186 OptionsWise downside perceived risk or likelihood that a share price will fall early assignment a random exercise where an option seller/ writer is called upon before expiry to buy (if a put) or sell (if a call) the underlying share Endowment Effect term coined by Richard H. Thaler that describes the phenomenon whereby people demand much more to give up an object than they would be willing to pay to acquire it equities, shares, stocks ownership in a company listed on a stock exchange equity options options issued over listed equities or shares or stocks ex without something—for example, shares bought ex-dividend do not entitle the purchaser to dividends. This right remains with the seller exchange traded options (ETO) options with standardised features issued by the ASX. There are three types of ETOs, equity options, Index options and low exercise price options ex date the date on which shares change trading from ‘cum’ to ‘ex’ status franked dividend dividends with attaching franking credits franking credit an amount associated with a dividend that represents income tax paid by a company Gamma measures the rate of change in Delta compared to the change in the underlying share gap up where the opening price of the share is significantly higher than the previous day’s closing price
187 Glossary gearing the use of borrowed funds. A company (or individual) is described as “highly geared” if the ratio of borrowed funds is high in relation to shareholders’ funds (or person’s equity) global financial crisis a financial situation which caused a shrink in liquidity and lending across major financial institutions and financial systems in the world haircut a reduction in the market value of a share lodged as margin cover hedge funds a managed fund designed to take speculative long or short positions on various assets hedging a risk minimisation strategy that protects investors against losses income monies received in profit or sales Index constitutes a number of shares that acts as a benchmark or representation of an entire market or a particular sector of a market Index option an option that derives its value from an Index. It cannot be exercised early and can only be settled in cash on expiry initial public offering (IPO) the process by which a company first seeks to be listed on a stock exchange, usually by way of a prospectus instalment warrants a form of derivative with in-built gearing that is issued by providers other than the ASX interest rate the rate charged or paid for the use of borrowed money, expressed as an annual percentage of the principal in the money (ITM) option has high intrinsic value
188 OptionsWise leg-in executing any protected spread strategy by selling the put first and waiting for the share to rise before buying the put retrospectively. This dramatically increases an investor’s risk profile leverage gearing, the use of borrowed funds to supplement an investor’s money when acquiring an asset. The higher the leverage, the higher the use of debt liquidity the state of having assets either in cash or readily convertible into cash. A liquid market is one in which there is enough activity to satisfy both buyers and sellers loan to value ratio (LVR) percentage of the market value of a share a margin lender is willing to lend to a buyer of the share long call or put buying a call or put long share or index taking a bullish, positive or up-trending view on the underlying share or index low exercise price option (LEPO) a form of deep in the money option with a risk profile similar to a futures contract. The buyer is margined and gains control over a large parcel of shares for a low entry price margin a requirement placed on sellers/writers of options, like a deposit. Can be met with cash or shares acceptable as collateral cover margin explosion occurs when share price jumps or plunges significantly and margins required for option positions increase dramatically margin interval dollars measures the maximum trading range of a share in a day in terms of dollars margin interval percentage measures the lowest and highest intra-day movement of a share in terms of a percentage
189 Glossary margin lenders companies that lend money to investors based on the value of their share portfolio market capitalisation the value of a company as set by the stock market. Calculated by the number or shares on issue multiplied by the price per share market makers companies that provide bid and offer quotes for option traders to provide liquidity in the market naked call writing selling call options without the cover of underlying shares. This strategy is used by aggressive investors to speculate on a falling share price or to short a share options a security which gives the holder the right to purchase or sell an underlying share in a company at a specified price on a specified date options enhanced portfolio (OEP) the investment return of a portfolio is increased by premium income earned from the selling of options out of the money (OTM) option has low intrinsic value perfect hedge a scenario whereby a hedging investor makes a $1 gain from an option for every $1 drop in the share price portfolio a share portfolio holds more than one share. An option portfolio holds more than one option position in one or more shares portfolio hedging an overall approach to hedging by combining strategies of various shares in the portfolio to achieve an investor’s overall cash flow and risk management objectives premium the price of an options contract
