OptionsWise how to invest sensibly

36 OptionsWise following day. After the adjustment of the rights issue, the SPC of Rio options was increased from 1,000 to 1,268 to reflect the additional shares issued to shareholders. All the strikes on RIO options were adjusted down in the case of both calls and puts, for example, a $60 strike was adjusted down to $47.31. During that period of adjustment, an existing covered call investor in RIO who did not take up the rights entitlement or who sold their rights on the market would have found himself short on cover by SPC and delivering the shares at a lower strike price. In addition, the covered call investor, a seller of options, is required by the ASX to meet margin requirements. This is to ensure the seller is able to meet the obligation of selling the underlying shares, if assigned. This commitment is called margin obligation/cover. Though this cover can be met by cash or other large market capitalised shares (mostly the top 200), the best form of risk management for a covered call investor is to lodge the specific underlying shares of the call contract as margins and to hold the specified number of shares according to the SPC of the particular option series. When a covered call is fully covered, the risk of assignment, either early or at expiry, becomes a non-event or an expected event, so it is no longer a risk. The seller is in control. The only potential “loss” for a covered call investor in this scenario would be if he had to sell his shares at a price that is lower than the prevailing market price. This is the trade-off for earning an income in the present. Table 3 summarises the potential rewards and risks of the protective put and covered call strategies. The rewards, or positives, on the buy put side seem to be longer while there seem to be more negatives involved on the side of the covered call. As mentioned earlier, time is a big issue for the buyer of put options and when and if the share will fall is not in the control of the investor. You may have encountered the saying that the

37 Protecting Portfolios Protective put Covered call + Unlimited protection as share falls + Receives cash + Maximum loss to premium paid + Gains from time value + No margin obligation + Right to exercise to sell shares - Must pay cash - Limited gain/upside capped - Runs against time value - Margin requirement - Obligation to sell underlying share - Unlimited loss (to $0) beyond the breakeven price Table 3 Summaries of potential rewards and risks moment you buy a new Ferrari and drive it out of the showroom, its price depreciates by 30 per cent. The moment you buy a put, time runs against you, and where it goes and when is not within your control. When the pre-qualifying conditions are met, buying puts does give the investor total peace of mind within the option period. Conversely, with a covered call, the negatives are all within the control of the investor to manage before the position is entered into. The maximum gain is part of the risk and reward evaluation that the investor has to determine, a percentage gain that he is satisfied with before entering into the trade. The gain can be adjusted through the strike he chooses or the length of the option. Once determined, the gain is certain, it’s earned. In addition, margin obligations and assignments can be easily met by holding the required number of

38 OptionsWise the underlying shares according to its SPC. These risks are in the control of the investor to be managed away upfront. Strategy 5 Portfolio hedging This approach takes into consideration the cash flow and risk constraints of an investor and combines strategies 1 to 4 to produce a better outcome in terms of cash flow requirement and/ or risk management. For example, if cash flow is a constraint to the investor, and he expects a large fall in the underlying share, the cost of buying put options can be defrayed or lowered from the receipt of the premium from the sale of covered call options on shares he holds. Hedging strategy recap • Protective put—Buy put if a large and/or sharp drop in underlying share price is expected. Buyer enjoys unlimited gain for the term of the option. The downside in this strategy is cash flow negative and pays for time erosion on the option (Diagram 7). • Covered call—Sell call, investor covered by shares if a mild drop in the share price is expected. Maximum gain on a share is capped, seller is obligated to sell shares if called but upside is being cash flow positive and no other capital is required other than the shares already owned. Benefits from time erosion on options (Diagram 8). Now that the concepts and strategies have been explained, let’s see how Will applied them to his situation. Will’s hedging strategy planning This is Will’s portfolio: PORTFOLIO HOLDING STATEMENT Date: 31 March 2008 For Client: William C Account No.: 123456

39 Protecting Portfolios No. of shares Last closing price Market Value Australian Agriculture AAC 40,000 $2.62 $104,800 AGL Energy Limited AGK 7,880 $11.04 $86,995 Asciano Group AIO 9,650 $3.20 $30,880 ANZ Banking Group Limited ANZ 6,250 $22.55 $140,938 BHP Biliton Limited BHP 10,121 $35.81 $362,433 Commonwealth Bank CBA 8,255 $41.81 $345,142 CSL Limited CSL 6,547 $36.91 $241,650 GPT Group GPT 40,000 $2.19 $87,600 Insurance Australia IAG 40,267 $3.66 $147,377 Oil Search Limited OSH 20,000 $4.83 $96,600 Paladin Energy Limited PDN 20,000 $5.09 $101,800 Suncorp-Metway Limited SUN 6,250 $12.13 $75,813 TABCORP Holdings Limited TAH 9,670 $13.41 $129,675 Telstra Corporation TLS 32,150 $4.40 $141,460 Westpac Banking Corporation WBC 6,460 $23.75 $153,425 Woolworths Limited WOW 7,566 $29.00 $219,414 TOTAL MARKET VALUE $2,466,000 Table 4 Will’s portfolio

40 OptionsWise After much research, reading and consultation with his adviser, Will reassessed the way he felt about his portfolio. In the calendar year ending 2007, the Australian share market returned a positive performance of 11.8 per cent for the year, outperforming most other indices globally, despite the turmoil brewing in the US housing market. But the strain is beginning to be felt as, in the last quarter of 2007, the Australian market is down 3.5 per cent. Will sees that the resilience of commodity prices, which translates practically to Australian resources companies holding firm in 2007, may not be sustainable if the US conditions continue to deteriorate. Low or negative growth in the US economy will potentially lead to lower demand for Australian commodities. With his large holdings in BHP, Will knows he will feel more comfortable if he can protect his shares against a gentle weakness. However, Will is more pessimistic about the banking sector and believes that Australian banks will not be able to hold if global banks continue to fall victim to the financial crisis. Will must protect his large holdings in retail bank CBA from a big downslide. Will has decided to protect his shares with a portfolio approach. He will buy Index options to provide an overall cushion for his portfolio and take specific covers on the two largest holdings in his portfolio, by buying puts on CBA and selling covered calls on BHP. The following are Will’s pre-qualifying conditions on his shares and the strategies he chooses for each. Security Pre-qualifying conditions Strategy XJO weak, provides overall cushion buy put CBA weak, should be affected by credit crunch buy put BHP resilient, may hold price, moderate weakness sell call Table 5 Will’s pre-qualifying conditions

41 Protecting Portfolios Now that the specific strategies are determined, Will needs to work out the risk and reward for each. This will be a tradeoff between the premium price and the strategy’s effectiveness as a hedge. This can be compared to the higher price we pay for brand name products or the higher housing prices we pay to live in a desirable suburb. Trade-offs are inevitable. A more effective hedge will cost more and a higher income from an asset now will lock in a lower sale price later. Will needs to ensure he buys or sells his options at the appropriate strike price whilst maintaining the protection he needs and an income he will be satisfied with. In order to strike this delicate balance, Will first needs to understand the Delta concept. Delta Delta d is the fourth letter of the Greek alphabet and is used by options investors to describe the measurement of the movement in option prices in relation to the movement of the underlying share price. Delta allows investors to predict how much an option will move in comparison to a change in the underlying share or Index. Call options have Deltas of between 0 and 1 and put options have Deltas between 0 and -1. A call’s Delta rises from 0 towards 1 as the share rises. A put’s Delta moves from 0 to -1 as the share falls. Call and put Deltas of 1 and -1 respectively are most sensitive to the movement of the underlying share. A 1 cent movement in the underlying share translates to a 1 cent movement on the option price. Calls and puts at Deltas 1 and -1 respectively are most ITM and are most costly or valuable, depending on whether one is a buyer or a seller. Delta depicts the slope of the line that measures the movement of the underlying share price with the change in the price of the option. This is demonstrated in diagrams 9 and 10 on the next page.

