136 OptionsWise Combination Strategies Strategy 1 Buy share and sell strangle Next, Simon is interested in using options to gain exposure to gold share Newcrest Mining Limited (NCM.ASX), the largest market capitalised company in the gold sector. NCM last closed at $30.20. Simon deduces that the NCM share price has been flat, trading in a range between $28 and $34. Buying the share outright at $30.20 may not be enough return in the short term (after costs) within the tight range as he intends to allocate no more than $100,000 of his $500,000 to each share strategy. He thinks the best strategy to use in this instance, to take advantage of this range-bound share is by using a combination strategy of buying shares and selling strangles at the same time. The buy and strangle strategy involves buying shares and simultaneously selling equal numbers of put and call options, to ensure full cover. This strategy is a strong income generator as it reduces the purchase price of the shares immediately with two lots of income from the put and the call and provides the investor with some hedging for the shares he has just purchased. In addition, the tactic gives the investor the potential to buy more shares at a lower entry price or to sell shares at a potentially higher sale price. The buy and strangle strategy can be applied by spending half of one’s allocated cash reserves buying shares to ensure “a foot in the door”. The put strike can then be adjusted according to the investor’s intention. If the investor is using the put strike to defray the purchase price and is prepared to buy more of the shares if assigned, he would be more likely to sell an OTM put to reduce the risk of buying shares. The reverse option would involve selling an ITM put for a higher premium to compensate for the higher risk one runs of buying more of the shares. Likewise, the strike of the call options can be adjusted (ITM or OTM) according to whether the investor
137 Optimising Returns, Managing Risks intends for it to be an income generator or to lock in a sale price for delivery. The investor will have effectively set a range for his shares and beyond those points, he will be required to either buy more shares or sell the shares he just purchased. In order for Simon to determine the level of the put strike, he must decide on a price at which he would be comfortable buying more NCM shares. In the case of the level of a call strike, he must decide on the level at which he will be willing to take profit on the NCM shares. There are various ways of combining the strikes and expiry months to create different income potential. Simon can choose spreads of $1, $1.50 or $2.00 between the strikes of the put and call, to set a low enough put strike (to buy) and high enough call strike (to sell) his shares. Whilst a longer expiry month will boost the income potential of these options. With the help of the Optimiser application on the OptionsWise website, Simon has narrowed his choices down to the possibilities below. Expiry months Spreads, strikes and prices ($) for strangles $1 spread $30 put/ $31 call $1.50 spread $29.50 put/ $31 call $2.00 spread $29.50 put/ $31.50 call August $1.80 ($1.00+$0.80) $1.60 ($0.80+$0.80) $1.40 ($0.80+$0.60) September $2.95 $2.70 $2.50 October $3.90 $3.65 $3.50 Table 32 Option prices for three different strangles
138 OptionsWise Simon picked the $1 spread August 2009 $30 put and $31 call strangle. He decides he is willing to buy NCM shares at the current price of $30.20 and it will be an added bonus for him if he can pick more up at $28.20 ($30 put strike - $1.80 net premium received). Simon’s shares have a call strike at $31, so if NCM shares are valued above $31 at expiry and he is called to deliver the 1,000 shares he holds, Simon will sell his shares at $32.80 each ($31 call strike plus $1.80 premium received) in about a month. Simon picked a short-dated option as he believes they present a higher chance of expiring worthless. If things go according to plan, he can replicate the strategy again the following month, thereby creating an income stream. Buying shares at $30.20 and selling puts at $30 will require Simon to spend $30,200 now (before costs) and $30,000 later, if assigned. He will not be taking leverage on this strategy and intends to reserve the full $30,000 cash for it. Selling one contract of the August 2009 put will return $1,000 and selling one contract of the August 2009 $31 call will return $800. The combined total income from selling the strangle is $1,800. The 1,000 NCM shares purchased will cost Simon $28,400 ($30,200 purchase price - $1,800 received) before costs. Margins will be required on both the options (both are shorts). Simon will need to reserve $30,000 to meet margins for two days until the NCM shares are settled and lodged as margin cover for the spread. Once the 1,000 NCM shares are lodged as eligible collateral, the cash used as margin cover will be credited back to Simon’s bank account and it can remain there until expiry or until he is assigned. This is the most conservative form of risk management. The buy and strangle stratgery is illustrated in the next three diagrams with the investor’s final position depicted in diagram 23c.
139 Optimising Returns, Managing Risks the middle line in grey, pls differentiate it like a gradient. tks. 1 Underlying share price $30.20 $ $ + – 0 Profit and Loss Underlying share price $ $ + – 0 Profit and Loss $ $1.80 $31 4 $30 3 Diagram 23 Buying shares and selling strangle Diagram 23b Diagram 23a 1 Investor buys shares 2 sells put and call for a combined income of $1.80 3 Put strike set at point where investor is locked in to buy more shares 4 Call strike set at point where investor is locked in to sell his shares 2
140 OptionsWise Exit Strategy Before expiry: If the NCM shares rise strongly, the $30 put can be closed early as it will be OTM and will have little value left. The call will be ITM and at a high risk of being called away (if the underlying share is above $31). On the flip side, if NCM shares tumble, the call becomes OTM and is left with little value whilst the put may be assigned early and Simon will buy the shares at $30 (if the share price falls below $30). At expiry: If the NCM shares close between $30 and $31, Simon will have earned three per cent of his outlay in one month ($1,800/($30,200 spent + $30,000 reserved)) or lowered the entry price of the 1,000 NCM shares to $28.40 ($30.20 purchase price - $1.80 premium received). 6 7 5 Underlying share price $30 $31 $ $ + – 0 Profit and Loss 8 $1.80 $1.00 5 Investor’s breakeven purchase price is $28.20 6 There is no protection beyond breakeven purchase price 7 Investor’s breakeven sale price is $32.80 8 Point beyond which investor will not benefit Diagram 23c (note: Diagram is not to scale)