190 OptionsWise premium margins income from the sale of an option which forms part of the margin cover price to earnings (PE) ratio measures the number of times the market price covers the earnings of a share protected loan Lender buys put options on shares. Investors pay a higher interest rate in compensation for not losing more than the loan amount protective put buying a put to protect an investor’s share punt a gamble or speculation put option a contract that entitles its holder to sell a fixed number of shares in an underlying company at a stated price on or before a specified date. A put option appreciates in value as the underlying share/Index falls range As in, he expects the share market to move in a range. Sideways, neither up nor down strongly ratio hedge combination of buying put and selling call at different number of contracts to meet investor’s objectives Rho measures the effect of a change in interest rate on the price of an option rights issue undertaken by listed companies to raise additional capital by issuing new shares to shareholders in proportion to their existing shareholding. Rights can be tradable on the market (if they are renounceable) for shareholders who do not wish to take up or pay for additional shares in the company. Rights that are not tradable (nonrenounceable) will be lost if not taken up risk the uncertainty that a particular outcome will eventuate or that an investment will not deliver an expected return
191 Glossary risk margins the cash or share cover required to cater for the daily volatility of the underlying share self-funded retiree a retired person who does not receive social security benefits, but instead has ample savings to support themselves for the rest of their lives share purchase plan (SPP) an offer of shares by a listed company to its existing shareholders shares ownership in a company listed on a stock exchange shares per contract (SPC) contract size or the number of underlying shares represented by one contract of an option series short call or put to initiate an option position by selling a call or put short position(shorting) strategy that involves selling shares then buying them back later, at a cheaper price short share or index taking a bearish, negative or down-trending view on the underlying share or index speculate involvement in any market purely to make a profit without direct interest in the commodity or underlying asset traded spread difference between the buying and selling rate of an option, or difference between the strike prices of two options status quo the existing condition straddle an options strategy whereby the trader realises a profit when there is a rise or fall in the underlying stock (for buyers) or stay 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
192 OptionsWise strike price the price at which the underlying security may be purchased or sold on the exercise of an option superannuation (super) fund a fund that holds money or savings to provide for a person’s retirement. Monies can be held and invested in various structures, for example, they can be self managed (SMSF) or employer managed (in a corporate super fund) synthetic long option strategy that 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 take buy option to open or initiate a trade Theta measures the erosion of time in a day for an option total margins sum of premium margin and risk margin upside the profit potential Vega measures the change in an option price with a change in its volatility volatility a measure of uncertainties in both the movement and direction of the underlying share/Index wash a strategy used when an option seller is assigned and he does not want to follow through with the share obligation, so he chooses to remain with the exposure in options write sell an option to open or initiate a trade writer a person who provides newly-created options to a purchaser for a premium
193 References 1 Thaler, R., Sunstein, C. (2008) Nudge: Improving Decisions About Health, Wealth, and Happiness, Yale University Press, New Haven & London p. 40 2 Kahneman, D., Knetsch, J., Thaler, R. (1991) “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias” in The Journal of Economic Perspectives, 5(1) p 194 3 Shaviro, D. (2007) Taxes, Spending and the U.S. Government’s March toward Bankruptcy, First Edition, Cambridge University Press, New York, p. 25 4 McCaffery, E., Baron, J. (2003) “Heuristics and biases in thinking about taxes”, Social Science Research Network, University of Pennsylvania, Inst for Law & Econ Research Paper 03-31, USC Law School Olin Research Paper No 03-22, USC CLEO Research Paper 03-23, last cited 30 August 2009, p17, http://ssrn. com/abstract=467440 5 Harford, T. (2008) The Logic Of Life, First Edition, Little, Brown Book Group, UK p.4 6 Russo, E., Schoemaker, P., (1990) Decision Traps: The Ten Barriers to Decision-Making and How to Overcome Them, First Edition, Fireside, New York, p. xvii (the above edition is no longer in print and is now replaced by a new book—Russo, E., Schoemaker, P., (2002) Winning Decisions: Getting it Right the First Time, First Edition, Doubleday, New York)