42 OptionsWise ATM d - 0.5 Put option price $ + – 0 Negative delta of ITM puts d 0 $5 d - 1 OTM Underlying $ share price Diagram 10 Relationship between a $5 strike put option, the underlying share price and its Delta Diagram 9 Relationship between a $5 strike call option, the underlying share price and its Delta Call option price $ + 0 Underlying $ share price Positive delta of ITM calls d + 1 $5 d + 0.5 ATM d 0 OTM –

43 Protecting Portfolios When options are ATM, when the strike price of an option is equal to the underlying share price, the Delta of the call is 0.5 and the Delta of the put is -0.5. As a call moves from OTM to ATM, its Delta moves from 0 to 0.5 and it will continue to rise from 0.5 to 1 as it moves closer to ITM. Put options operate in the reverse direction, moving down from OTM to ATM from 0 to -0.5 as underlying share price drops. Puts move progressively towards -1 as the share price drops further towards ITM. It is important to understand the concept of Delta as it helps an investor determine which strikes to choose based on expectations of the movement of the underlying share. This in turn determines the price an investor should be willing to pay for the required level of protection and the income to be received balanced with the probability of the covered call investor selling the underlying shares. Delta and buying put options In order to decide on the relevant strike at which to buy a put protection, one can start by looking at the price of the ATM strike (where the underlying share price is trading at the same amount as the strike price) where the option will have a 50 per cent chance of ending ITM or OTM at expiry. Then, scan the premiums above and below the ATM strikes to decide on the trade-offs one is willing to accept. For every $1 drop in the underlying share price, an ATM put with a -0.5 Delta will increase by 50 cents. If the investor chooses a more ITM strike (ie. the underlying share price is currently trading below the strike), then it will be more costly, but it will increase by more than 50 cents for every $1 drop. Delta and covered call For a covered call investor attempting to determine strike price, the concept of Delta must be examined with a particular question in mind; “At what price am I willing to part with my shares?” An investor must decide how much he would like to be compensated

44 OptionsWise for forgoing the possibility of further upside from the shares because selling the underlying shares is part of the deal of a covered call strategy. The higher the Delta (more ITM) of a call strike, the higher the premium to be received and the higher the chance of the covered call investor selling the underlying shares. This is a crucial question for a covered call investor because it’s very common for covered call investors to resent having to follow through with the delivery of the underlying shares. The higher the share price has gone above the strike, the stronger this reluctance becomes. This is a common emotion, but it is also a trap. Professor Richard H. Thaler calls this emotion the “Endowment Effect”.2 He found that people often demand much more to give up an object than they would be willing to pay to acquire it. I was recently conducting a dinner seminar with some clients and one of the attendees brought a few bottles of 1998 Penfolds Bin 389 to share. I asked him how much he had paid for the wine, he couldn’t really remember, but estimated that each bottle was around $32 four years ago. I then asked the client how much the wine would cost him if he were to buy it today, “Around $65,” he said. When I asked if he would buy the wine at today’s price, he was reluctant, but he was also reluctant to sell the rest of his bottles on the market today, even though he would earn double what he had paid for them, because he felt the wine would continue to appreciate in value. This scenario totally encapsulates Thaler’s Endowment Effect and demonstrates the reluctance of covered call investors to part with their shares the more the share appreciates above the call strike level. But why is this behaviour a trap? Endowment trap Investors who experience the Endowment Effect can become trapped because they second-guess their initial judgment or don’t follow through with their original objective for the covered call. If

45 Protecting Portfolios the investor’s initial objective was to take profit at the strike price, but he hesitates while the share experiences a short-lived spike, he risks the opportunity to come out on top if the share eventually falls through the strike. In addition, the investor can be left with a losing share if the share price subsequently falls through the breakeven protective price. At this point, the protection will no longer be sufficient and it becomes clear that the investor would have been better off selling the share at the strike price. It is important for investors to be aware of the Endowment Effect because it can impede an otherwise successful options strategy. On the other hand, there may be situations where an investor makes a valid decision not to follow through with the covered call strategy of selling the underlying share. For example, if there is an improved outlook on the profitability of a company or a renewed increase in confidence in market conditions, the decision to defer the delivery of the shares would produce a better outcome because there is a likely chance of receiving a higher sale price for the shares from the higher strike or higher premium. In this scenario, the sold call position can be rolled to a higher strike for a later month (more on this concept later). If a decision to roll is made on an investor’s emotional whim when a share appears to be climbing, the individual should review his or her investment strategies in a sensible, logical manner. Perfect hedging With protective puts For an ATM put, the protection from the hedge is only 50 per cent (as a $1 drop in share price produces a 50 cent increase in put option price). So is it possible to have a perfect hedge? To achieve a perfect hedge, the investor will need to have a -1 Delta on his option position. This can be achieved by buying a -1 Delta put at the start and then maintaining it by increasing or decreasing the number of options as the share price moves to achieve a continuous -1 position. This is not a practical strategy

46 OptionsWise for individual retail investors as it involves continuous monitoring and transaction costs. In addition, buying a Delta -1 option for protection is very costly. Buying such an expensive ITM put protection normally does not meet the risk and reward evaluation of most retail investors. Another way of achieving a perfect hedge is by buying an increased number of options that have a Delta of less than -1 to make up an equivalent Delta of -1. For example, by buying two ATM puts instead of one ITM put. However, this “perfection” is only achieved at the time of trade and as the underlying share price moves, the ATM put can increase or decrease in Delta. This strategy also requires continuous monitoring, which is not practical for most retail investors. In practice, investors do not normally have a perfect hedge at the start. They would choose a strike based on the trade-off between cost and effectiveness. However, as the underlying share drops, especially if the drop is significant, an investor who has chosen an OTM or ATM strike (to keep initial costs down) can find themselves with an ITM put or even a -1 Delta put and earn dollar for dollar of protection at that point. Remember that particular prequalifying conditions needs to exist for the put hedging strategy to be successful. Using covered calls From the perspective of a covered call investor, the call should always be a perfect hedge, that is, fully covering (and not more than) the number of shares held. If an investor is a few shares short for a full cover, then it is good practice to top up on the shareholding as the call is written. Other Greeks In addition to Delta, options traders use four other letters of the Greek alphabet to describe trading terms. These terms are of lesser

47 Protecting Portfolios importance than Delta when it comes to a portfolio investor’s decision-making, but can be useful for other things. Gamma describes Delta’s rate of change with every one point move on the underlying share. Theta measures the rate of time erosion in a day of the life of the option and is at the highest when options are ATM. Deep ITM and OTM options have minimal Theta. Vega measures the rate of change on the option price with a 1 per cent change in implied volatility and Rho measures the effect of a change in interest rates on option pricing. Will’s Hedging Strategy Will studied the Australian share market for three months. As the market drew to a close for the March 2008 quarter, the XJO index was standing at 5,355 points, a drop of more than 20 per cent from its peak. Will needs to determine the put strike that will give him the level of protection he needs at a cost he is willing to pay. These are the pre-qualifying conditions and expectations of his hedging strategies. Security Current level Level of protection Relevant strategy XJO 5,355 Around 10 per cent downside Buy put CBA $41.80 Around 10 per cent downside Buy put BHP $35.80 Moderate weakness of 5 per cent Sell call Table 6 Will’s hedging strategy In terms of the length of protection, Will has decided to take a long-term view on the buying of puts so that the long options have more time to perform according to expectation, though may cost more, as they are calculated according to time value and share price. Will only expects a moderate weakness on the covered call so a shorter term call will allow him the opportunity to have calls

48 OptionsWise that are worthless at expiry, at which point he can re-write them and generate recurring income. Will is going to buy nine-month options for the puts and sell a three-month option for the call. These are the premiums, or option prices, per contract for ninemonth put prices for XJO and CBA and three-month call prices for BHP. On the day of Will’s trades, the closing price for XJO was 5,355 points, the price for CBA was $41.80 and BHP closed at $35.80, where the nearest strikes were selected as the ATM strikes. XJO Put (9 month) CBA Put (9 month) BHP Call (3 month) ITM Strike 5,500 $44 $34 Premium $2,450 $6,250 $4,130 Delta -0.39 -0.46 0.67 ATM Strike 5,300 $42 $36 Premium $1,690 $5,160 $3,060 Delta -0.30 -0.41 0.56 OTM Strike 5,000 $38 $40 Premium $870 $3,300 $1,560 Delta -0.18 -0.30 0.36 Table 7 Premiums for selected XJO, CBA and BHP options Note: the strikes displayed above are not exhaustive for each share, but are selected for illustration purposes. The premiums are back calculated for illustration for the relevant expiry dates and strikes using the OptionsWise Option Pricing Calculator. They are based on the closing prices of 5,355 points, $41.80 and $35.80 for XJO, CBA and BHP respectively, with variables for each security (volatility, dividend amounts and ex-dates, interest rates) at that time. They are for one contract.