141 Optimising Returns, Managing Risks If the NCM shares close below $30, Simon will be buying an extra 1,000 NCM shares at $28.20 ($30 put strike - $1.80 premium received). He will have purchased 2,000 NCM shares at an average entry price of $28.30 ($28.40 + $28.20). If the NCM shares close above $31, Simon will be taking profit on the 1,000 shares he bought one month ago at $32.80 ($31 call strike plus $1.80 premium received) giving him a before costs return of 8.6 per cent (($32.80 - $30.20)/$30.20). The pre-qualifying condition of this strategy demands that the underlying share moves in a determinable range, so Simon will not be protected on the downside if NCM breaks below $28.20. Should NCM break out of the upper range of $32.80, Simon will forgo further upside. What if Simon decided to reduce the capital spent and just sell the strangles without buying the shares? The diagram below depicts the difference in the investor’s risk profile at Point 9. $ $ + – 0 Profit and Loss $31 Call strike $30 Put strike 9 Unlimited losses as share rises beyond breakeven sale price Diagram 24 Shorting naked strangle exposes investor to a higher risk profile 9 Underlying share price
142 OptionsWise Simon will face unlimited losses should NCM rise above his breakeven sale price of $32.80, which could happen in a takeover scenario or a sudden spike in gold price. Strategy 2 Buy share and sell straddle The third share Simon would like to buy is telecommunications giant, Telstra Corporation (TLS). Telstra has a stable income and is about to report a positive result with dividend going ex in a month. In a similar case to NCM, Telstra’s share price is trading within a tight bracket. Buying the share to sit and wait for dividend does not seem like the best use of resources. Simon is going to use the buy share and sell straddle strategy on TLS. This strategy involves buying the underlying shares and selling calls and puts at the same strike price. The underlying shares are bought to cover the writing of the call options while the shorting of the put will either provide a boost to the investor’s total income or the chance to buy more of the underlying shares. At the time of this strategy, TLS was trading at around $3.40. An upcoming positive result announcement is expected to see the share price jump mildly and then hover at the inflated rate. The strike prices available that are close to the current price include $3.36, $3.61 and $3.85 (these are set by the ASX). The $3.61 level is about six per cent above the current price and it is a reasonable expectation that the TLS share will rise to this point. Simon decides on the strike of $3.61 for the straddle. Table 33 on the next page lists these prices for the combination of call and put options for the next three expiry months, with TLS’s share price last traded at $3.49. straddle: an options strategy whereby the trader realises a profit when there is a rise or fall in the underlying stock (for buyers) or staying the same (for sellers). It involves simultaneously buying or selling an equal number of put and call options over the same stock with the same exercise price and expiration date
143 Optimising Returns, Managing Risks Expiry months Strikes and prices ($) for straddle $3.61 call/$3.61 put August 0.24 (0.08 + 0.16) September 0.275 (0.09 + 0.185) October 0.33 (0.115 + 0.215) Table 33 Option prices for three TLS straddles The expected ex-dividend is a key determinant when choosing the expiry month as Simon wants to receive the dividend from the 10,000 shares he holds before having his shares called away. As the ex-dividend date for TLS is expected to be in late August, Simon has decided on investing in the September series to reduce the risk of his shares being called away pre-dividend. On the other hand, if the September put is assigned after the ex-date, Simon will not be entitled to receive dividend from the purchase. However, he is prepared to buy additional TLS shares in this instance for the purpose of boosting the overall income of the strategy. In order to reduce the risk of being assigned on the put, his intention is to close the put early when TLS rises to, or above, the strike and leave the call until expiry. This is the cash flow implication of this strategy. Simon will spend $34,000 buying 10,000 shares in TLS and reserve another $36,100 for the short put. He will sell 10 contracts of September 2009 $3.61 calls and 10 contracts of September 2009 $3.61 puts. His net cash flow will be $31,250 ($34,000 - $2,750 from the total premium of calls and puts). These are depicted in diagrams 25 a to c on the next two pages.
144 OptionsWise Diagram 25a 1 Underlying share price $3.40 $ $ + – 0 Profit and Loss Diagram 25 Buying shares and selling straddle 1 Investor buys shares at $3.40 Diagram 25b 27.5c 3 4 2 Underlying share price $3.61 $ $ + – 0 Profit and Loss 2 And sells call and put at the same strike price of $3.61 and receives a combined income of 27.5 cents per contract 3 Locked into potential of buying more shares at breakeven price of $3.34 4 Locked into potential of selling shares bought at breakeven price of $3.89
145 Optimising Returns, Managing Risks Exit Strategy The calls and puts can be closed off individually before expiry if prices are advantageous in order to lock in profits. The best outcome for Simon will be if TLS rises strongly and the short put can be bought back to lock in the profit and, most importantly, rid him of the risk of potentially purchasing more TLS shares (Simon’s intention was to boost income). If TLS falls, the written call will be OTM and worthless, and can be bought back early as well, but this is of a lesser priority as Simon has the shares to deliver and he will do so at a profit if he is called upon. If TLS is above $3.61 at expiry, Simon will be selling the 10,000 TLS shares at $3.89 ($3.61 strike plus $0.275 premium received), at a return of 14.3 per cent (49 cent gain per share) in two months’ time. With the addition of the expected dividend of 14 cents, Simon’s total return will be 63 cents per share or 18.4 per cent ($0.63/$3.40) in two months. Diagram 25c 6 5 Underlying share price $3.61 27.5c $ $ + – 0 Profit and Loss 5 Unlimited loss if share falls beyond breakeven purchase price 6 Does not gain beyond breakeven sale price
146 OptionsWise If TLS closes below $3.61, Simon will be buying another 10,000 TLS shares at $3.34 ($3.61-$0.275). This is below the entry price of $3.40, the rate at which he purchased the first 10,000 shares. Simon’s total capital spend will be $67,400 before costs. With the shares in his portfolio, Simon could sell calls again in the following months to continue the generation of income or he could sell calls ITM to increase his chances of delivering his shares at a profit and move on to the next dividend paying share. Combinations can be structured in various arrangements of strikes, types and expiry dates, so it is essential that the investor mixes these elements with particular objectives in mind at the outset. The Optimiser application on the OptionsWise website is ideal for analysing suitable combinations.
