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Clever portfolio options

This article appeared in the November 2013 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.

Index options are often overlooked for more complicated and costlier products. But, used well, they can grow and protect your wealth.

Photo of Dr Steven Enticott By Dr Steven J Enticott

Get ready, sit back and prepare to enjoy this journey into some of the opportunities that index options can give to your investment activities. First, let's be clear about what index options are, before exploring two very practical ways to extract the best from them.

(Editor's note: To learn more about the features, benefits and risks of options, take the free ASX Options course.)

Index options are available over the S&P/ASX 200, with the index code XJO (at the time of writing the market index was at 5250).

Index options effectively provide exposure to all the securities that particular sharemarket index comprises. For example, XJO is made up of all the shares in the ASX top 200, and buying a call index option in XJO effectively provides bullish exposure to all those shares in one trade.

A call index option gives the buyer the right (or the option) to buy that index at a certain price, while a put index option gives the buyer the right to sell that index at a certain price. Call and put option buyers limit their risk to the premium they pay for the right to buy or sell. On the other side of the transaction, the seller of a call or put index option has the obligation to meet these rights when called upon to do so, so their risk is theoretically unlimited.

One key difference between an index option and a traditional option over securities is that index options are settled in cash at expiry. In other words, their value is transferred in cash, not in the equivalent underlying shares. Index options are also exercised in the "European" style, which means they are "cashed out" on the date of expiry, not before it (but they can be bought or sold at any time).

An index option's value is expressed in points. For example, XJO applies a $10 per point multiplier to give the option a dollar value.

Leverage is a key component of index options - much the same as an ordinary share-based option - so when the market rises or falls, the percentage gains or losses are greater than the rises and falls in the underlying index. For example, buying an XJO call option for, say, $3500 with a 12-month expiry at the current index level (5250) could mean that if the market moved up 15 per cent over the next 12 months, a value of $7875 is possible, representing a leveraged return of 125 per cent.

Synthetic protected margin lending

A big advantage with index options is their ease of purchase and low trading costs. Consider the transaction fees involved in buying an equivalently diversified exchange-traded fund (ETF) share portfolio at full dollar value, compared to buying an index option giving the same exposure. The costs of the index options are obviously much lower.

Do not misunderstand me. I am a huge fan of ETFs. An ETF will pay a dividend, which is an obvious advantage over an index option. With ETFs, though, there is no downside protection if the market falls (we will look at how to protect ETFs in our second index option example later). An index option's big advantage is the default capital protection built into buying a call option, where risk is limited to the premium paid (with an ETF purchase the upside is potentially unlimited).

For example, let's say we want to borrow (margin lend) to invest $105,000 in a diversified share portfolio, where we need at least 15 different share parcels to achieve it (meaning 15 separate brokerage charges). Or we may decide to make just the one ETF purchase for diversification both with brokerages applied on a $105,000 capital value, along with margin lending establishment fees, etc.

Alternatively, in just the one brokerage trade we can purchase two XJO call options at a very low brokerage cost, giving the same leveraged exposure and with built-in capital protection, as our risk is limited to the amount of the premium paid if things go wrong.

Buying call options this way is called "synthetic protected margin lending". In other words, you pay a premium to have the right to the index's growth, but your losses are limited to the premium paid. On the downside, you do not receive any dividends with an option purchase. However, back on the upside, you do not have to pay interest on any margin lending borrowings.

The humble (simple) call option is often overlooked in preference for more complicated margin lending arrangements with higher interest rates and transactional costs, and with no protection against dips in the market. Call options are a genuine alternative to margin lending and should at least be considered when looking at leveraged exposure.

Protect share portfolios

At ASX roadshows held recently in Melbourne, Brisbane and Sydney, I spoke about the controversial notion that shares are safer than property, which is a subject I devote a chapter to in my recently released book, How to Deal with Financial Distraction. The fact is, a put index option can be used to insure against dips in the broader sharemarket, and there is no equivalent method to insure against capital losses in the property market.

The point is that we can easily protect shares against market risk by buying a put index option. If the market turns bear, the profits on the put will either partly or even fully compensate for the loss of share value in your portfolio, and that is "sleep well at night" assurance.

For example, considering the $105,000 share portfolio from our previous example, we could purchase two XJO 5250 (at the time of writing) put options with a 12-month expiry providing a very effective insurance premium, so much so that if the market falls we do not incur a loss.

But insurance comes at a cost, and the premiums in this instance are based mainly on the current volatility of the market. When that volatility is moderate or low (costs are lower), as a rule of thumb we can expect the following range of insurance costs.

To fully protect a share portfolio will cost around 8 per cent per annum. To protect against a fall greater than 10 per cent (in other words, you are willing to lose no more than 10 per cent, a little like an insurance excess) costs around 4 per cent per annum. And to protect against a fall greater than 20 per cent (real disaster insurance and what I generally advise clients) costs around 1 per cent.

Consider our $105,000 share portfolio again. Say we have purchased a 20 per cent "excess" comprising two 4200 XJO put options (with the market at 5250) with approximately 12 months to expiry, at a cost of $1050 to protect our portfolio, and the market dips 30 per cent because of a temporary bank credit failure. Consider we have also received $6300 in dividends (including franking credits based on the returns we might expect from a typical blue-chip portfolio of this value), here is the outcome:

Share portfolio value (after the dip) $73,500
Balance $89,250 (15% loss)
Insurance proceeds (put option payout) $10,500
Dividends $ 6,300
Less cost of insurance (put index option) $ 1,050

The real question is, should we insure against risk at all?

I'll leave it to former Treasury head Dr Ken Henry's summation from his 2012 speech on fixed-income (secured) products: "I know it's an old-fashioned notion, but I do think risks, and that includes sequence risk, are managed best by taking out insurance, not by substituting one set of risks for another."

Sequence risk is simply the risk from not knowing when market crashes will occur during any period of investment, and my key point here is insure.

I am often asked, just how safe is the insurer? The options market is highly regulated by ASX and collateral must be lodged to cover an insurer's counterparty risk. Even though we traversed the recent GFC meltdown relatively unscathed, the regulations for counterparty risk have been tightened even more. So how safe is an insurer? Certainly safer than not being insured at all.

Let's get interested about using index options in our everyday strategies. For more information, the ASX Index Options Fact sheet is a great place to begin. Then you can start the conversation with your adviser.

About the author

Dr Steven Enticott is a finance professional, author of How to Deal with Financial Distraction, speaker, taxation specialist and senior partner of accountants, a chartered tax adviser, registered financial adviser, Fellow of the Institute of Public Accountants, Fellow Member of the Taxation Institute Australia, and a passionate member of the International Positive Psychology Association.

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