49 Protecting Portfolios Will’s Hedging Plan i XJO Index put—Will decided on the OTM put of 5,000 points as he is confident that the XJO will fall around 10 per cent, which will bring it to around 4,800, rendering the 5,000 series ITM. For a low price now, the put will give him a good protection. Choosing the 5,000 series is also a cost effective trade-off, though the Delta at the time of buying is only -0.18, which is a $1.80 increase on the put for every point fall in the Index. However, once the Index falls to 5,000 points, the option price will move up $5 for each Index point fall and once it passes 5,000 and gets deeper ITM it will increase by $10 for every point fall. To calculate the number of contracts needed to protect Will’s portfolio, which is worth $2.5 million, he will need to divide the portfolio value by the strike of the put he is buying, then multiply this by $10 per Index point. This calculation comes to 50 contracts. $2,500,000/(5,000 points * $10 multiplier) = 50 contracts At $870 (87 points * $10) per contract, gross cost of the 50 XJO puts come to $43,500 ($870 * 50). This is equivalent to 1.75 per cent of Will’s total portfolio. ii CBA shares—In a similar fashion to his XJO shares, Will went for the OTM $38 strike with his CBA shares for the trade-off of a lower cost. In total, Will spent $26,400 for eight contracts to cover 8,000 shares, even though he holds 8,255 shares. The other alternative is nine contracts, which renders him over covered by 745 shares. This is not permitted in a super fund environment, however, outside of the super environment, nothing will stop an investor from over-covering, except for the issue of risk. When over-covering occurs, an investor has moved from a hedging profile to a trading or speculating one. He will be speculating for the shares to fall and profit from it and if it doesn’t he will lose the premium spent. In this case, over-cover by less than one contract exposure is not

50 OptionsWise significant, but the point is that a change of risk profile is easily entered into and every investor should be aware of that danger. Will paid $3,300 per contract or $3.30 debit per option at the strike of $38, which is the price at which Will has the right to sell his shares. If the share falls below $34.70, Will will not lose more than $34.70 (selling CBA at the strike of $38 minus the cost of $3.30 paid for the premium). The benefit is that he will enjoy any upside from the share. Alternatively, if the share price rises, Will will only start to benefit from the increase beyond the breakeven price of $45.10, after adding the cost of the $3.30 premium paid to $41.80, the price of CBA when he embarked on hedging, to bring him to a position similar to an investor who had not undertaken the hedging. This is depicted in diagram 11 on the next page. iii BHP—In order for his BHP shares to be fully covered, Will can sell a maximum of 10 contracts (he holds 10,121 shares and SPC is 1,000). Will has chosen to go for an OTM strike on the call to reduce his chance of selling his shares. With assignments imminent for calls at a Delta of 1, a $40 call with a Delta of 0.36 has low risk at the time of writing the call. Will wants to avoid delivering his shares for the opportunity of writing for income, but he understands that he runs the risk of being forced to sell them. Will received $15,600 from the 10 covered calls ($1560 * 10 contracts). In writing the calls over his shares, Will is willing to forgo any upside beyond $41.56 ($40 strike + $1.56 premium received) for his shares in return for an income of $15,600 now, with the potential of losing if the share falls beyond the price of $34.24 at expiry ($35.80 share price at the time - $1.56 premium). Effectively, he has set a range of $34.24 to $41.56 for his shares. As BHP was trading at $35.80 at the time the call was written, the hedging is mild or moderate but he has chosen this to reduce the risk of having to sell his shares. This is depicted in diagram 12 on the next page.

51 Protecting Portfolios Profit and Loss $ + – 0 -$3.30 Underlying share price $ $38 1 2 Diagram 11 Protective put on CBA with a strike of $38 1 Investor pays for put to limit downside to $34.70 2 Investor continues to gain if share rises beyond $45.10 Profit and Loss Underlying share price $ + – 0 $40 $1.56 1 3 2 $ 1 Investor sells call and upside capped 2 Investor receives premium income 3 Downside unlimited with shares Diagram 12 Covered call at $40 strike

52 OptionsWise Will has taken a portfolio approach to his hedging strategy by providing an overall blanket for his portfolio with an XJO put, an unlimited downside protection for CBA shares and an income generating mild protection for BHP shares. These hedging strategies not only address Will’s concerns about future performance of his shares but at the same time provide solutions that meet his (negative) expectations, at a cost acceptable to him. Will’s hedging portfolio is summarised in the table below. XJO Put (9 month) CBA Put (9 month) BHP Call (3 month) Total Strike 5,000 $38 $40 Premium $870 $3,300 $1,560 Number of contracts 50 8 10 Total premiums $43,500 dr. $26,400 dr. $15,600 cr. $54,300 dr. Brokerage* $478.50 $290.40 $171.60 $940.50 ACH fee^ $56.10 $8.98 $11.22 $76.30 Net premiums (after costs) $44,034 dr. $26,699 dr. $15,417cr. $55,316 dr. Table 8 Costs of Will’s hedging portfolio * Assumed one per cent with GST ^ Australian Clearing House registration fee of $1.02 per contract exclusive of GST. From 1 September 2009, the fees were increased to $1.30 exclusive of GST.

53 Protecting Portfolios Expiry at three months and nine months How do you think Will fared with his hedging portfolio? Below is the performance of each underlying security in Will’s options portfolio at expiry. XJO CBA BHP Start of Hedging 5355 $41.80 $35.80 End of Hedging 3581 $26.50 $43.95 % Change -33% -36.6% +22.8% Expectation -10% -10% -5% Better than expectation 23% 26.6% (17.8%) Table 9 Performance of Will’s hedging portfolio The XJO and CBA have exceeded Will’s expectation as has BHP, which did so in the opposite direction to what he predicted. Hence, all the options ended ITM on expiries. From a buyer’s perspective, expiring ITM is positive, as the options are valuable and can be sold for profit. As the XJO and CBA shares have fallen more than 30 per cent, the XJO puts have gone up from 87 to 1,419 points at expiry, an increase of more than 15 times, whilst the CBA put increased more than two and a half times. Will had done exceptionally well in achieving protection in these positions. However, the BHP covered calls have expired ITM (the share rose 23 per cent instead of falling as expected) and Will will be assigned to deliver the shares. What can Will do? Before we examine his options, let’s review the profit and loss position of Will’s hedging portfolio in Table 10.

54 OptionsWise XJO Put (9 month) CBA Put (9 month) BHP Call (3 month) Total Strike 5,000 points $38 $40 Traded Premium (per contract) $870 $3,300 $1,560 Number of contracts 50 8 10 Closing prices at respective expiry dates: Three months $43.95 Nine months 3,581 points $26.50 Option price at expiry (per contract) $14,190 ITM (1,419 points) $11,500 ITM $3,950 ITM Gross profit & loss (before costs) $709,500 cr. $92,000 cr. $39,500 dr. (see section below) $762,000 cr. Table 10 Result of Will’s hedging portfolio In focus: BHP covered calls expiring ITM The BHP $40 call, which expired ITM, will be exercised and Will will be required to deliver the shares. Should Will stick with his investment plan and deliver the BHP share? He is tempted not to sell because the BHP share traded as high as $50 about a month before the calls were to expire. What are his choices? He could consider one of these remedies: a Closing b Rolling c Delivering

55 Protecting Portfolios a Closing—Buying back ITM call Closing involves buying back the call options before they expire. As they were $3.95 ITM (above the call strike), it will cost $39,500 to buy back 10 contracts. It will be the right decision to spend $39,500 (before costs) to close off an ITM position only if Will thinks he can earn back the cost (and more) from the sale of another call option at a later date. This can only occur if the underlying share appreciates more than what he has lost in the buy back and the increase in the intrinsic value outweighs the loss in time value. If the appreciation happens sooner rather than later and the increase is greater than the losses in buy back and time value, Will will be more than compensated. If he chooses this option, Will will be suffering a short term pain for a longer term gain. Closing involves making a judgment that the underlying share price will continue to rise. Making the wrong judgment comes at a great cost. The investor will suffer the loss of further protection, he will have lost the opportunity to sell shares at a profit ($41.56) and he will lose the amount spent to buy back ($39,500). In Will’s case, he will be worse off by $39,500. Closing is an unlikely alternative for Will as he believes the weakness in the commodity sector will soon set in. b Rolling—Staying with it Rolling means replicating the current position with another option position, and this can be to a different strike and/or expiry month. It involves the buying back of the current position and the simultaneous selling of a new position. This alternative involves the investor retaining the decision to hedge without delivering the underlying shares. This could be due to a number of factors, including the Endowment Trap, a genuine anticipation of the underlying share performing according to expectation or the investor simply being unsure of his position and looking to buy time to consider.