147 Optimising Returns, Managing Risks Summary of strategies Option strategy Put spread Execution Sell put and simultaneously buying put at lower strike Implication Downside and margins requirement limited to the spread between the strikes Option strategy Buy and strangle Execution Buy shares, sell put and sell call. Selection of strikes depends on investor’s desire to buy or sell shares. Number of shares bought matches the SPC of the calls Implication Enhanced income potential, two lots of premium. Potential to buy more shares and sell shares bought. No downside protection, but upside is limited to call strike plus combined premium received Option strategy Buy and straddle Execution Buy shares and sell put and call at the same strike. Number of shares bought matches the SPC of the calls Implication Enhances income potential, but investor is likely to get assigned on one side of the transaction unless share ends at the strike at expiry. Closing OTM option (call or put) early during the term of the option is recommended if opportunity presents itself. Table 34
148 OptionsWise Summary of diagrams Underlying share price $ $ + – 0 Profit and Loss Underlying share price $ $ + – 0 Profit and Loss Underlying share price $ $ + – 0 Profit and Loss Put Spread Buy and strangle Buy and straddle
149 6 Managing Portfolios Many people allow their fear of losses or the unknown to hold them back from investing with options. Investors must face their fears in order to make sound investment decisions. Fears will empower us if directed towards positive actions. If risks are managed up-front, when they occur, they are no longer a risk, but an expected outcome. Using options as a sensible investment tool can produce ongoing rewards. An investor who uses options as a leveraging tool can earn exponential returns with a small outlay, while an investor who uses options with full cover can gain a continuous income stream. However, if one is to manage his investments sensibly, he must consider the potential risks of a venture before he considers the potential gains. Investors need to confront the fear factor associated with investing. Find a knowledgeable investment adviser and talk about your concerns, ask about the worst-case scenarios, understand the pitfalls, then take steps to manage them. Managing risks will grant the investor control over his investments and the power to change his financial future. The aim of this book is to allow readers the opportunity to understand not only investment concepts, but also the risks inherent in these concepts and the most effective way to minimize them. This chapter is about confronting some of the common issues that
150 OptionsWise option investors face after their strategies have been executed. The main difference between managing a share portfolio versus an option portfolio is that the latter entails more decisions; every expiry date is a decision point. Investors also need to make decisions during the life of an option and up-front risk management allows individuals to make these decisions in an informed, calculated manner. There are some common management issues for short option positions that arise during the life of an option and at expiry. These management issues are more prominent in investors who deal with short puts as these positions present the investor with cash-spend obligations. These potential “problems” occur when short puts are: 1 Very profitable 2 Large paper losses 3 Due to be assigned 4 Exercised We will examine these outcomes and explore some good management practices for each. 1 Very profitable This is when short positions are OTM and very profitable before expiry. This issue is particularly important for naked positions. Short positions become OTM when the investor’s envisaged outcome eventuates and the option is in a profitable position. A short put position is OTM when the underlying share price rises above the put strike, causing the put to drop in value. A short call position is OTM when the underlying share price falls below the call strike, rendering the call less valuable. These scenarios can occur at any point during the life of the option so long as the loss of intrinsic value is more significant than the time value. It may seem incongruous to consider a substantially profitable option position a portfolio management issue. The common
151 Portfolio Management response of an investor or trader in such a position is to let the profits roll in, allow the position to expire worthless and enjoy the run. I must admit there is a certain thrill in seeing a short position expire worthless. It gives you the validation of being right in your initial assessment and sees you save the costs needed to buy back a position. Should this be the case, though? I propose that sensible investors fight this inherent tendency to do nothing. The modus operandi of many share investors is to let profits run as they are long (or hold) shares and their potential upside is uncapped. If the share price falls and profits vanish, only opportunity has been lost and the investor is no worse off. The implication for a short option seller involves higher stakes. A short option seller (of either puts or calls) has upsides capped, and failing to lock in profits means the investor is at risk of seeing real gains slip away and may be forced into spending more money later or accepting a compromised price level for either the purchase or sale of shares. A profitable short put position left unrealised may force an investor to spend more cash to buy the underlying shares, especially if the share price has fallen through the strike price at expiry. Rather than buying the shares at a price lower than the market price, as intended, the investor may now need to spend more to close off a position to avoid buying shares at an unfavourable price (higher than the market price). For a covered call writer, a profitable position left unclosed could force the investor to deliver shares at a price lower than the prevailing market price or to spend more cash than originally received to close off this obligation. Whether covered or not, short put and call positions must be closed in order to protect the investor from buying or selling shares at a compromised price level. An options investor should habitually and actively lock in profits as part of a risk management plan.
152 OptionsWise These profits are low-hanging fruit and should be grasped while in reach. When it costs 10 cents or less to close one contract of short position, which may have cost the investor $200 ($100 plus $100 in costs), this small sum should be considered money well spent. The following is Clare’s story; her experience is common among investors. Clare manages her own super fund and uses options as part of her overall investment strategy. Clare has written some ITM call options over shares she obtained and manages to deliver them at profits in late 2007. Her super fund is sitting on some extra cash after the sales. Clare has been observing the market for six months and is feeling confident in her ability to predict its direction by mid 2008. She begins to sell puts on shares she wishes to purchase for her super fund. Woolworths (WOW) is one of these shares and it is currently trading at around $24. Clare sells a $25 six-month WOW put, which is slightly ITM, for $2,200. Her strategy is to pick up the shares if assigned. If she’s not assigned, she will have earned some income for her super fund. Her strategy works so well that about one and a half months before expiry, WOW rises strongly to over $29 as other investors chase the share for a defensive holding in their portfolios. The $25 put option is now OTM and its premium has dropped to just $80 per contract. To lock in the profits, Clare will be required to pay $80 (before costs). This equates to forgoing four per cent of the income already earned to close off this position and lock in a 96 per cent ($2,120) profit. While this sounds like a logical way to proceed, in reality, most option sellers in this situation prefer to do nothing in the hope of seeing the option expire worthless. They feel the pinch in spending the extra four per cent so much that the real gain of 96 per cent seems less tangible. Investors must concede that, in addition to realising profits on the income earned, closing the option position also frees up the
153 Portfolio Management capital reserved to invest in a new strategy. While income can be earned on a short position, gains are not realised until the position is closed and profits locked in. If it is not locked in, a profitable position can still turn the other way at or near to expiry. This is a common occurrence. A share can comfortably stay above a seller’s put strike during its life only to fall through the strike near expiry or on expiry day, due to unexpected news or announcements. There are no sure wins until they are in your pocket. There may be some instances where the strike is so OTM and the share has appreciated so strongly that it’s almost impossible for it to fall back near to the strike, especially if the expiry date is close. But there will be other times where profit not locked in is profit gone. The latter is more common. 2 Large paper losses When short positions are deep ITM before expiry, investors can choose to: i Close out ii Roll out Let’s look at the management issue for an ITM short put position as ITM covered call positions should be simply covered by the delivery of the underlying shares. i Closing out A short put position will trade ITM when the investor’s anticipated outcome of the underlying share does not eventuate. In the case of a short put, if the underlying share falls, the put will be more valuable. The investor who owns the short put will be sitting on unrealised losses as it will now cost more to buy back the short put position. The investor must decide on a suitable point at which to pay the higher premium to close off the position and lock in a loss. This point occurs when the underlying share is nose-diving
154 OptionsWise or when further downside is expected. The investor must lock in a small (or smaller) loss to rid himself of the obligation to buy shares later at a price substantially higher than the prevailing market price. Locking in a small loss also allows the investor to avoid potential margin escalation. This is particularly important for a trader who is only cash- or share-covering the margin requirement. After closing, albeit at a loss, the investor can wait for the stock to stabilise, then sell a put at a lower strike price and enjoy the peace of mind that comes with avoiding a substantial downside. ii Rolling out This is the strategy to implement when the investor is sitting on an unrealised paper loss on his or her option position and does not intend to follow through with either the obligation of buying (from short put) or selling (from short call) of the underlying shares just yet. In order to avoid being assigned early to fulfill those obligations, due to the position being ITM, rolling this ITM position out to further months will reduce the imminent risk of early assignment and increase the possibility of boosting the investor’s income from higher time value. In this scenario, rolling out entails buying back the current ITM short position and simultaneously selling another position at the same or different strike (normally lower for short put or higher for short call) to expire in future months. This strategy uses the increase in time value to offset the cost of the buy back. Rolling nearer to an ATM position, which is down to (for put) or up to (for call) where the market price is, will help the investor capture the highest time value. The choice of the strike price and expiry month is a balance between the desire to reduce the risk of assignment and the increased value from the length of time to achieve an outcome which is acceptable to the investor. This could end up being a credit or debit roll. A credit to cover costs or enhance income is generally achievable, except in situations
155 Portfolio Management where the short position is very deep ITM or the investor chooses to roll to a strike so OTM that the minimal time value in both cases is insufficient to cover the intrinsic value received. This debit roll may be acceptable to the investor in compensation for a lower risk of assignment or if his option is very deep ITM, and he just does not have any other choice. Ultimately, the selection of the strikes and expiry terms on rolling depend on the view and tolerance level of the investor. There is no restriction on the number of times an option seller can roll an ITM position, but costs may be a consideration or limitation for an individual because an option gets more and more expensive to roll as it becomes deeper ITM. The decision to close and take a loss in this scenario may be a pain in the short-term, but it can be more cost-effective in the long run. 3 Due to be assigned These are ITM short position with early assignment imminent. Being assigned to fulfill the obligations under an options contract (to buy or sell) at any time during the life of an option is the tradeoff sellers of options have to accept for the privilege of receiving an income upfront. This is less of a problem for a covered call investor but may not be so for a put seller. Some people believe being assigned is not a risk if the seller of the put option wants to buy the underlying shares. When planning strategies, an investor may believe he will be happy to buy CBA shares at a $40 strike price because it is $2 cheaper than the current market price. However, if CBA were to fall below the strike and beyond the $2 earned after the strategy is executed ($38), the investor will probably be less willing to follow through with the original plan. Assignment to buy the underlying shares becomes a risk and an undesirable event. So, how do we deal with this risk of being assigned a share that is now too expensive? Below are some options.
