This article appeared in the May 2014 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.
By Graham O’Brien, ASX
Retail investors have sometimes considered equity options as a form of risky derivatives. Yet, when used correctly, options have the potential to provide insurance over your share investments, much like your home and contents insurance works.
This article, the first in a two-part series, examines how investors can use options to protect against sharemarket losses and the role they can play in portfolios.
(Editor's note: To learn more about the features, benefits and risks of options, take the free ASX online options course).
Retail investors that have done a little bit of homework widely accept that Exchange Traded Options, 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.
Two of the most popular strategies are protecting your shares and generating income
This month we will review protecting your shares and next generating income.
1. Protecting shares
Options are often referred to as risky derivatives and overlooked by every day investors. However, when used correctly they can reduce the risk of investing in shares. Options have many characteristics a key one is their ability to protect shares against a fall in the market. Similar in purpose to buying insurance on your house or car, put options can ensure you don't lose significant amounts of capital from a disaster like a crash in the market.
How does one go about buying this protection? So the first question is what protection is available?
ASX Options are available over the top 71 shares in the market as well as the ASX 200 index (XJO).
How do you go about implementing protection?
When buying put options you pay a premium to lock in a value for shares you own at the agreed value or exercise price. If a company's shares fall significantly in value, you simply exercise your option to redeem the value you locked yourself in at.
With options the person selling is obligated to buy the shares from you at the pre-determined price.
The pricing dynamics in the world of options mean if you purchase 12 months protection it costs more than the 6 month equivalent as the seller is taking on more risk.
Similarly if you are looking to protect shares, the price at which your protection kicks-in will have an effect on the premium you pay. A protection level around or higher than the prevailing share price will cost more than selecting a protection level below the prevailing share price.
Perhaps most importantly, the level of risk associated with the thing you are protecting is a key determinant of the premium you will pay. You must expect to pay a higher premium to protect volatile shares, just as you would expect to pay a higher premium on your house if you lived within 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 then this will affect the price of options over that stock. Although highly simplified these are the fundamental dynamics that affect the price of options.
Let's look at an example of using put options as protection against a fall in price. Based on pricing as at April 24.
On that day Westpac shares closed at $35.78 an all-time high and a significant appreciation of 62% over the past 2 years. As an investor you like the fully franked dividends that Westpac provides but may be concerned about a short term market correction.
By using ASX put options you can ensure a sell price for the value of your shares at $35.78. You do this by purchasing September 2014 $35.78 put options. Most options gives you the choice of selling your shares anytime up until the last Thursday in September at $35.78 whilst the others allow you do on the last day of the options life. If Westpac's share price was to rise you simply walk away without exercising the option and keep your shares. This is akin to other protection against adverse events where you have peace of mind even if you don't have to rely on it if markets move in your favour. If Westpac's share price does fall below $35.78 you can sell the option before expiry potentially at a profit to the purchase price. The profit on the option may offset the fallen share price. Alternatively, by this time you might have changed your view on Westpac and want to sell at $35.78 because you are no longer so confident about the longer term.
The cost or premium of the put options was $1.60 per share. Options are in minimum parcels of 100 shares. So the cost to protect 500 shares in Westpac for 6 months, would be $800 plus brokerage. If this cost seems expensive you can agree to protect you shares at an amount below $35.78. I you look to an amount 10% lower and protect your shares at $32.30 the cost would be $200.
Step 1: Do some homework
To learn more about options, register your details with ASX Keep Me Posted, so ASX can inform you about upcoming events. ASX will be holding a national series of seminars in June, so to be first to know the details, register your details today.
In the meantime, take the free online ASX options course to learn about the features, benefits and risks of these products and popular investment strategies.
Step 2: Set-up
Setting up an account to trade options is no more involved than buying and selling shares. To find out more about getting started:
- Contact your broker, or find one through the ASX Find a broker tool
- Read the ASX explanatory booklet your broker will send you
- Complete your account-opening forms
- Start trading to protect your share portfolio.
Don't forget, next month's ASX Investor Update will look at how you can use options to generate income.
About the author
Graham O'Brien is Manager, Equity Derivatives Sales, ASX
Equity options has information the features, benefit and risks of these products.
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