56 OptionsWise If an investor chooses to roll because he has succumbed to the Endowment Trap, he may be tempted to roll up to a higher strike (for an option that is less ITM) to avoid or reduce the possibility of being assigned to sell the shares. The investor in this scenario may even be willing to roll this out at a cost (a lower premium on a higher OTM strike and the higher time value may not be sufficient to cover it). This is called a debit roll. A debit roll will pay back or reduce the initial income received before the roll. Should the share subsequently fall beyond this now higher breakeven point, which is providing a lower downside protection, the investor will have lost the opportunity to sell the share at a profit and may even end up sitting on paper losses. If the investor chooses to roll in order to wait for the share to perform according to expectation, the investor may roll it out to the same strike for a higher premium due to time value (a credit roll). This is a better outcome than the previous action and still has a good chance of delivering. If the roll is carried out with the intention of buying more time, the investor may be buying time to consider the performance of the underlying share. This could be the case if new developments cause him to expect improved performance of the underlying share or overall market conditions or he may be buying time until the next result announcement to re-evaluate his decision. The decision may also be dividend motivated, where the investor has acted to avoid being assigned before a stock goes ex-dividend. In these possible scenarios, the investor may roll up on the strike to avoid being assigned and buy the amount of time he needs to come to a conclusion. The investor will most likely try to achieve the roll on a credit income so that the money it costs to buy back the shares is less than what he would receive from selling the new ones. However, if the existing options were very deep ITM (where time value is minimal) and were primed for imminent assignment, a credit may not be achievable. In this case, the investor should

57 Protecting Portfolios consider whether it is worth delaying the imminent and choose to receive the sale proceeds immediately, rather than later. Will could consider rolling the BHP calls out to another three months in September at the same strike (this would be at a credit) and then re-evaluate his position. At the time, a three-month $40 call was at $6,230 per contract. This premium is back calculated using the then-interest rate of 8.25 per cent and a higher volatility of 44 per cent than the 41 per cent three months previously for BHP. For 10 contracts, Will would have received a net credit income of $22,800, after paying off $39,500 to buy back the expiring calls from the additional income of $62,300. If he had done so, Will would have increased his potential sale price of the shares to $43.84 ($41.56 of call strike and first premium + $2.28) and his protection would be widened to $31.96 (share price at that time of $35.80 - $1.56 - $2.28) from $34.24 before he starts to lose from further fall in the share price. As it turned out, at the September expiry, BHP closed at $36.40. Will would not have been successful in selling his shares at a profit, but instead would have received a net income of $22,800 for holding on to the shares over the six months, whilst being protected from down side to around $32. He would have been $22,800 better off compared to not using options. c Delivering—Go with the deal Writing a covered call position involves the possibility of the selling of the underlying shares. Despite the fact that Will chose an OTM strike in return for a lower premium and lower risk of assignment, this assignment still eventuated. There are two key risk management issues that emerge from Will’s experience: • The best risk management strategy for a covered call investor is to expect the unexpected and be prepared for it. Will did not

58 OptionsWise expect to deliver his BHP shares, but he nevertheless managed away this possibility in the initial stages by having full cover of 10,000 BHP shares. • An investor who is not willing to go through with the deal should avoid the covered call strategy. Premium income is tempting, but investors must be prepared to sell their shares, regardless of how unlikely this may seem in the initial stages of the deal. Will originally decided to use the covered call strategy, despite being reluctant to sell the shares due to the huge CGT bill he would incur. After careful evaluation of each alternative, Will comes to the following conclusions: • If he is to go with the deal, he is better off with the writing of calls than without them. He was $5.76 per share ($40 strike + premium of $1.56) better off than the price of $35.80 when the calls were written. He could have gotten a higher price for them at expiry if they were not covered, but he could also have sold them at $35.80 if not for the calls. • He has re-evaluated the wisdom of allowing CGT to shape his financial objectives. Perhaps being an accountant has unconsciously pushed him to focus on tax more than he should? CGT Trap In his book about the fiscal language of the U.S. budgetary system, Professor Daniel N. Shaviro, a Wayne Perry Professor of Taxation at New York University Law School, found American taxpayers to have anti-tax sentiment (a sentiment I would argue is also alive and well in Australia) because “taxes require people to pay over money that is seen as theirs3 ”. This is another form of the Endowment Effect. Paying tax induces people to under weigh opportunity cost in relation to other costs. This is like under weighing the cost of

59 Protecting Portfolios keeping 52.5 per cent of money earned (assuming you fall into the highest tax bracket and pay 45 per cent tax, plus a 1.5 per cent Medicare levy and 1 per cent brokerage for the sale) and taking the opportunity to reinvest the proceeds (and the capital), against the cost of tax (of 46.5 per cent) and brokerage. The investor is still better off taking the gains after all the costs (and taxes). The effect of general resistance to paying taxes is also demonstrated in the empirical research carried out by Professor E. McCaffery, from the USC Law faculty and J. Baron, Professor of Psychology from the University of Pennsylvania. The researchers found that taxpayers do not like the term “penalties” but do like the term “bonuses4 ”. In economics, a penalty is the absence of a bonus, and a bonus is the absence of a penalty. They are two sides of the same coin. The Professors found that those who participated in their study preferred child “bonuses” in the tax system to childless “penalties”, even though they involved a similar amount of spending. A child bonus is a childless individual’s penalty whilst a family bonus is a single’s penalty. The aversion to tax can be avoided with the framing of the payment. What if investors thought of the capital gains tax problem as an expense to be paid instead of a penalty? Or if they conceptualised the gains after paying taxes as a capital gains bonus? And realised a fifty two and a half per cent bonus after selling an asset? Will comes to realise the CGT trap may be so ingrained in his thinking that it is his first consideration when it comes to evaluating a profit-taking decision, rather than analysing the underlying investment rationale for taking profit. This bias is especially common in a bull market where profits are easily made and the CGT trap becomes more paramount. With the possibility of a strong downturn in the investment environment looming, Will acted against his ingrained behavioural patterns and decided to “go with the deal” of the covered call. He took a profit and delivered his shares at a breakeven price of $41.56.