156 OptionsWise i Execute Protection This can be achieved by initiating a spread at the time of trade to limit losses, that is, sell a put and simultaneously buy a lower strike put. The spread between the two strikes represents the maximum tolerable level of “loss” the investor is willing to accept for the purchase of the underlying shares. Where an investor has a protective put in place, an early assignment can be met with an early exercise of the protection. The assigned shares will be bought at the strike of the short put and sold off at the strike price of the protection, at a loss that was determined at the start. Alternatively, where the short puts are assigned and the shares purchased, an investor can hold on to both the shares and the long put. The individual’s investment is protected and he continues to hold the share that he wanted to buy, without further downside beyond the protected put strike. Let’s follow the experience of Frank who is keen to protect his share purchase decisions. Frank is interested in purchasing ANZ shares. ANZ is trading at around $19.50 in early August 2009. He believes that bank shares have seen their lowest point, and he does not think they will return to the panicking low levels seen in the first quarter of 2009. Frank wants to see the ANZ shares make up a part of his long-term portfolio, but he does not want to suffer a loss of more than $2 per share. He believes ANZ may experience more volatility before the end of 2009. Frank devises a strategy he hopes will win him the shares at a reasonable price, with limited downside. ANZ is going ex dividend in early November, so Frank will sell an ITM October put in the hope of being assigned to buy the shares in late October and become entitled to dividend a few days after the purchase. In order to protect his potential investment and minimise his losses to no more than a $2 per share, Frank will buy puts for December to provide protection until the volatility settles.
157 Portfolio Management This is the spread Frank executed: Sold two October 2009 $20 puts for $1.30 credit per contract and Bought two December 2009 $18 puts for $0.80 debit per contract Net income received is $0.50 credit (before costs) If ANZ were to fall from the current price of $19.50 Frank will be assigned early on the ITM October put. He will be buying 2,000 ANZ shares at $19.50 ($20 strike -$0.50 premium received), but can be confident that he will not lose anything beyond $18 (his breakeven is $18.50 including the 50 cents premium received) on ANZ until end of the year. ii Fully cover with cash This remains the best “bulletproof” defense. The investor reserves the cash for the potential exposure, which is the strike price of the short put, multiplied by the number of contracts written, multiplied by its SPC. In the example above, to be fully covered, Frank would need to reserve $40,000 ($20 * 2 * 1,000) for the intended purchase of 2,000 ANZ shares. This may seem simple conceptually, but in reality we are easily tempted by other investment opportunities. It’s easy to tell ourselves we will put the cover funds back once we have profited on the other investment. This can create a dangerous situation if the other investment becomes unprofitable or if it simply cannot be sold on time. A sensible investor would keep the funds secure to eliminate the potential stress of early assignment or margin explosion. iii Use other shares as full cover Rather than using cash to cover a potential purchase, some investors choose to use the value of the existing shares in their portfolio as leverage. Shares that are eligible for use as collateral cover are lodged as cover for the short put margin requirement.
158 OptionsWise The danger in using shares as leverage is that shares must be sold before the cash can be used to buy the assigned shares. This transaction can be carried out on the same working day, but the sale price of shares is not within the control of the seller. The value of a parcel of shares earmarked for the potential purchase for a short put position may no longer be sufficient if the shares used as collateral have dropped in value. This can occur in a bear market where weakness is not confined to a particular share or sector. The investor is still faced with the potential of being caught short, especially on unexpected early assignment. iv Use a margin loan Apart from super funds, investors who have the risk appetite to undertake leverage may use margin loan facilities to partially fund the purchase of shares if assignment occurs, either early or at expiry. If such a leverage strategy is undertaken, the investor still has to reserve between 30 and 40 per cent of the underlying exposure (depending on the loan to value ratio or the percentage a margin lender is willing to lend on a particular share). Investors should be aware that this strategy is not infallible. The risks of utilising this defense are twofold. A margin lender has the right to change the lending ratio on a share at any time. This normally occurs when the fundamentals of a share deteriorate, such as when the share price plunges and short puts have the highest risk of being assigned early. A margin lender can also reduce the lending quota on a particular share or eliminate it from their lending list altogether. In this case, the investor has to stump up more or all the cash required to purchase the shares. The other, more lethal of the two risks, occurs because the lending ratio is calculated on the current market price (when the share is assigned), not the strike price. Let’s re-visit Frank’s situation to examine how a margin loan defence for a short put assignment can unravel.
