Most companies listed on the ASX report their earnings as at 30 June (full year) and 31 December (interim or half-year). We are now on the eve of full year reports with the expectation that companies will have made their announcements by mid September.
As investors this can be a nervous time to enter the market as any unexpected variations in a companies earnings can have a significant impact on its share price. Volumes tend to be thinner and the market seems to have no direction until after the results are announced.
There is a strategy that some investors have started to employ that allows them to gain exposure to a rising share price whilst keeping a majority of cash, normally needed to fund the share purchase, in the bank. Importantly, the decision on whether or not to buy the shares is delayed until after the company reports its earnings and its share price stabilises.
The strategy uses call options and allows the buyer to lock in the right to purchase shares at a predetermined price before a pre-selected date in the future. The cost to the investor is the options premium that is generally a fraction of the cost of buying the shares. The options premium paid is the most an investor can lose and therefore protects them from a significant fall in a share price as a result of a poor earnings announcement.
Let’s look at the following scenario, with no perceived view on the direction of the market this reporting season.
Commonwealth Bank is currently trading at $37.00. Last year CBA announced its full year results on 13 August and the expectation is that they will announce their results around the same time this year. As an investor we have two choices.
1. Buy 1,000 shares at the market price of $37.00. Total cost is $37,000 (excluding brokerage).
2. Buy 1 August $37.00 Call at a premium of $1.40. Total cost is $1,400 (excluding brokerage).
In the first choice we are exposed to the risk that CBA’s full year result is worse than market expectations and the share price subsequently falls. But if the report is good then we hopefully benefit from a share price rise.
In the second choice we are buying an option that gives us the right to buy 1,000 shares in CBA at $37.00 any time between now and 27 August. A full two weeks after the expected release of the full year results. For this right we must pay $1,400.
If the results are poor and CBA’s share price falls then you would decide not to purchase the shares at $37.00 and the most you can lose is $1,400. If the result is good and the share price rises then as the option holder you would exercise your right to purchase the stock at $37.00 no matter how high the share price has risen.
The down side to the strategy is that the cost basis for your shares rises from $37.00 to $38.40 as the option premium of $1.40 has increased your cost of purchasing the shares.
The greatest positive is that the options have allowed you to delay your decision on whether or not to buy CBA shares at current market prices until after the full year results, all whilst reducing your market risk to the option premium paid.
Table of performance shares vs options
|Share price at expiry||Scenario one: Share P&L||Scenario two: Option P&L|
|$27.00||- $10.00||- $1.40|
|$32.00||- $5.00||- $1.40|
Do all brokers offer access to the options market?
Not all brokers provide access to ASX options. To find out which brokers do select options out of the product list on the find a broker service.
If you are looking for advice on options then you should seek an Accredited Derivatives Adviser. ASX supplies a list of Accredited Derivatives Advisers.
How many shares are in an options contract?
The standard contract size for most options is 1,000 shares per contract in this example a $1.40 option costs $1,400
Commonwealth Bank is expected to pay a dividend prior to 27 August do I receive this dividend when holding the option?
Options holders do not receive dividends, instead the premium you pay for the option is reduce by the market expectation of the upcoming dividend. In this example if the expected dividend is equal to last years then the options premium has already been reduced in value by $1.53.
If you want to receive dividends and franking credits then you will have to exercise your right to buy CBA at $37.00 on the last cum-dividend date.
Once the dividend has been announced by the company you can view this date by entering the code CBA.
View a full list of options FAQs.