60 OptionsWise Twelve months down the track, we can reflect on Will’s decision to deliver the shares and see he made a prudent choice as BHP shares have not risen much higher than $42 since that period. Will took a good profit in a volatile environment, saved himself from the CGT trap and reinvested the proceeds. If he had chosen a different avenue, he would have lost the opportunity to lock in the profit he made. His discipline to follow through with his investment plan has paid off. Strategy 6 Combination hedging Collar Collar is a term used for the simultaneous buying of the put and selling of the call options of an underlying share. There are two possible motivations for doing this. The first motivation is that the investor believes the underlying share will drop in value significantly and wants to be protected by buying puts. However, as he wants to reduce the cost of the protection, he sells a covered call at the same time to earn some income, but his intention is not to sell his underlying shares. The investor may also choose to collar if he wants to sell his underlying shares because he predicts the current share price is a good level at which to take profits, hence he sells calls to enhance his returns. However, should the share price weaken beyond his breakeven point and he misses out on selling his shares at the strike, he wants to be protected from the loss of value of his shares, hence he buys puts. The distinction of the two motivations for embarking on a collar is important because it helps to determine the strikes for the put and the call. Collar could be a suitable hedging strategy for Will’s CBA shares. Will has the view that the banking sector will continue to be embroiled in the credit crisis in the US and believes shares will fall at least 10 per cent. CBA holdings make up a large percentage

61 Protecting Portfolios of his portfolio (15 per cent) and he has an investment of almost $400,000 in the shares, so Will can make better use of the capital. Writing call options will be a good way to release some income from his holdings. The caveat is that as these shares were bought a long time ago, and accumulated since the initial IPO, selling them would incur a large tax bill. So, to reduce the risk of selling his shares, Will could write the call options at a further OTM strike. The income he would get from this call will be less, but it achieves his objective of releasing some income from his large holdings and he won’t need to pay as much for his puts. Below are the call and put strikes Will has to choose from with CBA last traded at $41.80 CBA Put CBA Call ITM Strike $46 $38 Premium $7,430 $7,780 Delta -0.51 0.69 ATM Strike $42 $42 Premium $5,160 $5,860 Delta -0.41 0.59 OTM Strike $38 $46 Premium $3,300 $4,360 Delta -0.30 0.48 Table 11 Nine month premiums for selected CBA put and call Will chooses an OTM call option with a strike of $46. This reduces the risk of the shares being assigned with the trade-off of a lower premium.

62 OptionsWise Combining this with the OTM $38 put he has purchased, Will would be creating a collar of $38 put and $46 call, with a credit of $1,060 per contract ($4,360 credit - $3,300 debit) or $1.06 per share. By giving up any upside beyond $47.06 per share ($46 strike price + net credit of $1.06), he is getting better protection for his shares with a higher breakeven price of $39.06 (strike price of $38 at which he can sell his shares + $1.06 credit premium) whilst being paid $1.06 per contract at the present. Forgoing upside beyond $47.06 and a willingness to accept the risk of selling his shares would give Will a better outcome with a collar strategy. The call and put strikes of a collar can be customised according to the investor’s trade-off between upside cap, willingness to sell shares and cash flow. For example, for better downside protection, an ATM put with a strike of $42, combined with a $46 call collar, will cost $640 per collar. Instead of generating an income, the collar will cap upside gain at $45.20. Collars can be achieved with a net credit or debit income according to the investor’s requirements. Diagram 13 A collar with OTM strikes of a $38 put and a $46 call $ + – 0 Profit and Loss -$3.30 $4.36 Underlying share price $ $38 $46 OTM call OTM put Net $1.06

63 Protecting Portfolios Tabulated below are the trade-offs between receipt/payment of income, quality of protection and potential upside gain for the three strategies mentioned above with CBA at the price of $41.80. Strategy Buy Put OTM Collar Split Collar Action Buy $38 OTM put Buy $38 OTM put and sell $46 OTM call Buy $42 ATM put and sell $46 OTM call Premium per contract $3.30 dr. $3.30 dr. + $4.36 cr. $5.16 dr. + $4.36 cr. Net per contract $3.30 dr. $1.06 cr. $0.80 dr. Net premium $26,400 dr. $8,480 cr. $640 dr. Breakeven Protection* $34.70 $39.06 $41.20 Upside cap None, beyond $45.101 $47.062 $45.203 Table 12 Trade-offs of three different combinations *Level to which shares need to fall before protection kicks in 1 $41.80 + $3.30 2 $46 + $1.06 3 $46 - $0.80 A suitable choice for an investor would be the one with the trade-off he is willing to accept. Ratio hedge Ratio hedge is another variation on the collar strategy, which can either enhance downside protection or further reduce the cost of hedging. A variety of collar ratio hedges can be achieved through the various combinations of the number of contracts on the puts and calls and the strike rates of the puts and calls, depending on the trade-offs the investor is willing to accept. Following from the $38 put and $46 call collar on CBA shares above, in order to avoid

64 OptionsWise capping the upside on all 8,000 CBA shares, a ratio collar can be achieved by buying eight $38 puts and selling four $46 calls. Ratio collar could have been used for Will’s BHP strategy as well, by buying puts to get better downside protection in addition to the 10 covered calls written. Will can buy a maximum of 10 puts to create the collar if he wishes for his 10,110 BHP shares to remain fully covered. A lower ratio of puts and calls can then be created, for example, by selling 10 $40 calls and buying five $38 puts for better downside protection. Combination trades like collar and ratio collar strategies allow the investor to customise option strategies according to his or her objectives, cash flow requirements, upside cap on gains from shares and willingness to sell underlying shares. Options are a flexible and powerful tool but will only yield results regularly if the investor establishes firm objectives and then uses options to enhance the position of a portfolio of shares. The use of options can often produce a better outcome, with some accepted trade-offs. Will and his hedging experience Over nine months, Will has gained a wealth of experience with using options. The use of options has allowed him more choices that produced better outcomes, without having to take additional risks. His initial experience has been successful. With his portfolio protected for the nine-month period, he found that the more he read about the deterioration of the credit crisis in the media, the gladder he was that he had acted on his hunch. His mind was at rest with the knowledge that his portfolio was protected, which gave him the peace of mind he needed to concentrate on his business and his clients’ tax returns. Will promised himself he would take Connor out for a nice lunch (and maybe offer him a promotion too!). ratio hedge: combination of buying put and selling call at different number of contracts to meet investor’s objectives

65 Protecting Portfolios Summary of strategies HEDGING (covered) Strategies Protective puts Covered calls Collars Ratios Suitable for Super funds Portfolio investors Traps to be aware of Endowment CGT Table 13 Summary of diagrams $ + – 0 Underlying share price $ Profit and Loss $ + – 0 Ptofit and Loss Underlying share price $ Covered call Collar Protective put Profit and Loss + – 0 Underlying share price $ $

66 OptionsWise PART B NON-HEDGING When is selling a call not a form of hedging? Selling Index calls Selling, or shorting, Index call options is not a hedging strategy for a portfolio investor. It is an aggressive shorting of the market strategy that’s undertaken by traders with a bearish view. This strategy cannot be covered by underlying shares. There is no covered call on an Index, as a seller of an Index call cannot realistically deliver the 200 shares that constitute the Index on expiry in various quantities, even if he owns them. The situation would be a nightmare to administer. A loss on an Index position is always settled in cash. If the market closes up (instead of down, as expected) at expiry, the buyer of an Index put for hedging would have lost the premium he spent, as he didn’t need the protection. On the other hand, if the market closes up at expiry, the seller of an index call option pays cash for every Index point the XJO closes above the strike price. This figure is calculated by multiplying every point by $10. The amount of this potential payment is unknown, unlimited and uncapped, it depends on how high the share market rises above the call strike within the option period, hence this cannot be a hedging strategy, in fact, it’s the opposite of one. Selling calls on shares without cover The technical term to describe selling calls on shares without cover is naked call writing. This is one of the popular strategies undertaken by aggressive investors to trade or speculate on a falling share price or to short a share. The writer of the call does not own the underlying shares and margins are covered by lodging cash or other shares. Traders will short the call when the share price is high and if their bearish view is right and the share falls the bearish: an individual who holds a pessimistic opinion of future share performance and believes prices are heading down

67 Protecting Portfolios position can either be bought back early to lock in profits or, if the share price trades below the strike price at expiry, the short call will expire worthless and the writer will earn all the income. This is an aggressive trading strategy as there is theoretically no cap on how much a share can appreciate. The potential loss is unlimited. This strategy is especially lethal if a trader’s company receives a takeover offer or if there are rumours circulating that a takeover is in the pipeline. In these circumstances, traders could see the share gap up to, or above, the takeover price. The other danger can occur when underlying stock is about to go ex-dividend, particularly a high dividend yielding stock with fully franked dividend, like bank shares. A naked call writer with an ITM call runs a high risk of being assigned on the last day the stock trades cumdividend. Once assigned, the earliest the seller can deal with the stock is the next business day when the stock trades ex-dividend (XD), without the dividend. The seller must buy the stock onmarket ex-dividend and deliver cum-dividend (CD) and franking credit. The naked call writer would have to pay the difference out of his pocket. The facility to short is not as readily available as it is to go long for retail investors. Shorting, which means selling shares before buying them back later (at a cheaper price), requires the investor’s broker to pre-borrow shares and administrate the margining position after the trade. Following the huge share sell off at the outbreak of the global financial crisis, shorting was banned altogether by exchanges around the world. The ban was later lifted after some stability returned to the market, but the ban was extended on financial shares and was only finally lifted in May 2009. One of the appeals of naked call writing is that the strategy is easy to implement and execute, like any other option trade and the seller earns an income for doing it. However, this appeal is gap up: where the opening price of the share is significantly higher than the previous day’s closing price