159 Portfolio Management Frank didn’t buy puts for protection, in order to earn the maximum income of $1.30 from the short put contract and wants to use leverage if his October $20 puts become deep ITM. His puts do become deep ITM when ANZ plunges to $16. If Frank is assigned to purchase 2,000 shares with a LVR of 75 per cent for ANZ, instead of contributing $10,000 cash (25 per cent * $20 strike * 2,000 shares) as the original 25 per cent equity planned for the purchase, he is required to inject $16,000. With ANZ at $16, the margin lender will only lend Frank 75 per cent of the prevailing market value of ANZ at $32,000 (instead of $40,000), which is $24,000 (75 per cent of $32,000). Frank has to stump up an additional $6,000 to carry out the purchase ($40,000 purchase price - $24,000 from margin lender - $10,000 of Frank’s reserved cash). If this scenario is coupled with a reduction in the LVR from the margin lender, Frank can easily run into a cash flow problem. This was a common occurrence during the depth of the credit crisis, and many unassuming put sellers were caught short. This form of defence can easily go wrong, especially in a bear market. 4 Exercised Deep ITM short positions will be assigned at expiry. When the market price of the underlying share is trading under the strikes of the puts or above the strikes of the calls, which are still open after the close of trading on expiry, the short positions are ITM and will be exercised automatically. An investor with ITM puts will have to buy the underlying shares, while an investor with ITM calls will have to sell the shares. After realising the cash, a covered call holder of an ITM written call can move on to the next share purchase. However, a short put position holder will be forced to purchase the underlying shares. There are four alternatives open to the investor after buying shares for more than the market price (from ITM put): i Take delivery and hold
160 OptionsWise ii On-sell at market price iii Write call options iv Wash and replicate i Take delivery of shares and hold Taking delivery of a share that an investor wants to own is a good thing. However, where a short put position expires deep ITM, it is normally not the preference of the holder to take delivery, as he will be sitting on an instant paper loss. However, there are times where this is a better alternative than realising a loss, if the investor has reserved the cash for it and has the view that this is a shortterm aberration and the share has the potential to recover. In this situation, it will be more beneficial for the investor to hold on to the shares and wait for a recovery. ii On-sell at market price Buying high and selling low may not be an investor’s strategy at the outset, but this may be the only option available if the holder of a short put position has not reserved the cash to purchase shares. An investor might also sell his shares at a loss if he has changed his mind about the fundamentals of the underlying share. He may have concluded there is further potential downside and he will be better off realising a loss now than suffering a larger one later. The third reason an investor might choose this strategy would be because he has simply changed his mind about buying the shares due to his own financial position. Investors in this category will most likely be selling the shares on market at a substantial loss. iii Write call options over the assigned shares Once the holder of a short put position takes delivery of the shares, call options are written over the shares. This reduces the entry price of the shares and generates some income from the holdings. The downside of this strategy is that for a deep ITM put position, as
161 Portfolio Management share price has fallen significantly, call option values will be low. In order to earn a reasonable amount of premium income, the writer may have to sell lower strike calls. If the underlying share starts to recover during the life of the call, the investor risks being forced to deliver the shares at a compromised level, at a lower strike than he would like. Occasionally, for the sake of income, the call strikes may even be lower than the purchase price, locking in an overall loss for the investor. iv Wash and replicate Washing involves buying up the assigned shares and on-selling them immediately in the equities market (normally at a loss) whilst simultaneously replicating the exposure by selling put options with similar exposure (in terms of contract size). For example, to replicate the washing of 1,000 BHP shares, the investor may sell one contract of BHP. The income from the shorting of the put options is used to recover or fund the loss from the sale of the assigned shares. The choice of strike, or term of the put, replicating the exposure would depend on the investor’s comfort level. The investor may choose to lower the strike of the put to reduce the risk of further assignment whilst footing some of the losses from the sale of the shares. The wash and replicate strategy is suitable only if the investor intends to maintain exposure in the underlying share and believes the share will recover. The downside is, if the share continues to fall, the investor will carry on suffering losses and these losses may be larger with the wash and replicate strategy. The doubling-up trap Investors who utilise the wash and replicate strategy are often cash strapped and usually have to foot higher margins or are realising some losses. In order to recover some of the losses or to fund the washing, some choose to increase their exposure when replicating
162 OptionsWise the option position. For example, an investor might wash 1,000 BHP shares, then sell two contracts (instead of one) of BHP put options to increase his income to pay for the loss. Often investors sell the put options at unrealistically high strikes for the sake of a higher income, but get stuck with a similarly high risk of assignment. Increased income may make this doubling up seem tempting, especially when a share has fallen substantially and volatility has increased as a result of the fall. At this time, the higher premiums make selling new put contracts more attractive, but if the share continues to fall, the investor will be in twice the number of short positions compared to when he started the strategy, with double the trouble; he now has a higher exposure to a losing position (with more contracts) and has more ITM positions eating up more margins with higher risk of being assigned. There is a short-term gain to be had, but the investor has created a long-term pain for himself. The sunk costs trap There are many reasons investors choose to pursue high-risk option positions. One is an inability to cut losses. Instead of cutting small losses, individuals try to make the best of what has already been done. We tend to ignore the warning light that flashes when share prices drop. We choose not to lock in small loses and instead hang onto the hope that the share will bounce back. Psychologists who research this behaviour have found that once costs have been sunk into a project (or share or option position), the desire to get one’s money’s worth makes most people willing to spend additional funds to justify the sunk costs.17 Let’s follow Peter’s option experience and consider his choices in managing an ITM short put position. Peter has been watching resource company BHP closely. In the first half of 2008, as the financial crisis unfolded, BHP outperformed the Index. Resource companies were seen as safe
163 Portfolio Management havens because demand from China was strong and investors sold off their financial sector shares to invest in such companies. Peter is a trader who uses short put options to generate income and cash to cover margin requirements. In the middle of 2008, BHP retreats from a high of $50 to around $44 and Peter shorts a three month September put in BHP at a strike of $40 for $1,800 income per contract. Unfortunately, since Peter initiated this position, BHP has not returned to the mid $40 price level. In fact, the GFC has started to take its toll on the company and break down what was once a safe share choice. When Peter’s put expires, BHP is trading at around $36. Peter’s BHP $40 short put position is expiring ITM. If this position is not rolled out before expiry, Peter will be assigned to buy the shares at $40, while it is trading at $36.50 on market (an instant $3.50 paper loss per share). As Peter’s intention is not to buy the underlying shares, he rolls the short put position out for another three months and at the same time lowers the strike to $39. Fortunately, as BHP is not very deep ITM, he manages to roll down $1 on the strike and receives 60 cents per contract, for an extra income of $600 per contract (paid $3.50 per contract, and received $4.10 for the new contract). However, as time progresses, the BHP share price drops even further and, at the depth of the share price in mid November, Peter is assigned on his December $39 BHP put. At this point, BHP is trading at $21. Peter is now sitting on a substantial paper loss. Peter’s original intention was not to buy the underlying shares and he does not have protection on his positions. The prospect of realising an $18 loss per share is too much for him to bear. As he is quietly confident that BHP will recover from the depth of $21 to at least $30, if not more in longer term, the best alternative available to him is to take delivery of the shares. Fortunately, Peter is not leveraged at this time and he manages to sell some other shares to gather enough resources and take delivery of the shares.