194 OptionsWise 7 Tavris, C. and Aronson, E. (2007) Mistakes Were Made (But Not By Me): Why We Justify Foolish Beliefs, Bad Decisions and Hurtful Acts, First Edition, Harcourt Inc., Orlando, Forida, p. 2 8 Insurance and Superannuation Commission (1997) Superannuation Circular No.II.D.7 Derivatives, Australian Prudential Regulation Authority, Australia (copyright Commonwealth of Australia, reproduced by permission) 9 Insurance and Superannuation Commission (1997) Superannuation Circular No.II.D.7 Derivatives, Australian Prudential Regulation Authority, Australia, p. 8, s22 (copyright Commonwealth of Australia, reproduced by permission) 10 Insurance and Superannuation Commission (1997) Superannuation Circular No.II.D.7 Derivatives, Australian Prudential Regulation Authority, Australia, p. 37, appendix 2i (copyright Commonwealth of Australia, reproduced by permission) 11 Insurance and Superannuation Commission (1997) Superannuation Circular No.II.D.7 Derivatives, Australian Prudential Regulation Authority, Australia, p. 8, s19 (copyright Commonwealth of Australia, reproduced by permission) 12 Kahneman, D., Tversky, A., (1979) “Prospect Theory: An Analysis of Decision under Risk” in Econometrica, The Econometric Society, Vol. 47, No.2, p. 279 13 Zeckhauser, R., Keeney, R., Sebenius, J. (1996) Wise Choices: Decisions, Games, and Negotiations, Harvard Business School Press, Boston, MA. p. 85 14 Zeckhauser, R. J., Keeney, R. L., Sebenius, J. K. (1996), Wise Choices: Decisions, Games, and Negotiations, Harvard Business School Press, MA p. 89 15 Zeckhauser, R., Keeney, R., Sebenius, J. (1996) Wise Choices: Decisions, Games, and Negotiations, Harvard Business School Press, Boston, MA. p. 6–7
195 References 16 Thaler, R., Sunstein, C. (2008) Nudge: Improving Decisions About Health, Wealth, and Happiness, Yale University Press, New Haven & London, p. 36 17 Zeckhauser, R., Keeney, R., Sebenius, J. (1996) Wise Choices: Decisions, Games, and Negotiations, Harvard Business School Press, Boston MA, p. 68 18 Gladwell, M. (2005) Blink, First Edition, Allen Lane, the Penguin Group, Australia p. 23 19 Gladwell, M. (2005) Blink, First Edition, Allen Lane, the Penguin Group, Australia p. 33 20 Gladwell, M. 2005, Blink, First Edition, Allen Lane, the Penguin Group, Australia, p. 11 21 Gladwell, M. 2005, Blink, First Edition, Allen Lane, the Penguin Group, Australia, p. 11 22 Gladwell, M. 2005, Blink, First Edition, Allen Lane, the Penguin Group, Australia, p. 97 23 Samuelson, W. and Zeckhauser, R. (1988) “Status Quo Bias Decision Making”, Journal of Risk and Uncertainty, Volume 1, Number 1, Kluwer Academic Publishers, Boston, p. 7 24 Gigerenzer, G., Todd, P. M. & the ABC Research Group (1999) Simple Heuristics That Make Us Smart, Oxford University Press, Inc., New York, p. 5 (By permission of Oxford University Press, Inc.)
196 OptionsWise A adaptive unconscious 168 American options 19 assignment defence strategies 156–159 explained 19, 20 high risk of 20 aversion trap 96 B Baron, Jonathan 59 bear call spread 68, 69 bid and offer allowable spread 21 quotes 18, 21, 22 spread 15 Binomial tree 16, 17 Black-Scholes model 16, 17 inputs 18 breakeven price definition 33 bull put spread definition 124 margins 125 margin evaluation 128–134 versus naked put 126 buy calls to buy shares breakeven price 88 features 97 trade-offs 88–89 buy write and dividend 98 definition 98 features 109 margin requirement 100 C call option definition 10 rights of buyer 12 capital gains tax 27 CGT trap 58-60 closing early for profits 95–97, 150–153 ITM call 55 Index
197 Index ITM put 153 early for losses 178 cognitive dissonance 78, 79 collar as hedging strategy 60, 61 trade-offs 62, 63 covered call (selling) and delta 43, 44 and dividend and franking credit 34 and time value 32, 33 breakeven protective price 33 closing early 55 definition 32, 38 endowment trap 44, 45 expiring ITM 54, 55 features 32, 33 fully covering and SPC of 34, 35, 46, 50 margin requirements 36 on XJO 66 rewards and risks 37 risk of assignment 34, 36, 57 risk management strategies 36, 37, 57, 58 roll, debit or credit 55–57 workings of 50 D Delta and relationship with call and put 41–43 explained 41 perfect hedging 45, 46 dividend in option pricing 15, 16, 18 doubling-up 161, 162 E eligible collateral as margins 36, 72, 157 explained 92 endowment trap definition 44 European options 19 Exercised covered calls 54 definition 159 remedies 159–161 expire worthless 87, 113, 135, 151 F fast and frugal 178, 179 framing trap 116, 117 franking credits and option pricing 15 and naked call writing 67 G Gamma 47 Gladwell, Malcolm 167, 168 gearing 83, 84, 171 H Harford, Tim 77, 80
