This article appeared in the October 2010 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 Daniel Chulakovski, Alpha Securities
Many investors may have not considered options as part of a diversified investment strategy but they are a viable way of generating income and capital gains, and protecting investments.
An option is a financial instrument that gives its owner the right, but not the obligation, to engage in a specific transaction on an asset for an agreed premium. Options are derivative instruments, as their fair price derives from the value of the other asset, which would be known as the "underlying" asset. This is commonly a share, bond or a futures contract, although many other types of options exist and can in principle be created for any type of valuable asset.
When combining options, you are able to formulate trading strategies with your particular views on the market.
In these challenging times, investors crave an opportunity to be flexible. Gone are the "set and forget days" of holding a share for many years and hoping it will continue to rise each year. Our markets have developed and so has the need to redefine trading strategies. It is time to give options careful consideration.
An income strategy that can be applied to any shares
When delving into options, one of the most common yet effective strategies is the simple covered call. It is best applied when markets are tracking sideways or have potential for a small breakout. The market currently is at low levels and there is nothing convincing on the horizon to lead a very strong rally, in our view.
The covered call is the most widely used strategy that combines the flexibility of listed options with share ownership. If you own the shares, it is simple: you find the correct option to sell to earn that additional income, or alternatively to reduce the purchase price on the shares within your portfolio. If you do not own them, it is simple to do a "buy and write". With that, you purchase the shares and sell the call.
Consider this example:
|Buy 1000 BHP @ $37.91||$37,910.00|
|Sell 1 BHP 3950 call options @ $0.85||$850|
|If on expiry, price of BHP is over $39.50, you will receive $850 premium plus $1.59 capital gain on 1000 shares = ($1590)|
|Total profit will be $850 + $1590 = $2440|
|Profit as a percentage $2440 / $37.91= 6.4%|
|If on expiry, price of BHP is below $39.50 and the option not exercised, you will receive $850 premium|
|In the event BHP shares fall below $37.91 at expiry, the premium of 85c per share helps lower your purchase price to $37.06 ($37.91 - 0.85c) so it does offer some limited downside protection.|
This strategy can offer limited protection from a decline in price of the underlying share and limited profit participation with an increase in share price. But it generates income because the investor keeps the premium received from writing the call.
At the same time, the investor can appreciate all the benefits of underlying share ownership, such as dividends and voting rights, unless the investor is assigned an exercise notice on the written call and is obligated to sell the shares.
As with everything, this strategy has some risk. If the investor's market view is incorrect, the risk of financial loss is in a declining price of the shares held. The premium received from the initial sale of the call will partially offset this loss.
The calendar spread
An extension of this strategy is the calendar spread. It contains many similar traits to the covered call but the difference is, it avoids the risk of the share position collapsing due to the elapsing of the option. The risk in this instance is if the shares (or replicated long call position) expires, leaving the investor with no return or capital gain.
The calendar spread represents one of the more flexible option strategies, providing a fairly even risk-to-reward factor. It does require patience and presents a similar payoff to owning fully-paid ordinary shares. The idea behind the strategy is to generate income against the long-term call by selling calls with short-dated expiry to capitalise on the differential in time decay, similar to buying in bulk.
Consider this example:
CSL Limited (CSL)
Although this strategy is an extension of what is described above and is slightly more difficult to interpret, what we attempt to do here is quite simple. Buy an at-the-money long-term call and follow up with selling short-term calls with the same strike price.
In this example, we bought some March 2011 CSLLJ8 $32.00 calls for $2.92 (contract is 1000 units). We simultaneously sold some July 2010 CSLDP8 $32.00 calls for $1.12.
If we keep it simple and stick to one contract, the result is a net outlay of $1.80 (x1000) = $1800.
The cost in this instance is $1800 if the share price is $32.00. After July, the maximum profit is what CSL is trading at above $32.00.
The risk is if by March 2011, CSL is trading below $32.00 and no additional calls have been written in the remaining months after the initial sale, you lose the opportunity to make premiums and hence generate income.
In summary, the idea is to buy a long-dated call option and then continually sell near-term options so the premiums received will cover the initial outlay. By doing this quite early, you will be in a position to own a call option on the shares that have been completely paid for - thus enabling participation in any upside, free of risk.
Options strategies for when companies report
Entering the market prior to companies reporting can be a nervous time as unexpected surprises can alter the profit or loss of a trading strategy. Some investors have started to employ a strategy that enables them to gain exposure to a rising share price while 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 price stabilises.
One such strategy is the mere purchase of call options. The cost to the investor is the options premium, which is generally a fraction of the cost of buying the shares. The premium paid is the most an investor can lose and can protect them from a significant fall in a share price as a result of a poor earnings announcement.
Consider this example:
Australia and New Zealand Banking Group (ANZ) is trading at $22.00. It is due to report its annual results on the October 28. An investor has two choices.
- Buy 1000 shares at the market price of $22.00. Total cost $22,000 (excluding brokerage)
- Buy 1 October $22.00 call at a premium of $1.50. Total cost $1500 (excluding brokerage).
In the first choice we are exposed to the risk that ANZ's full-year result is worse than market expectations and the share price falls. But if the report is good, we hope to benefit from a share price rise.
In the second choice we are buying an option that gives us the right to buy 1000 ANZ shares at $22.00 any time between now and October 28 (the expiry date of the option). This is more than two weeks after the expected release of the full-year results. For this right we must pay $1500.
If the results are not what the market expected and ANZ's price falls, you would decide not to purchase the shares at $22.00 and the most you can lose is $1500, the amount paid for the premium. If the result is better than expected and the share price rises, as the option holder you would exercise your right to purchase at $22.00 no matter how high the share price has risen.
The downside to the strategy is that the cost basis for your shares rises from $22.00 to $23.50 because of the option premium of $1.50.
This strategy does have a tangible upside. The options have enabled you to delay a decision on whether or not to buy ANZ shares at current market prices until after the full-year results, while reducing your market risk to the option premium paid.
Shares v Options: Performance?
|Share price at expiry||Scenario 1: Share P&L||Scenario 2: Option P&L|
In percentage terms, let us assume ANZ's share price rose to $25 after the annual report. If you had bought shares you would have made a return of 13.6 per cent ($3/$22). Had you gone down the path of purchasing the option, your return on investment would have represented 100 per cent ($1.50/$1.50). This accelerated rate of return also applies inversely; losses can be exacerbated should the share price fall.
About the author
Daniel Chulakovski is an adviser with Alpha Securities. For further information, visit the Alpha education section.
To learn more about a range of options strategies, read the free ASX guide, Options Strategies - 26 proven options strategies for clever investors.
The ASX Options Library also outlines a range of bullish, bearish and neutral strategies, as well as strategies for price breakouts. A number of options strategies have been published in ASX Investor Update over the past few years.
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