164 OptionsWise After taking delivery of the BHP shares at $39 (even though his breakeven price was $36.60 due to the $1.80 initial premium received plus $0.60 from the second premium on rolling), Peter sits on the shares for almost six months, waits for BHP to recover, then takes the opportunity to sell call options over the shares. In June 2009, BHP recovers to around mid $34, and Peter sells a one month $35 covered call for $1.20. Though the delivery price of $36.20 will still be $0.40 shy from his breakeven purchase price, Peter is more than happy to recover from a substantial paper loss and move on.
165 Portfolio Management Summary of portfolio management issues Before expiry Profitable (substantially) Close early Paper loss Close—take loss Roll—defer obligation and avoid assignment Assigned early (put) Defence: a. Execute protection b. Full cover c. Use other shares d. Use margin loan Assigned early (call) Deliver shares At expiry Exercised (put) a. Buy shares b. Sell on market c. Sell covered call d. Wash and replicate Exercised (call) Deliver shares Table 34 Option portfolio management strategies
166 OptionsWise
167 7 Creating Certainty In An Uncertain World When we meet a new person, most of us decide what kind of friend, client or boss they may be within a few minutes. We make an assessment of their character according to our perception of the individual’s looks, body language and speech and decide whether he or she is genuine or whether they’re just being nice because they’re trying to sell us an idea or product. Think about the number of decisions you made today. Each of us decides when to wake up, what to wear and where or what to eat according to our schedule and budget. Perhaps you walk past a new café or restaurant and decide not to try the food because you get a negative vibe from the place. How do you get this sense, these vibes? Thin-slicing Psychologists call it the ability to thin-slice. Malcolm Gladwell, journalist and sociology writer says, “‘Thin-slicing’ refers to the ability of our unconscious to find patterns in situations and behavior based on very narrow slices of experience.”18 We are often told not to judge a book by its cover, but a person’s dress, attitude and manner send particular signals to us and we form an opinion on them, which is coloured by our prior experience. “It’s sifting through the situation in front of us, throwing out that is irrelevant while we zero in on what really matters.”19
168 OptionsWise Thin-slicing is not undertaken by a select few, every one of us does it. Our adaptive unconscious is what allows us to intuit things we don’t really know. Gladwell explains this, “The part of our brain that leaps to conclusions … is called the adaptive unconscious, and the study of this kind of decision-making is one of the most important new fields in psychology.”20 “This new notion of the adaptive unconscious is thought of … as a kind of giant computer that quickly and quietly processes a lot of the data we need in order to keep functioning as human beings.”21 Think about the way we receive, process and retrieve information all the time. A decision made in two seconds is not just two seconds worth of work; it is made with the assistance of a lifetime of knowledge and experiences. However, when it comes to thin-slicing, the crucial question is, do you regularly make snap judgments that are correct? All people have the ability to be right more often than they are wrong in these judgments if they properly train their senses. This power of intuition needs to be honed. According to Gladwell, “Taking rapid cognition seriously— acknowledging the incredible power … that first impressions play in our lives—requires that we take active steps to manage and control those impressions.”22 The investor’s ability to make timely, accurate investment decisions is centred on the planning and analysis carried out before those decisions are required. Having a pre-determined investment plan is crucial to making the right snap judgment. Options provide a number of variables that require an investor’s time and consideration. One must think about strikes, terms, cash flow, risks and the behaviour of underlying shares. We lead busy lives and it can be difficult for people to make optimal investment decisions under pressure. We feel there is not enough time to consider all the relevant factors and
169 Creating Certainty In An Uncertain World either let good opportunities slip away or forget to limit our losses. The ability to act fast is key to maintaining a long-term investment habit, because often this is how important investment decisions need to be made. So how do investors prepare themselves to make educated snap judgments and controlled first impressions? It’s all in the investment plan. A great deal of analysis goes into the construction of your option investment plan. Among other things, investors should decide on the level of risk that is acceptable for their circumstances and the minimum amount of reward required before a strategy is undertaken. When a snap decision is required, the investor can fall back on this pre-set plan as a benchmark. This is the equivalent of thin-slicing, without having to go through the rationale and risk and reward analysis each time a decision is required. If the decision an investor makes deviates from the planned benchmark due to higher risk, lower reward, or both, he will only follow through with that decision if he expects a better outcome. This investor will be able to make better snap investment decisions as he builds on his experiences, and gradually this process will become easier and more accurate. There is another reason why having a pre-set option investment plan is important; we have a tendency to maintain the status quo. Do you allow service providers to take money out of your bank account through direct debit? Most of us agree to the direct debit payment plan system because of the perceived convenience of allowing the bills to “pay themselves”. My account is direct debited by more than one service provider. Over the past year, there have been several occasions where I have noticed increases in my agreed monthly deductions, and, in the case of one service provider, there were several increases that I only picked up on a few months after the money had been withdrawn. However, even though I noticed the increase in the charges, I did nothing about them. I remained with the service providers and
170 OptionsWise never bothered shopping around. I told myself I would look for better deals once I completed this book, or after I finished my tax return, but it’s probably unlikely that I will ever get around to it at all. I’m busy and it’s just too much effort. This attitude is exactly what service providers are hoping for when they encourage users to set up direct debit accounts. We have a propensity not to change the status quo. Professors Samuelson and Zeckhauser have conducted a series of decision-making experiments and found that individuals disproportionately stick with the status quo. Their data shows that the status quo bias is substantial in important decisions like the selection of health plans and retirement programs by their faculty members.23 People and corporations use the concept of the status quo to achieve a desired outcome. This can also be seen in the tactics of television networks who put popular programs to air at prime time, in the hope that those viewers who tune in to those programs will continue to watch the channel for the rest of the evening. If you have the ability to program Foxtel IQ to record your favourite show and set default programs to open when you log on to your computer, why not plan a set of investment strategies to form a personal status quo? Once an investor knows what that status quo is, he has a basis upon which to evaluate his investment opportunities. Knowing for certain where your lowest denominator of risk is positioned allows you to not only plan investment strategies, but also to plan defence strategies and ensure you have adequate resources to cover your risks. If you stick to your plan, it will deliver you to your destination, even when you are operating automatically based on your status quo strategies. A plan is part of creating certainty in an uncertain world.