68 OptionsWise met with huge risk and a potentially unlimited loss. This strategy does not allow portfolio investors or super funds any control or certainty and is not recommended. See the potential for unlimited losses of a naked call writing position in diagram 14. In order to limit losses, some traders create a spread by buying a call option at a higher ITM strike than the short call position. The trader may seem to be protected to a maximum loss between the two strikes, but this is not exactly so. In situations where the trader is assigned on the short call to deliver the shares a day before it goes ex-dividend, the trader will exercise his protection to buy shares with the exercise of the long call in order to meet the delivery of the shares. This will create a loss for the trader at the spread, but this is not all. It produces two problems for the trader if the Call option price 1 3 2 Underlying $ share price $ + – 0 1 Short seller does not hold shares 2 Sells call to earn income 3 Exposed to unlimited losses if share rises Diagram 14 Shorting calls naked

69 Protecting Portfolios shares have franking credits attached to the dividends, especially large ones, as the shares he exercised to buy are XD (they went ex the day before he bought them) and will not include dividends or franking credits. This amount has to be compensated to the buyer of the shares, as the shares are exercised on a CD basis. The second problem is that there will be a one-day delay in the settlement of assignment. A call bear spread may work for shares that do not have a high component of dividend and franking credit. However, this high-risk strategy is still not one to be undertaken by a super fund or conservative portfolio investor. Let’s have a look at our second character, George and his experience with investing with options, in particular, let’s look at his experience with naked call writing. George was not always an OptionsWise investor and often approached the process erratically and without fully understanding the concepts involved. He sold puts if the share looked cheap and sold calls if the share looked expensive. He traded without the cover of shares or the full cover of cash. George would have sufficient cash just to cover his margins and he never intended to buy or sell any shares. This is George’s pre-OptionsWise experience. In 2007, George was in his early 30s and on top of the world. He had just married his childhood sweetheart, Amber, and was doing very well in his job as an IT professional. He earned a good salary package, which included generous bonus payouts every quarter. Amber worked as an office manager for a real estate firm. George and Amber had been saving up to buy their first home before they have children. George is the more financially astute of the two and he was assigned with the task of investing the couple’s savings to build them up over the next few years. George attended many investment seminars, which dealt with everything from investment properties to share investments to motivational talks organised by self-made millionaires. He dabbled in a few of these schemes but became

70 OptionsWise wary after his first investment foray. George invested in a property that failed to generate the rental income promised by the operator. Fortunately, he managed to find a buyer quickly and sold off the investment with a small loss. George then tried his hand at share trading. Initially, in order to minimise risk, he only traded with the top 200 ASX listed shares, on which information is more readily available. He had some success but soon found the returns too slow. He then moved into buying smaller shares to make his capital work harder. He tried getting ideas from chat rooms and acting on his own perceptions by looking at a combination of charts and available information on trading websites. This second strategy worked somewhat better and George’s capital grew, but in a haphazard way. One day, George was surfing investment websites and was attracted to a caption on options. Most alluring was the concept of receiving income before making any payments and committing to a small outlay for big gains. George proceeded to learn more about options by attending a course run by an independent operator. He learned that selling, rather than buying options, could be a very lucrative strategy as time value is on the seller’s side and he receives income first. George went on to set himself up with an Internet options broker and has since started using the following strategy: he sells puts when he thinks a stock is going up and he sells calls if a stock is expected to go down. He always ensures he has sufficient capital to meet the margin requirements and keeps another 20 per cent aside as buffer. George has been using this strategy for a few months and has had good success. He tells Amber that if he keeps trading this way for a few more months, they will be looking at being able to afford a double storey home with a big backyard and a pool. One afternoon, George is heading out of his office for lunch when he spots his normally reclusive coworker Aidan grinning

71 Protecting Portfolios ecstatically. Curious at the sudden change, George asked Aidan if he’s just been offered a promotion. “No, it’s better than that,” Aidan replied. “I just made a lot of money … from options.” George was happy for Aidan, until his coworker began to explain the reason for his sudden cash bonus. “I bought some call options on RIO a couple of days ago and today there is speculation in the market that BHP will launch a takeover bid on RIO,” Aidan said. “The stock just jumped 22 per cent.” This scenario occurred in November 2007 when an announcement of a takeover bid was made. RIO stocks opened at $138 following the news after closing at $113.40 the day before. As the buyer of a call option, Aidan’s options would have jumped significantly that morning based on the appreciated share price (intrinsic value) as well as on the increased volatility on the jump. George felt sick. His appetite vanished. He had had a busy morning and had not read the newspaper. RIO stocks hit a new high of $110 two days previously and at the time, he thought this would be a peak. So he sold two $115 calls on the share for expiry in three months, naked, as usual. George and Amber experienced a period of intense anguish following the sale of the RIO calls as they succumbed to the margin explosion trap. This trap took both George and Amber on an emotional ride which left an indelible mark on their lives. Before we explore this trap, we first need to understand margins in options trading. An option investor’s ability to manage margins is a key component in using options successfully. Margins For the privilege of receiving an income upfront, sellers or writers of options (those who sell to open or initiate a position), have an ongoing obligation to ensure they meet margin requirements calculated by the Australian Clearing House (ACH). Margins are

72 OptionsWise like a deposit payment on their obligations as sellers. They have received an income for their promise to fulfill the underlying requirements of the option contract (to buy if it’s a short put or to sell if it’s a short call). This concept may be clearer if you think about the lay-by system in Australia. Though it does not fully encapsulate the dynamism of options margining, it will help paint the picture from the seller of put option’s perspective, whose obligation is like the buyer of a product. In the lay-by system, a consumer lay-bys a product with the promise to buy the product at a later date and to show good faith, he pays a deposit (initial premium margin). After the initial transaction, the buyer has the option of paying regular amounts (total margins) towards the full purchase price (the strike price) to reduce his final obligation. The difference with options is that this payment to top up or pay towards the final obligation is not voluntary, but mandatory, and instituted by the ACH. In addition, as the price of the underlying share moves, the margin requirement changes with it. Margins will be in excess and credited back to the seller if the underlying share closes in favour of the seller’s position. If the reverse occurs, margins will be in shortage the next day and cash or share value lodged as collateral will be debited. The ACH advises broking firms of their total margins broken down to their individual clients’ margin situation daily and this debit or credit of margins to individual clients’ accounts is administered electronically by the broker firms. For put option sellers, margins will be in debit if the underlying share falls at the time of closing the day before. More margins are required as the share falls because as the put gets more ITM it becomes more attractive for the buyer of the put to exercise the put to sell the share at the higher strike price. The buyer may be motivated to do so for various reasons, for example the share price may have gone below their protective breakeven point and it is

73 Protecting Portfolios more beneficial to exercise the put to sell their shares than at the market price. Conversely, for sellers of call options, margins will be in debit when underlying share rises. As the underlying share rises, the call option moves further ITM and the likelihood of buyers wanting to exercise their right to buy the share at the lower strike price increases. The margins payable consist of two components, premium margins and risk margins. A premium margin is the premium income a seller receives at the opening or initiation of a position. It moves with the intrinsic value of the underlying share, so as share price rises, call premium rises and a seller of a call will need to pay more premium margins to make up the difference between the premium he first received and the higher market value of the call option. Put premiums increase when the underlying share falls. The premium margins on a short put position increase and the seller of a put will need to pay more to cover premium margins than the amount he first received. The risk margin measures the increase in the risk of a short position. Risk increases when the underlying share moves in the direction that disfavours the seller. Each share has a specific margin interval percentage (MIP), which is set by the ACH from their observation of the maximum probable price range of a share in a day (the daily high and low price of a share) over a period of time. MIPs are reviewed every quarter by the ACH but if there is a huge change in the volatility of a share, its MIP can be changed immediately. There have been occasions where the ACH has called for an intraday top up of margins in instances where the underlying share has jumped or plunged significantly during the day and where the top up has to be met on the afternoon that the call is made, literally within hours. MIPs are used to determine the margin interval dollars (MID). This is calculated by multiplying the share price by the MIP. For

