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Options over the StreetTracks S&P/ASX200

Overview

In 2005 ASX announced the listing of options over its first Exchange Traded Fund – the StreetTracks S&P/ASX 200 Fund (ASX code STW ). This article looks at this contract and strategies to improve returns combing the ETF with its options.

Learning objectives

Contract specifications for STW options
Strategies for STW fund holders using STW options

In the US, nearly every index and exchange-traded fund (ETF) has related exchange-traded options with the QQQQ - Nasdaq-100 Index Tracking Stock and its options the most active of all. In Australia however, this was the first time investors will have options over an ETF with both markets expected to benefit. So what are ETFs and why list options over them?

What are ETFs?

ETFs are ASX listed index tracking funds that invest in a portfolio (or basket) of securities, which may include:

Australian shares
International shares
Fixed income securities
Listed property trusts
or a combination of asset classes

Often touted as ‘hybrids’ between shares and managed funds, ETFs combine the tradability and convenience of shares with the diversification and simplicity of managed funds.

Appealing features of ETFs

Low cost - MERs are much lower than traditional managed funds ranging between 0.28 and 0.40 per cent, due to low turnover in the portfolio and lower administrative expenses. Investors will incur brokerage on entering and exiting the fund as per any normal share transaction
Tax advantages - franking credits attached to underlying shares are passed through to the end investor, along with a concessional rate of CGT if the ETF is held longer than a year
Income generation - current dividend yields for the StreetTracks products (S&P/ASX 50 and S&P/ASX 200) range from 7.5% - 10.7% (as at January 2009)
Can be purchased by Self Managed Superannuation Funds (SMSFs)

Core and Satellite approach

A major trend driving the increasing use of ETFs is the adoption of the ‘core and satellite’ approach to portfolio construction by smaller investors. This approach is based on the principle of separating ‘beta’ returns (i.e. the general performance of the underlying investment market) from ‘alpha’ returns (i.e. the excess returns above benchmark gained due to your fund manager’s skill). It’s an approach that larger investors have used for some time to gain better overall portfolio returns for lower overall fees. Some developments over the past 5 years that have reinforced the rationale behind this approach are that:

Many investment managers fail to outperform on a ‘consistent’ basis. This is making it increasingly hard for investors to pick ‘winning’ active managers
In periods of lower market returns it is harder for fund managers using ‘traditional’ investment strategies to deliver high returns for investors. When lower overall returns are on offer, the impact of fees also becomes more critical in terms of eating away at investors’ net return.

For these and other reasons, more investors are deciding to hold a ‘core’ portion of their portfolio in a low cost index strategy which will capture the ‘beta’ or market returns, and to combine that with active ‘bets’ using more aggressive active managers that are better positioned to capture ‘alpha’.

View the STW chart

Contract Specifications for STW Options
Underlying asset	StreetTracks S&P/ASX 200 Fund (ETF)
Option Code	STW
Exercise style	European
Settlement	Stock settled based on the closing prices of the STW at the end of the day
Expiry cycle	Quarterly (Mar / Jun / Sep / Dec)
Expiry day	The last Thursday of the month, unless otherwise specified by ASX
Premium	Expressed in cents
Strike price	Expressed in cents
Contract size	1000 units

STW options follow the expiry day of equity options and are FLEX ETOs, therefore they carry no market maker obligations. Trading hours follow stock options, not index options. The contract size for STW options is 1000. As with regular ordinary distributions by stapled securities or trust units from 3 October 2005 for the ASX Options market (except for the transitional arrangements for Transurban Group ETOs) no adjustments will apply to STW fund units for its regular distributions.