171 Creating Certainty In An Uncertain World A speculative trader whose strategy is to sell naked puts with only margin covering may sell multiple contracts for a great income in a bull market, but if conditions deteriorate into a bear market, naked puts will get more and more ITM and be assigned or the investor will experience margin explosion. If selling naked puts is this trader’s status quo strategy, then, in seeing a change in the market environment, the trader must revisit his strategy and review the merits of his aggressiveness. Margin covering can easily allow a trader a gearing ratio as high as 90 per cent at the start of a trade, but is this suitable in a bear market? Being aware of his status quo will allow this investor a greater chance of adjusting his gearing ratio for future trades and to tailor his strategies to the changed market environment. Creating your own status quo strategies Good investment decisions are made when one has a solid plan from the outset. With this in mind, let’s learn what’s involved in conducting the necessary research and help you create your own status quo strategies. To begin, I would like you to evaluate what the words “risk” and “return” mean to you. They have different meanings for different people. For some, risk means “I want the returns, under whatever conditions,” while others say, “I am only willing to consider even the highest of returns if particular conditions are met,” or even, “I will only consider an investment if its ultimate failure will not cripple my financial situation”. Understanding your personal attitude towards risk and return is important because investing is a balancing act, and the point of balance will be different for different investors. You need to strike a balance that is appropriate for you and then set this as your status quo strategy. Over the course of this book, you have met four investors who have very different personalities. Will is conservative and careful; George is keen to build wealth, but is impatient and naïve about risks; Dr Alfred is
172 OptionsWise looking for a sensible, sustainable way to grow his super fund; and Simon wants to create an income stream by running his option investments like a business. What about you? What is most important to you? Maximum return Minimum risk Less concerned about risks, more interested in returns Less concerned about returns, more interested in risks What do you expect from your investment portfolio? Surprises (on the upside) The unexpected (on the downside) Pleasure Stability Safety How does volatility sound to you? Vulgar Fun Stress Adrenaline rush Necessary evil How much does your investment mean to you? Everything, it’s my life source It doesn’t matter It’s my second, third or fourth source of income It’s my entertainment It’s a way to spend my time It’s nice to have It’s my career, profession
173 Creating Certainty In An Uncertain World What is the maximum loss you have experienced in any one share? Everything Half 10 per cent per cent How did you feel about the loss? It was unfortunate, but I got over it and moved on I had sleepless nights, nightmares, dreamt of shares I couldn’t concentrate at work, experienced a loss of performance, lacked concentration I lost my appetite and desires My family life became a fiasco I experienced migraine, hyperventilation, insomnia, memory loss What if the maximum loss you experienced above affected your entire portfolio? Would you or did you also feel or experience any of the following? Suicidal tendencies Family ruined Sacked from work Were you affected in the following manner? Sold family home Sold all assets of value (eg. investment property, car, boat, business) Maximised personal loan, line of credit, mortgage equity Borrowed from friends and family The answers to the above questions will be different for each individual and you may not even have the answers to some of them,
174 OptionsWise but they demonstrate the possibilities that can occur with risks or losses. As you were going through the questions, it is likely you made a mental note of your answers (or lack of them) and placed yourself somewhere on the spectrum of the risk and return trade-off. Your investor type is coloured and shaped by your past experiences with investments, your personal outlook in life (whether you tend to be optimistic, realistic or pessimistic), and whether you enjoy or fear risk. Your status quo strategies should meet your values and cater for your fears. Below are some status quo strategies set at the lowest possible risk factor. These are suitable for a super fund or a conservative portfolio investor; each investment is fully covered and does not use any leverage or speculation. It is a platform for any investor who is beginning to use options as part of his or her share investments and it is also a base from which more risk tolerant investors can gear up, by adjusting the rules. The table below details the status quo strategies for an options portfolio investor. Investor’s intention: Conviction: BUY SHARE Strong Option strategy: Risk(s): Rule(s): i. Buy call View does not eventuate during term of option Only undertake if prepared to lose all capital. Full cash cover for super funds ii. Sell put (ITM) High likelihood of early assignment to buy share Full cash cover for put
175 Creating Certainty In An Uncertain World iii. Synthetic long May only be partially successful in purchase of shares. May end up more expensive if trade is a debit. May lose capital on call Full cash cover for put. Super funds cover for call as well Investor’s intention: Conviction: Moderate BUY SHARE and bullish uptrend Option strategy: Risk(s): Rule(s): i. Sell put (ATM/OTM) If naked, no downside protection Full cash cover. If investor buys put, cash to cover spread is acceptable, except for super funds ii. Protective Buy Share may fail to appreciate beyond higher purchase price No further cover required Investor’s intention: Conviction: BUY SHARE Low and mild uptrend Option strategy: Risk(s): Rule(s): i. Sell OTM put May be assigned to buy share above market price. May lose opportunity to buy share Full cash cover ii. Buy write Only a mild downside protection. May end up selling shares too cheaply Only undertake if intend to sell shares. Provide full share cover according to SPC
176 OptionsWise iii. Buy and collar Good protection. May end up selling shares too cheaply As above Investor’s intention: Conviction: SELL SHARE Strong Option strategy: Risk(s): Rule(s): i. Buy put Good protection up to term of option only Buy no more than number of shares held ii. Sell call ITM May end up selling shares too cheaply. Moderate protection only. May lose out on dividend. Only undertake if intend to sell shares. Provide full share cover according to SPC. Avoid selling too close to ex-dividend date iii. Collar As above, except good protection As above Investor’s intention: Conviction: Moderate SELL SHARE and bearish trend Option strategy: Risk(s): Rule(s): Sell call (ATM/OTM) May end up selling shares too cheaply or holding on to losing shares As above
177 Creating Certainty In An Uncertain World Investor’s intention: Conviction: Low SELL SHARE and mildly bearish Option strategy: Risk(s): Rule(s): Sell OTM call or just hold shares May end up holding on to a losing share and lose opportunity to sell shares. Income may not be sufficient compensation As above Table 35 Status quo strategies These status quo strategies are a good reference and you can fall back on their recommendations when you want to switch to auto pilot. With them, you can be confident that you won’t lose more than what you put in and your downside is known. They create clarity and certainty in your investments. Setting your own status quo rules of thumb Options investors are constantly faced with decisions about whether to close (to cut losses or take profit), to reduce risk (to use hedging or not), to react to the passing of time (due to the erosion of time value or expiry date), to avoid strategies or assignments or to deal with assignments or margin escalations. Sometimes these decisions need to be made in highly uncertain or stressful environments. Throw a busy lifestyle, family pressures and work commitments into the mix and it is clear investors don’t have the luxury of sitting down to think through all the issues before making a decision. As a result, most investors either think on their feet or drag their feet when it comes to making decisions.