74 OptionsWise a short call position, the risk is the share price plus the MID (a higher share price, as the risk is on the upside) whilst for a short put, the risk is share price minus MID (a lower share price as risk is on the downside). The option price of the derived share price (with plus or minus MID, where relevant) is the total margin required to cover (or spend to close off) an existing short position. Risk margin is then worked out by determining the difference between this total margin and the premium margin. Hence, the calculation of the risk margin includes the six variables used in pricing options as well as the MIP. It’s important for investors to understand how margins are calculated and which variables impact margin changes. An estimation of total margins can be obtained from the ASX and OptionsWise websites with the latter providing an additional risk analysis. The OptionsWise Margin/Risk Analyser allows investors to change the key variables that make up the calculation of margins— share price, MIP and volatility—and study how they affect the margin requirements of a position. This instrument is particularly useful as an upfront risk management tool, as it allows an investor to simulate how the margins requirement of their short position can change should one or more of the variables change. The Risk Report in the application is also useful to help investors determine if their available resources are sufficient to cover the strategy they are undertaking or if they are using options as leveraging tools. By understanding margin changes, investors can proactively put risk management strategies in place before the execution of a trade. For example, this can be accomplished by buying put or call options for protection at a certain level, executing combination trades to reduce risk or margin requirement or assisting in determining a stop loss level should there be insufficient margin cover. Being prepared and in control are the keys to managing an option portfolio successfully.

75 Protecting Portfolios Margin explosion trap Margin explosion is common in a scenario where a share price jumps or plunges significantly in a day. Sellers of options must meet daily margin requirements set by the ACH until the position is closed off or expired. If George held 2,000 RIO shares in his portfolio, the margin explosion would not have been a trap for him because the value of the underlying shares lodged will always be sufficient to cover the margins required by the ACH on the specific position, as margins are just a fraction of the full value of the underlying share. Margin explosion will always be a non-event for a covered call investor. The worst event in the RIO scenario is the sale of shares at the strike, which is about 22 per cent below the market price. For a naked call writer however, margin explosion is a completely different story. The objective of a naked call writer is to use options as a form of leverage, hence the level of cover is normally just the required margins with perhaps some buffer. As expected, naked writers may not have the resources (cash or lodgeable shares) to meet a sudden explosion in margin requirements. Why would margin explosion be a trap for a naked writer? Margin explosion occurs when the underlying share price moves significantly away to the disadvantage of the written position, so, in order to get out of the explosive situation, the writer has to pay a price that is higher than what he originally received in order to close off his position. This represents an immediate locking in of a loss and, even if the writer has the funds to pay the increased margin, the obligation is a big cash drain. The alternative is to buy a call or put (depending on whether it was a short call or short put) to halt further losses and margin escalation. The bad news is, at this stage, the belated “protection” is expensive and this may be a further cash drain. If the naked call writer decides against either of the two actions above, he will be trapped feeding this margin and will not know for certain how

76 OptionsWise long the problem will go on or how much money it will eat. The investor finds himself between a rock and a hard place. The trap gets worse if the share keeps moving in the disfavoured direction continuously on consecutive days. Unlike a share investor, who sees the price of the share he owns drop on paper only until the share is sold, naked writers pay real cash in the form of margins for every dollar rise or fall in the share price. For naked writers, the fluctuations aren’t confined to numbers on paper; there is real money involved in the day-to-day movement of underlying stocks. In addition to the exhaustion of cash, the naked writer is liable to suffer the mental and emotional strain that is involved in being trapped in such a situation. This pressure cannot be overlooked. Investors trapped by margin explosion are known to make other hasty investment decisions in their panicked state, such as prematurely selling off other profitable investments in order to fund this margin requirement. They also neglect to focus on other positions in their portfolio and find it difficult to spend quality time on their work and family. George never expected to get caught in a margin explosion. When he opened the trade to sell two contracts of calls when RIO was at $110, his initial margin was a total of around $40,000. With the allocation of $100,000 to this trade, George felt more than comfortable that a 60 per cent buffer would allow him to meet margin obligations up to a share price of $130 (stop loss levels are calculated at the Margins/Risk Analyser page of the OptionsWise website). In George’s mind, a $20 rise is more than sufficient upside buffer on his short position, as he is expecting the share to fall off from this level anyway. As it turned out, two days after his sale, RIO actually climbed 22 per cent in one day, breaching George’s maximum tolerable level of $130. There was no opportunity for him to react to stop loss at $130, as the takeover announcement was made before trading

77 Protecting Portfolios started in the morning and the share jumped immediately on the opening trade to $138. George knows he will be short on his margins tomorrow, and they will eat up all of his buffer and more. Since that day, he has been faced with the pressure of constant margin shortages, and he is always hoping he will not be assigned early, as his position draws nearer in time and moves deeper ITM. If George is assigned on the ITM position, he will have to buy shares from the market (at a price of $130 compared to the delivery strike of $115) or he will have to roll the position. If he rolls up on the strike to reduce the risk of being assigned again, he will have to pay up. In the meantime, all he can do is hope … and pay. George and Amber sell their other shares and max out their personal loan in order to fund the margin explosion as RIO stubbornly stays around the $130 mark. They have almost no funds left when the credit crisis eats up the last of their resources. Nine months later, after rolling the position several times and paying each time to do so, the position finally expires worthless (under the $115 strike) as the GFC sets into the resources sector. George is out of the trap. George feels incredibly relieved after nine anxiety-ridden months. His sense of guilt remains when he remembers he is responsible for dragging Amber into the trap too and he feels he has failed her because he has been unable to deliver their family home. In the end, George was lucky. Plenty of investors had to cut their losses during the global financial crisis as they could not come up with the funds to meet the margin requirements any longer. After that experience, Amber made George stay away from the share market for a long while. She said she would rather stay in a rented place than a double storey house if it meant she had to go through that emotional rollercoaster ride again. In his book titled The Logic of Life, Tim Harford argues that while people occasionally act in illogical ways, “when it becomes

78 OptionsWise more costly to do something, we will tend to do it less”, because rational people respond to incentives (or disincentives).5 For George, the incentive to sell naked calls has certainly diminished after this experience. The rewards from naked writing come with a very long, knotted string attached. After the initial financial storm passed, George reevaluated his position, conducted more research and spoke to some option advisers about his experience. Below are some of his conclusions. The over-confidence trap George realized that his successful option trades made him overly confident. He had no fear of getting it wrong because he had gotten it right so many times before. Russo and Schoemaker have helped many Fortune 500 executives with their decision-making skills. Their book, Decision Traps, argues that over-confidence is among the 10 most common barriers in decision-making.6 Not just for executives in business, this is also a common trap for investors, particularly in a bull market environment, where profit comes easily to almost anyone who invests in shares. This can make investors relaxed with their investment criteria or risk management. Investors were unprepared for the Rio Tinto fiasco because it seemed unlikely that anyone would launch a takeover offer on such a behemoth. As it turned out, the takeover was thwarted a few months later, but the lesson investors learned is that rumours, speculation or expectations are enough to unravel a trade. The self-justification trap When a bad investment decision is made, it is common for investors to deflect blame. This phenomenon is explored in a book called Mistakes Were Made (But Not By Me): Why We Justify Foolish Beliefs, Bad Decisions and Hurtful Acts.