198 OptionsWise Hedging Combination strategies 60, 63 explained 23, 24 perfect 45, 46 portfolio 38, 53 strategies pre-qualifying conditions 32 trade-offs 41 with XJO Index 28, 29, 49, 66 with specific share call or put 30, 31, 49, 50 Howard, Ronald 111 I Index option (XJO) 28 features 29 hedging 28, 29, 49 shorting 66 in the money definition 12 sold call 54–58 sold put 153–154 interest rates 15, 16, 18 intrinsic value and option pricing 18 definition 8 K Kahneman, Daniel 96 L leg-in 125, 126 liquidity 20, 21, 127 leverage and super fund 84, 85 with margin loan 158, 159 with options 94, 102, 115, 149 with shares 157 M margins definition 71 workings of 72–74 margin escalation defence strategies 95 example of 94 margin explosion definition 75 margin interval dollars (MID) definition 73, 74 margin interval percentage (MIP) definition 73, 74 increase in 93, 94 workings of 129–131 market makers 18, 20–22 McCaffery, Edward 59 N naked call writing (shorting) dangers of 67–69 definition 66 margin explosion 75, 76 margin obligation 71–74 O options
199 Index company 2 definition 10 exchange traded 2, 8 financial 2, 8 out of the money definition 13 short positions 150–153 over-confidence 78, 79, 80 P premium margin definition 73 protection example of 156, 157 protective put (buying) and buy shares 87 and delta 43 and time 36, 37 breakeven price 87 definition 32, 37, 38 features 32 rewards and risks 37 risk of 34 workings of 49, 50 put option definition 10 rights of buyer 12 R ratio hedge definition 63 strategy 64 Rho 47 rights issue 35, 36 risk margins definition 73 workings of 129 rolling definition 55 covered call 56, 57 short put 163 strategy of 154 Russo, Edward 78 S Samuelson, William 170 Schoemaker, Paul 78 self-justification 78 self managed super fund and options 82 guidelines 83-–86 sell (short) put and dividends 104, 106, 108 cash reservation 91, 125, 157 closing early 96, 97, 152, 153 exercised 159 expiring ITM 135, 163 explained 89, 90 features 105 margin escalation 94, 95 margin requirement 91, 92, 107 risk of being assigned 106, 155 rolling strategy 135, 154 trade-offs 90 using margin loan 158, 159
200 OptionsWise with full cover 157 with lodgement of collateral 92, 93, 157, 158 with protection 156 Shaviro, Daniel 58 shorting 66, 67 SIS Act guiding principles of 83–85 speculating 82–85 status quo bias 170 rules of thumb 177, 178 strategies 174–177 straddle and dividends 143 definition 142 risk of assignment 143 strangle definition 136 margins 138 spread 137, 138 strike price definition 10 summary of diagrams 65, 80, 119, 148 summary of strategies 65, 80,118, 147, 165 sunk costs 2, 162 synthetic long construction of 100–103 and dividend 111 definition 100 dangers of 114, 115 features 114 T Thaler, Richard 1, 44 Theta 47 thin-slicing 167–169 time value and option pricing 9, 18 definition 8, 9 in rolling 56, 154 Tversky, Amos 96, 117 V Vega 47 volatility and margin requirements 74 and risk margin 94, 131 and option pricing 15–18 definition 13 historical 13 Implied 13, 19 W Wash 161 Z Zeckhauser, Richard 170
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202 OptionsWise Author’s note The concepts, stock and investment principles and option strategies described in OptionsWise are to be used as a guide only and all material is the opinion of the author alone. There is no express or implied endorsement of the author’s view in OptionsWise by her employer. Stock and option prices quoted in the book are the figures available at the time of writing. Past stock and option prices are arrived at using previously recorded information for the purpose of illustrating concepts and strategies. Though reasonable care has been taken, due to dynamism of the share market, the completeness and accuracy of these figures cannot be guaranteed. The recommendations and strategies presented in OptionsWise are of a general nature and do not take into account a reader’s specific investment objectives, financial situation or personal needs. Use of options may not be appropriate for some investors. Readers must seek professional advice from a Level 2 ASX Accredited Derivative Adviser (a list of advisers is provided on the ASX website) before embarking on any of these strategies. Advisers will tailor investment plans according to an individual’s objectives and financial circumstances. An adviser will also provide invaluable assistance when trades do not go according to plan. As a licensed adviser at the time of writing, the author discloses that she may have an interest in, and may hold the securities (shares,
203 Author’s note options, rights and/or warrants), mentioned in OptionsWise and may earn brokerage, commissions, fees and other benefits and advantages, whether pecuniary or not and whether direct or indirect, in connection with the making of a recommendation or dealing by her clients in these securities. No liability will be accepted for any loss or damage suffered as a consequence of any use or purported reliance on any concepts, ideas, strategies or methods mentioned in this book.