178 OptionsWise Fast and frugal Options portfolio investors should get used to making fast and frugal decisions. “Fast and frugal” decision-making, coined by Gigerenzer and Todd, involves making decisions quickly using a limited amount of information, and the outcomes of the decision should satisfy requirements or at least do the job at hand.24 What if the investor had a set of pre-determined rules of thumb that he or she could fall back on when a fast and frugal decision was required? It would free him from going through the whole process of rationalising decisions. Below are some basic rules that will get an options investor started when forming a personal status quo. Rules of thumb (for options sellers) Why? Take profit if cost equivalent to 10 cents or less per contract Trade-off – outlay small costs for reward of locking in bigger gains Do not open new positions for the sake of income Income should never be the motivation. Does your fundamental investment view justify the position? What is your conviction or view? Always consider whether protection is needed (even if you really want the shares) This will affect how much capital/ resource is required and your risk and return analysis Close early for small losses if your comfort level of the underlying share drops Protects against margin escalation and frees up cash reserves, allowing you to re-implement the strategy at different price or on a different share Do not average up on contracts (especially on a losing position) Number of contracts has to be determined at the outset (planning stage), though can be executed in stages Table 37 Status quo rules of thumb
179 Creating Certainty In An Uncertain World These rules can supply peace of mind for an investor in a stressful environment. However, if you have the time to change or further explore the options available, the OptionsWise website applications can help you with the analysis work that should be done before you begin trading. These tools should not replace sound advice from an investment professional, but they are very powerful planning assistants. The Optimiser application helps you select the most appropriate strategies and variables like strike prices, terms and the number of contracts to buy or sell according to your resources. The Margin/Risk Analyser supplies a risk analysis of your chosen strategies by providing information such as required margins cover, the potential exposure of your strategies, whether you have excess or shortage margins based on your resources or if you need a stop loss level. The Margin/Risk Analyser application can also pre-determine your entry and exit strategies with the “What-If” function which simulates the movement of your chosen strategy with movement in the underlying share price and changes in option pricing variables like MIP and volatility. The Pricing application estimates options prices and helps with planning and analysis work. These applications will prepare you for the unexpected events that can occur in options trading and will continually hone your decision-making skills. It becomes much simpler to make fast and frugal decisions for investors who utilise the OptionsWise online applications, stick to their status quo strategies and follow the advice of an investment professional.
180 OptionsWise Epilogue Investing can be like standing in the centre of a seesaw, feet apart, arms wide open, trying to balance. You’re simultaneously having fun and trying not to fall off. Investing is always a balancing act and investors position themselves between risks and returns, costs and payoffs, fear and greed. Sometimes, when you think you have struck a safe balance, an overly active kid might unexpectedly bounce onto one end of the see-saw, tipping you off. You get back on the seesaw and try to maintain a different position by tensing the muscles in your feet, lowering your arms and moving your body away from the boy, but, he jumps off as suddenly as he jumped on, and you are once again off balance. When investing, the first rule of thumb should be to expect the unexpected. Clarity and planning will help you keep your balance. Uncertainties loom in the investment market, but that’s how money is made. Investors who have clear core values will be able to create certainties in an uncertain market and remove the stress that comes with the balancing act. This will allow you to enjoy the product of your investments and the process of investing. All things were made for your enjoyment, including money.
181 OptionsWise Acknowledgements I was in a hospital maternity ward following the birth of my third child when I decided to start writing this book. I was being treated like a star, with my own room, meals delivered when I was hungry and fresh sheets daily, so I took the opportunity to begin writing. I suppose I should thank my son Alexander for giving me that period of time when I could be away from my normal job, the stock market and the day-to-day demands of family life to get stuck into it. In the midst of changing nappies, feeding Alexander and putting him to sleep I found solace and enjoyment in penning OptionsWise. There are many people who have assisted me along the way. I would like to thank my early readers, Stephen Chensee and Patsy Sealey, for their constructive criticism and encouragement. My thanks also go to John Wasiliev who has given me such important feedback, Tony Hunter from the ASX for reviewing my early work and Hamish Dee who spent a huge amount of time painstakingly reviewing each and every page of my first draft to ensure the accuracy of the numbers and concepts. I’m also grateful to Glenn Mumford, who steers me towards the right people and my colleagues at the RBS Morgans Asian Desk and options team who have supported me in various ways. My appreciation goes out to the team at Angusta, who have tolerated the numerous changes in my specs for the OptionsWise
182 OptionsWise online applications. Thanks to Angela Yeh, for her great patience and design skills and the team guided by Andrew Yong who produced the excellent web-based option applications for OptionsWise readers. To the team of ladies who worked on the book—Elizabeth Fenech, Helen Elward and Bernice Kesbah—you are a most professional and efficient group. You are the key people who helped bring OptionsWise to fruition and made the journey a pleasant one. Finally, to my dear Olivia and Eugenia, thank you for the quiet times you provided me when I needed to write.
183 Glossary acceptable collateral assets that can be lodged with the ACH to meet margin requirements for the sale of option positions at the money (ATM) the strike price of the option contract is equal to the market price of the underlying asset Australian Clearing House (ACH) the central counterparty and clearing facility for all products and markets across the ASX Australian Securities Exchange (ASX) the primary stock exchange for Australian shares. It regulates companies listed on its Exchange and is a public listed company itself bearish an individual who holds a pessimistic opinion of future share performance and believes prices are heading down. Also used to describe a bear market bear market a falling market breakeven price (point) the price where the option strategy places the investor in a similar position to a non-option position or investor 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
184 OptionsWise bullish an individual who holds an optimistic opinion of future share performance. Also used to describe a bull market bull market a rising market buy and strangle strategy involving buying shares by simultaneously selling equal numbers of put and call options, to ensure full cover. Strong income generating strategy call option a contract which entitles the holder to buy a fixed number of shares at a stated price on or before a specified expiry date. Call options appreciate in value as the underlying share/ Index rises capital assets, wealth, money that is invested capital gains tax (CGT) income tax calculated on the realised capital gains when assets are sold 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 collar option strategy whereby an investor simultaneously buys puts and sells call options on an underlying share if he believes the share value will drop or if he is happy with the market price and wants to sell his underlying shares collaterised debt obligations securities that are exposed to the credit risk of a number of corporate borrowers combination hedging a strategy involving buying puts and selling calls to achieve the investor’s cash flow and risk management objectives contract for difference (CFDs) a form of derivative and leverage tool. Only traded on the ASX platform if they are ASX CFDs
185 Glossary covered call option strategy whereby an investor sells a call option to hedge with the income. Requires a moderately bearish view of the underlying share credit roll a position that is rolled to a similar or different strike for a further out month with a higher income received from the new position cum with something—for example, shares bought cum-dividend entitle the purchaser to the rights to the dividend earned debit roll a position that is rolled to a similar or different strike for a further out month by paying, due to the lower premium received from the new position Delta measures how much an option moves in comparison to its underlying share or index demutualised association a mutual or cooperative association that has transitioned into a public company by converting the interests of members into shareholdings, which are traded through a stock exchange. A demutualised association’s structure limits its activities to servicing its members and inhibits its ability to pursue profits and diversification as freely as companies derivatives financial instruments that derive value from their underlying assets dividend the amount paid out of company profits to shareholders dividend play a strategy whereby an investor 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. This gives the investor some idea of reward and risk and the time and resources the strategy requires