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This article appeared in the May 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

This first in a series on options strategies looks simple ways to protect your capital.

Photo of Graham O'Brien By Graham O’Brien, ASX

Retail investors who have done some homework widely accept that exchange traded options (ETOs), when used in conjunction with a portfolio of shares, can provide more stable long-term returns. It pays to find out about option strategies that help reduce risk and improve returns.

ASX recently reduced the contract size from 1000 shares to to 100 shares per contract on its 69 options over shares, making the market more accessible to more people. Read about this important change.

One of the most popular options strategies, outlined below, is protecting shares. Next month, ASX Investor Update looks at enhancing income with covered calls as part of a series on options strategies.

Protecting shares

Options are often referred to as risky derivatives and overlooked by everyday investors. However, when used correctly they can reduce the risk of investing in shares. Options have many characteristics that are similar to insurance policies, even down to the language used. We take out insurance and the buyer of an option is called a taker. Insurance companies write insurance and the seller of an option is called a writer. By using the insurance analogy, much of the mystique about options disappears.

Similarly, the uses of insurance have parallels in the world of options in the sharemarket. Many people hold insurance on their house and car, yet leave their share portfolio – often the most valuable of their assets – to the volatile forces of the market. How much better would you sleep knowing your portfolio is insured?

How do investors go about buying this insurance? What sort of insurance and protection is available? ASX options are available over the top 69 shares in the market as well as the ASX 200 Index (XJO).

Just like home insurance, you pay a premium to lock in a value for your shares. If your house is destroyed, or in the case of shares the company falls significantly in value, you simply exercise your option to redeem the value at which you locked yourself in. With options, the person selling the insurance is obligated to buy the shares from you at the pre-determined price.

The pricing dynamics are similar. If you insure a car for 12 months it costs more than for six months, so if you take out a six-month option, expect it to cost more than a three-month equivalent. If you are insuring something for a large amount, the premium will be higher. If you want to insure more shares, you need to buy more options contracts to achieve that amount of protection.

Perhaps most importantly, the level of risk associated with anything being insured is a key determinant of the premium you will pay. You must expect to pay a higher premium to insure volatile shares, just as you would pay a higher premium on your house if you lived in a flood or fire zone.

Options over shares that are particularly volatile will be more expensive than options over shares that have a history of price stability and are expected to remain so. If that pattern of volatility changes, it will affect the price of options.

Although highly simplified, they are the fundamental dynamics that affect the price of options.

Using put options as protection against a fall in price

As an example, in April Commonwealth Bank shares were trading at $53.00. As an investor, we were concerned about sovereign risk issues in many European countries and the problems this posed for debt markets and bank’s funding rates. We were looking for some protection over the shorter term, but were happy to keep the shares as our view was bullish for the longer term.

By using ASX put options we can insure or ensure a sell price for the value of the shares at $53.00. We purchase June 2011 $53.00 put options. This gives us the choice of selling the shares anytime up to the last Thursday in June at $53.00. If Commonwealth Bank’s share price was to rise, we simply walk away without exercising our option and keep our shares. This is akin to any other insurance against an adverse event. We do not want our house to be flooded or be affected by fire, so if it does not happen we are happy – we don’t have to use the insurance.

If Commonwealth Bank’s share price falls below $53.00 we can sell the option before expiry at a profit. The profit on the options offsets the fallen share price. Alternatively, by this time we might have changed our view on Commonwealth Bank and want to sell because we are no longer so confident about the longer term.

The cost or premium of the put options was $1 per share. Options are now in minimum parcels of 100 shares, so the cost to insure 500 shares in Commonwealth Bank would be $500.

Introduction and advanced seminars

To coincide with ASX’s important changes to its options market, a series of seminars will be held for those new to options, lapsed traders looking at the changes, and current traders looking to expand their knowledge. Register for the options seminars.

There will be two sessions for investors with differing levels of experience.

  1. Introduction to Options will cover the basics of options, with examples on how to protect shares and generate an income stream above dividends.
  2. Advancing in Options is designed for options traders that already understand the basics. The presentations will provide an opportunity to learn how to:
  • Trade bull/bear spreads
  • Implement trades for price breakouts
  • Repair an existing share position
  • Understand how market makers, traders and hedge funds use the options market.

About the author

Graham O’Brien is a business development manager at ASX.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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