79 Protecting Portfolios Cognitive dissonance describes a phenomenon whereby people justify their foolish relationship, professional or investment decisions in order to live peacefully with their consequences. Tavris and Aronson suggest we do this so naturally and unconsciously that often we are unaware that we are deceiving ourselves.7 George experienced cognitive dissonance during the period of margin explosion. He justified his lack of safeguards to Amber by telling her that the takeover of Rio Tinto was “an unforeseen, once-ina-lifetime event”. This bias could block him from seeing the true risk in his investment style in the future and may rob him of the opportunity to make sound decisions in investments to come. The reality is, selling naked call options involves the highest risk of all option strategies. Naked call options are riskier than naked puts because puts have a loss amount limited to zero, whilst there is no limit to how high a share can go. Investors who undertake this strategy have surrendered control to the fluctuations of the market and the mercy of the buyers. It’s also common for investors to get stuck in the cycle of the latest, most familiar investment experience (especially large easy wins or huge painful losses), and then to expect the same outcome from future events. George’s OptionsWise experience George is learning not to be over confident in his investments and wants to get back into the options trading game so he doesn’t fall into the trap of thinking he will never be able to invest successfully again. He wants to learn from his experience with RIO and naked call options and has decided the best way to manage such “out of control” situations is to avoid getting into them in the first place and be prepared by having an upfront investment plan and predetermined trading rules like those provided by OptionsWise. George believes options are still a profitable way to grow his wealth, but this time around, his eyes will not be just on the prize

80 OptionsWise (or the two storey house), and he will be doubly alert to the risk he is undertaking. He will put defences in place to manage these risks up front. Harford5 was definitely onto something; if people are capable of learning from their mistakes, life is logical after all. Summary of strategies NOT HEDGING (naked) Strategies Buy (long) put Sell (short) call Suitable for Traders Leveraging Traps to be aware of Margin explosion Over-confidence Self-justification Table 14 Summary of diagrams Call option price Underlying share price $ $ + – 0 Short call Put option price $ + – 0 Underlying share price $ Buy put

81 4 Building Portfolios Do you remember the thrill that came with purchasing your first home? Or the rush of trading in your dependable old car for one that you actually desire? Most people feel a sense of exhilaration when they purchase a commodity they expect to bring them enjoyment. The purchase of a portfolio of shares should give a buyer the same sense of excitement. Once an investor takes the plunge, he opens the door to a range of new possibilities and succumbs to the expectation that the shares will deliver the security and wealth he desires. There is a small group of people who inherit shares or receive them through their involvement with demutualised associations. The rest of us need to buy them. Most people buy shares through IPOs or outright on the market through a broker. Once an individual owns shares, he or she could purchase more through dividend reinvestment plans, share purchase plans (both generally at a discount to the prevailing market portfolio: a share portfolio holds more than one share. An option portfolio holds more than one option position in one share or more 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. ipo: the process by which a company first seeks to be listed on a stock exchange, usually by way of a prospectus

82 OptionsWise price), rights issue or conversion of free company options. Other possibilities include using preference shares, debt instruments or converting from instalment warrants. Often all an investor can do is buy shares and hope for the best. Share investors often suffer emotional swings that are triggered by the rise and fall of share prices, which are beyond their control. Have you considered the possibility of share investments that afford you a consistent flow of income, stability and the feeling of being in control? Have you purchased shares through the use of options? Building a portfolio using options (unlike using options to trade or speculate) is not only a cost-effective enterprise; it also makes better use of your existing capital. The use of options with an overall share portfolio can produce not only a more consistent, better returns in the long term but also the possibility of pre-determined risk and reward. Investors who seek predictability and control in their investments should use options. Self Managed Super Funds And Options Options are malleable and can be used by an investor in a number of ways. They can be shaped aggressively, like a sword, or protectively, like a shield. Options can even take a neutral form, like a rod, to gently prop an investor up. Such a flexible financial tool can arm or harm. There is no body to police the use of options so an investor’s decisions about the financial tool are his and his adviser’s alone. On the other hand, in a self managed super fund environment, trustees of the funds act according to industry guidelines and are held responsible for the manner in which the funds are invested. Trustees are also “policed” by yearly audits. speculate: involvement in any market purely to make a profit without direct interest in the commodity or underlying asset traded

83 Building Portfolios Discipline is the most important attribute required to use options successfully as part of an overall portfolio investment and self-control is required when managing the leverage-potential options provide. An investor can unwittingly leverage without being fully aware of the consequences of those exposures. The guidelines provided by the SIS Act for super funds supply good advice for any investor, especially those who are starting out in the use of options. Investors should take note of some of the guiding principles of the Superannuation Industry (Supervision) Act 19938 (“SIS Act”), the legislation that determines what super funds can and cannot do and how they operate. The first rule is super funds cannot be geared up through the use of derivatives.9 An investor or super fund will be using options to gear if he or she buys calls and puts on the underlying shares with the hope of unlimited gain from their view (that the share goes up for calls and down for puts). The investor is gearing through a small outlay, a fraction of what the underlying share would have cost for a potentially similar, if not larger gain. The investor is punting on a large move on the underlying share price. An investor could also be speculating by selling options. He would be gearing if short positions (the sale of puts or calls) were only margin covered by existing shares or cash. As margins are only a fraction of what the overall underlying exposure would have been, the investor is gearing from the value of his existing shares and cash whilst earning an income. This can be an enticing gearing strategy for any investor (except for a super fund which is prohibited from speculating), but is the investor always alert to how 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) derivatives: financial instruments that derive value from their underlying assets punting: gambling or speculating

84 OptionsWise much he is gearing? Should returns be based on margin cover or overall exposure? Is the investor aware of the overall exposure or just the amount required for margin cover? If the above strategy is ruled out for a super fund, should everyday investors use it? How can options be used in a low-risk manner that is appropriate even for someone’s retirement savings (where safety and longevity is at the fore of one’s mind)? The SIS Act stipulates that super fund investments must be fully covered.10 This entails providing for the total exposure of short positions and not just the margins. The amount of cover used makes the difference between an investor who is gearing and one who is not. With this rule in mind, any investor who does not intend to leverage or borrow to buy shares should fully provide for the underlying exposure of his or her option position. An investor who sells put options would be fully covered by reserving the cash required for the total exposure to the underlying share. A non-super fund investor who reserves half that amount will be embarking on 50 per cent gearing. The second guideline for super funds is that they cannot hold uncovered derivatives. An investor who buys put options can be uncovered if he is speculating. He could also buy put options in order to cover the shares in his portfolio (up to the equivalent number of shares he holds). Both situations involve buying puts, but each entails a different motive and level of cover. Speculating and hedging are at different ends of the risk spectrum and the difference between them is the possession of the underlying shares. An alternative strategy involves selling call options over the investor’s existing share holdings (covered calls) or buying shares and selling call options simultaneously (buy write) to generate extra income from the shares purchased. In a similar vein, an investor could buy puts in addition to covered calls (creating a collar) for added downside protection. An investor is covered if he holds or is about to buy the number of shares equivalent to the options he has

85 Building Portfolios sold. Selling more than what he holds will leave him short of full cover or at the extreme, naked. This position brings the investor into the risk spectrum of a speculator. Selling Index call options is viewed by some as a valid form of hedging, but investors need to be aware that it is not possible to have any cover when selling Index call options because profit or loss at expiry can only be settled by cash and not shares. The use of options should be part of an investor’s overall share strategy.11 When used in isolation, options can make an investor short sighted and tempt him with the leverage potential they present. Options should be used as an overall strategy for control, protection and the enhancement of income for long-term wealth creation. The SIS Act principles are useful for all options users and are particularly helpful in encouraging investors to be disciplined and to take a long-term view of investing. For those who don’t wish to use options as a leveraging or trading tool, there is no better way than this: invest with options like a super fund, for sensible and sustainable growth. The most challenging aspect of maintaining full cover is possessing the discipline to stick to the rule. Cash allocated or reserved for covering trades can be easily spent on other trades, as the everyday investor doesn’t have anybody looking over his shoulder, making sure his options are covered. Using options successfully as part of an overall investment does not just entail knowledge and skills, it relies on an investor’s ability to stick to a plan. The back of this book features an options plan that will help you create certainty in your investments. We will now follow the experience of Dr Alfred in his use of options as part of his overall super fund investment strategy. Dr Alfred is a medical doctor in his late forties and his days are packed with managing a busy practice and treating patients. He works long hours and has hardly any free time outside of work.