STW Options Tracking

STW options can be expected to follow the price of the underlying ETF in the same was as any other stock option follows the price of its underlying stock. Distributions and their due dates are important in the same way dividends on stock options effect pricing. The fact that the Share Price Index futures contract (SPI) trades at a premium or discount to the underlying cash market should not influence the price of the STW options.
STW options can be expected to follow the price of the underlying ETF in the same was as any other stock option follows the price of its underlying stock. Distributions and their due dates are important in the same way dividends on stock options effect pricing. The fact that the Share Price Index futures contract (SPI) trades at a premium or discount to the underlying cash market should not influence the price of the STW options.
Re-weighting a portfolio using STW Options

Covered writing:

Covered call A perennial favourite of the options market, covered writing involves selling call options against an equivalent holding in the underlying security. The sale of the call sets a selling price which may or may not be achieved depending on whether the option is exercised by the buyer.

The strategy not only provides income but is a useful mechanism for re-weighting a portfolio. Where a portfolio holds a broad based ETF such as the StreetTracks S&P/ASX 200 Fund, writing covered calls against some of the ETF allows for simple and effective portfolio re-weighting.

As an example, a $200,000 portfolio with a weighting of 90% equities, 10% cash is established at an S&P/ASX 200 level of 4500 points. The equities component is invested in 4013 units in the STW ($180,000 / $44.85) at 1st November 2008 with a 6 month target for the S&P/ASX 200 of 4950 (10% increase).

The 10% increase in the S&P/ASX 200 occurs faster than expected with the index closing at 4956.70 pts on 1st February 2009. At this point it is decided to re-weight to 65% equities, 35% cash.

$200,000 portfolio with a weighting of 90% equities, 10% cash
		Nov 1	Feb 1
S&P/ASX 200		4474.70 pts	4956.70 pts
STW price		$44.85	$48.94

	$	Portfolio value	$
STW	180, 000	90%	196,396	90.6%
Cash*	20, 000	10%	20,279	9.4%
STW distribution	.		1,081
	200,000	100%	217,756	100%

*Compounding daily at 5.5% p.a

To achieve the new weightings it is decided to sell STW units using March STW options to bring in an option premium. As with all options strategies for every benefit there is a cost. In this case it is the units may not actually be sold if their price is below the level of the call at March expiry. Notwithstanding the risk, one contract of the STW / Mar /4900 calls for expiry 19 March 2009 is sold. If exercised the STW holding will fall from 4013 units to 3013 reducing the equities component of the portfolio to 67% ($147,456 – at $48.94)

March expiry and an S&P/ASX 200 index of 5000 pts		$	Weighting

STW (3013 units at $50)		150,650	68%
STW distribution	1,081
Cash*	20,408
Sale STW units at $49	49,000
Option premium **	1,379	71,868	32%
		222, 518

*Compounding daily at 5.5% p.a
** Theoretical value for a European call option INPUT DATA :Share Price: 48.940 Strike Price: 49.000 Maturity(yrs): 45 days Dividend Yld: 4%, Interest Rate: 5.5% Volatility: 20%

If the intention is to get to exactly 65% equities / 35% cash, additional units in STW can be sold to achieve this.

Re-weighting with cash covered puts on the STW

short put Just as covered calls can be used to reduce exposure, cash covered puts can increase it. Cash covered put writing involves selling put options against a cash amount equal to the value of the contract obligation (exercise price x 1000 x # of contracts ). The sale of the put sets a buying price which may or may not be achieved depending on whether the option is exercised by the buyer.

Continuing with the previous example and an S&P/ASX 200 level of 5000 points, a decision to increase exposure to equities back to the original 90% level is made. Selling one STW put option over 1000 STW units earns a premium and if exercised increases the STW holding by 1000 units. It is decided to sell one STW / Jun / 4800 put in expectation of a 200 point fall, before the market resumes its upward trend.

If we fast forward to June expiry and an S&P/ASX 200 index of 4750 pts.

June expiry and an S&P/ASX 200 index of 4750 pts		$	Weighting
STW (4013 at $47.50 inc. purchase 1000 STW units at $48 strike price )		190,618	88%
Cash*	24,233
Option premium**	1030**	25,263	12%
		$ 215,881

*Cash (5.5.% compounding daily)
** Theoretical value for a European put option: INPUT DATA :Share Price: 50.00 Strike Price: 48.00 Maturity(yrs): 90 days Dividend Yld: 4%, Interest Rate: 5.5% Volatility: 20%