335 Risk margin down -$1,885 $808 -$1,077 Total margin -$2,305 $0 -$1,412 Table 29 Margin cap on a CSL put spread Let’s examine how the margins requirement on the put spread will perform if CSL’s share price were to fall to $25 (or any lower price). As put increases when share price falls, both the premiums on the $30 and $28 strikes increase (though at different rates, each following its own Delta until they are both deep ITM where they will be at Delta -1), the difference is, the $30 strike margin is a negative value because it’s a short position whilst the $28 strike is a positive value because it’s long. If CSL were to fall to $25 per share, both the $30 and $28 puts would be ITM and with deltas close to negative one. They are both moving very close to the intrinsic value of the underlying share price. In regards to the spread, the increase in the risk margin for the short put is compensated by the increase in the value of the long put. This keeps the total margins of the spread close to the $2 difference between the strikes of $30 and $28.

133 Optimising Returns, Managing Risks The margin for the spread if CSL falls to $25 is $2,028. CSL at $25 Option series Net margin requirement Aug09 $30 put Aug09 $28 put Action Short Long Premium margin -$5,000 $3,000 -$2,000 Risk margin down -$2,250 $2,222 -$28 Total margin -$7,250 $0 -$2,028 Table 30 Margin capped to the spread With a put spread in place, the maximum loss and margin cover does not go beyond the spread even if the share falls further. 1 3 2 Underlying share price $28 $30 $ $ + – 0 Profit and Loss Diagram 22 Put spread 1 Short put where income is received 2 Protective put is bought to limit downside 3 Net income received from the spread (note: Diagram is not to scale)

134 OptionsWise The loss and margin cover are fixed at the spread. The increase in risk margin of the short put is covered by the increase in the long put. Diagram 22 on the previous page shows that the spread provides certainty in downside protection and margin cover. The margin evaluation has sealed the deal for Simon. He wants the certainty of maximum downside and margin cover and the certainty of the income that comes with it. He selects the bull put spread strategy. This is his plan. Simon will tighten the maximum loss between the spread to a maximum of $1 per contract and sell five contracts of the put spread. His margin cover will be a maximum of $5,000. The table below shows the prices for a $1 put spread for the next three expiry months. Expiry months Strikes and prices ($) on put spreads $29/$28 $29.50/$28.50 $30/$29 August -0.07 (-0.155 + 0.085) -0.18 (-0.275 + 0.095) -0.265 (-042 + 0.155) September -0.28 -0.33 -0.40 December -0.33 -0.38 -0.47 Table 31 Option prices for $1 put spread on CSL for three expiry months Simon’s strategy will be implemented by selling a high strike put and buying a put $1 lower in strike. The spread prices for three expiry dates are displayed in table 31. You will notice that the higher the strikes, the higher the net credit premium for the spread. For example, for the August spreads, the $30 (selling)/$29 (buying) spread gives a 19.5 cent (26.5 - 7 cents) higher premium than the $29/$28 spread, as the $30 strike is ATM and the investor has a higher risk of being assigned to buy the underlying shares.

135 Optimising Returns, Managing Risks The $30/$29 put spread net credit is $265 per contract. This is calculated with the -$420 from the selling of the $30 put and the buying of the $29 put for $155 per contract for protection. Selling five of the $30/$29 put spread contracts will generate an income of $1,325 for Simon ($265 * 5 * 1,000). Is the income of $1,325 Simon’s? Yes, the income is Simon’s, but only for now, until the spread expires worthless or is bought back early or if he is assigned on the short put. Exit strategy The successful application of this strategy requires an up-trend in share price. The best exit scenario for Simon is if the share price stays above the strike of the short put and expires worthless. Then he will earn all the income from the spread. However, if the underlying share fails to appreciate above the strike of the short put at expiry, it will expire ITM and Simon will be assigned to buy the underlying shares at $30. As Simon undertook this strategy as a trade with the reservation of $5,000 as a margin, it will not be a feasible solution for him to buy 5,000 CSL shares at $30. In this scenario, Simon will exercise the bought put at $29 to on-sell the shares, thereby realising the loss between the spread plus the cost of selling or delivering the shares to the counterparty. Once this is done, the investor has no further obligation. A third possible scenario eventuates if Simon believes that with time CSL should trade above the $30 price level. He can choose to buy more time to allow this to eventuate. Simon can roll out the spread (before expiry or assignment) to a later expiry month. The caveat is, depending on where the share price is, he may not be able to roll out the spread at a credit premium. Simon will need to pay for another two lots of brokerage and may also need to pay for more time for the protection. These costs will eat in to the initial gross income of $1,325 he has received.