204 OptionsWise About the Author Wai-Yee Chen has been helping Australians make sound financial decisions since 1996. She is a Certified Practising Accountant and currently works for RBS Morgans as Head of Asian Derivatives Desk. Wai-Yee holds a Masters in Applied Finance from Macquarie University, a Diploma in Financial Planning from the Financial Planning Association and is a Level 2 ASX Accredited Derivative Adviser. Wai-Yee founded the CPA Australia Investment Strategy Group and was Chairperson from 2000 to 2005. Wai-Yee enjoys advising clients on a large spectrum of investment strategies, from direct equities, fixed interest investments, derivatives to managed funds. Her area of expertise is in the use of the Options Enhanced Portfolio Strategy for private as well as self-managed superannuation fund clients. Well-respected by her peers, Wai-Yee shares her knowledge with the wider public by presenting a live market commentary regularly on Sky Business News, addressing different investor groups including sophisticated investors and accountants on various investment topics. She also lectures on Option Courses. Wai-Yee has written lecture notes and contributed to the Journal of Financial Planning in the area of her special interest, options. Wai-Yee believes personally tailored option strategies are suitable to all investors, not just traders and high-risk speculators.
205 About the Author OptionsWise, her first book, serves as a step-by-step user manual for the investor who wants a sustainable source of income and a sensible way of investing with options. Aside from helping her clients create wealth in a sensible manner during the day, outside of work Wai-Yee assists, lectures and runs seminars for non-profit organisations to help people from all walks of life manage their financial issues. Wai-Yee’s passion is to see people enjoy money and life as a result.
206 OptionsWise About the Book OptionsWise does not promise to make you rich overnight, but it does offer reader the opportunity to develop a sensible, sustainable investment lifestyle. If the use of the terms ‘sensible’ and ‘options’ in the same sentence sounds like a contradiction to you, this book will challenge your perceptions about money management. OptionsWise traces the sharemarket through the global economic crisis, the worst bear market since the Great Depression. The book’s four investors navigate through the challenging years of 2008 and 2009 with the use of options. OptionsWise is not just about share prices and derivatives, it delves into the social demographic and emotional state of investors and explains how and why they make the investment decisions they do in the most stressful financial period in living memory. Tailored specifically for the Ausralian investor, readers can learn from the OptionsWise investors, what they did right and how they reacted when their investments and strategies went wrong. Readers will identify with the common characteristics of the four investors in the book and can apply the option concepts and strategies to their own lives. Information is laid out practically and comprehensively, with actual shares and prices used. The appropriate option strategies for particular shares are brought out one at a time according to the objectives and views of the investors in the book.
207 About the Book OptionsWise helps the everyday investor understand which option strategies are suitable for particular situations. This is a must-read for would-be investors researching investment options, share investors, option traders, self-managed super fund trustees and anyone looking to earn an income stream in a sensible, sustainable style.
208 OptionsWise About optionswise.com.au The OptionsWise website is a web-based application that can be used to help portfolio investors plan options strategies before trading. Proper planning and good professional advice are key to achieving the returns and peace of mind investors desire. Whilst the OptionsWise website does not provide investment advice or promise to make users rich overnight, it aims to educate investors about the variables in options trading. Each investor needs to find his or her personal balance on the spectrum of risk and return. It is equally crucial to maintain this balance in the increasingly uncertain financial market. I invite you to make use of the OptionsWise applications on your foray into options trading. I believe fears can be conquered with knowledge, and for an educated investor, the sky’s the limit. Enjoy investing with options! Wai-Yee Chen
Wai-Yee Chen is a licensed investment adviser and currently works with RBS Morgans as Head of Derivatives for the Asian Desk in Sydney. Wai-Yee regularly presents investment market updates on SKY Business channel and at various investor seminars. She is a CPA, a qualified financial planner and holds a Masters of Applied Finance from Macquarie University. Having helped Australians invest for fourteen years, Wai-Yee is passionate about seeing her clients invest sensibly so that they can enjoy money and life. ISBN: 978-0-9807151-0-1 9 780980 715101 Become OptionsWise achieve stress free investing manage emotional dilemmas avoid common mental traps make confident snap decisions This book is a handy reminder that the original purpose of options was not short-term speculation, but to manage investment risk effectively. A useful practical guide for any investor wanting to know how to protect their portfolio in times of turmoil and carefully extract greater gains from even slow moving markets. David Bassanese, senior market commentator with Australian Financial Review and founder and managing director of PennyWise Investment. Aside from a comprehensive theory of options, this book explains the philosophy of trading. Too many times I have witnessed those that understand options attempt to “beat the market” rather than realising that successful option trading relates only to the individual’s circumstances. Wai-Yee has done a tremendous effort in exploring this through her four characters. Hamish Dee, Director of Equity Derivatives, RBS Morgans Limited