This article appeared in the December 2011 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.

See how these strategies can create extra income and protect portfolios.

Photo of Stuart McClure By Stuart McClure, Austock

Reflecting on 2011, it is easy to form a negative opinion of the Australian sharemarket. But we are starting to see positive economic numbers cycle through and growth shares being referred to as value plays. Focus should now be shifted towards 2012, with a solid portfolio of high-quality growth shares. This article highlights three tried and tested option strategies to deploy cash into the market and make the most of 2012.

(Editor’s note: Do the free ASX online options course to learn more about the features, benefits and risks of options strategies. Also, different options strategies, including those presented below, can be more effective in different types of markets. For example, selling puts can be a risky strategy in a volatile market, and writing covered call options for income may be more effective in a flat or slightly rising market. This ASX chart shows which options strategies work best if you are bullish, neutral or bearish on a stock or index. Use it to help decide if the options strategies presented below best suit your view on a stock or index.)

Strategy 1: Selling puts for income and shares entry

"Shorting puts" refers to selling puts through the option market. Its concept could be a little confusing at first but once understood it can be used as a powerful tool to generate a monthly income, or as a way to enter shares at a cheaper level than if you were to purchase them on the market at that time.

The buyer of a put is purchasing the right to sell shares at a predetermined price (the options strike price) before a predetermined date (the options expiry date). In return for this right the buyer will give the seller of the put a premium. As the seller of the put, you collect this premium and take on the obligation to purchase shares from the put owner.

If an investor would like to own XYZ shares in their portfolio, but would prefer to purchase them 5 per cent below today's price, assuming a share price of $35, they could do the following:

  • Sell 10 x XYZ $33 put options expiring in four weeks for a $0.70 per contract premium.

The seller is now paid $700 to take on the obligation to purchase 1000 XYZ shares at $33 if the shares are trading below $33 on the expiry day. If this was to occur, the effective purchase price would be $33 less the $0.70 premium received, so $32.30 per share (7.7 per cent below the original share price).

Regardless of whether XYZ trades below $33 and they take up the shares or not, the investor keeps the $700 premium.

The seller of the put can choose the strike price they would like to sell the put at. For example, if the shares are trading at $35, the seller can choose to sell a put at the strike price of $30; in this case the seller will receive a smaller premium because there is a lower chance they will be required to take up the shares. Should the shares fall below $30, you are buying the shares at $30 less the premium received.

Understanding the risks

When using sold puts to purchase shares, risk is limited to being forced to purchase at the agreed price on the agreed date. As long as the investor is prepared to do so, regardless of share price at the time, there are no further risks. Sold puts have a margin requirement which must be held with the Australian Clearing House (ACH) and most broking firms add a multiplier of 1.2 to 1.5 times the ACH requirement. In the example above, if the investor wished to purchase XYZ shares, the full $32.30 per share in cash would be required. However, the ACH may only ask for a small percentage of this, depending on where the shares trade.

Strategy 2: Writing covered call options for income

Many investors are interested in strategies that will help supplement their income on a monthly basis as a way to boost their portfolio yield. Covered calls are widely viewed as a conservative options strategy that can help to achieve this goal. It is the most common strategy used to generate a monthly income and has historically been shown to reduce the volatility/risk in returns across a blue-chip portfolio.

Investors who hold 100 shares or more in a blue-chip company are able to sell calls to collect a premium, typically on a monthly basis. The buyer of that call is buying the right to purchase the shares from you at a predetermined strike price before the expiry date of the call. These terms are described in more detail below.

The seller of the option is able to set the terms on the trade. The premium collected from selling calls will depend on three factors:

  1. Strike price. The predetermined price that the underlying shares will be traded at should the option be exercised by the options buyer.
  2. Months to expiry. Sellers can choose to sell options for any number of months; the further out they sell the larger the premium collected.
  3. Number of contracts to be sold. For every 100 units of shares held, investors can choose to sell one call contract.

Assume an investor holds 1000 units in XYZ, which is trading at $35. They can choose to sell 10 calls at a strike price of $37 that will expire in a month's times, for which they will receive a $700 premium.

If XYZ closes below $37, then the sold call will expire worthless for that month and the seller of the option will keep the $700 premium and continue to hold their shares. They can then choose to sell another call for the following month and collect another premium.

Before expiry, you may have the option of closing out the position to avoid exercise. However, if XYZ closes above $37 at expiry, as the seller of the call you will be required to sell your 1000 XYZ at the exercise price to the buyer.

Understanding the risks

Covered calls require no ACH margins as the shares themselves can be lodged with the ACH instead of cash. Covered call writing holds two main risks:

  1. Just like holding a normal shares portfolio, if the underlying share price drops in value, the investor will lose money on their portfolio. However, by selling covered calls they do collect a premium, which will help reduce these losses.
  2. If the share price rises dramatically, the seller of the option will only receive the exercise price of the option they sold. Therefore, the net sale price would be the strike price plus the premium received for selling the call. In the above example, this would be $37 plus $0.70 premium.

Strategy 3: Buying puts as protection

Investors looking to purchase shares when they are trading at historically low valuations, without the worry of further downside risk, may want to consider the "protective put" strategy. It is amazing the number of investors who insure their car but neglect to protect a much more valuable share portfolio.

For a relatively small cost, protective puts allow investors to lock in a guaranteed sale price on their shares over a predetermined period in the future. There are two main ways investors can take advantage of protective puts:

When buying shares

If an investor was to buy XYZ at $20, they could simultaneously purchase $20 protection for approximately $1.60. Which means that for the next 12 months, they have the right to sell the shares at the same price as they were purchased. In other words, the largest loss would be the cost of the insurance policy. In this example, total risk on the trade over 12 months is limited to just 8 per cent. The cost of insuring shares can be reduced or even eliminated if dividends or sold calls are used to pay for the protective put.

Locking in profits

The second way to implement the strategy is when a share has had some significant capital gain that you want to lock in, without selling. Similar to the example above, if an investor had bought a share at $20 and it ran to $30, they may have the view that, short term; it is overbought and wish to take out insurance allowing them to sell at the $30 level for six months. The cost could be expected to be around $1.35, or 4.5 per cent of the $30 share price. Again, dividends and sold calls can reduce costs further through this period.

About the author

Stuart McClure is a wealth manager for Austock Private Wealth. He provides advisory services on portfolio management utilising options to boost alpha and income. For more information on any of the above strategies or to find out how options could benefit your portfolio, email Stuart or call 1300 331 098.

From ASX

The ASX options course is broken into 10 modules. Each features a few key topics and takes about 10 to 15 minutes. The 10 modules are:

  • Introduction to options
  • What are options?
  • Options pricing
  • Choosing the right option strategy
  • Profit from a rising share price
  • Profit from a falling share price
  • Protect your shares
  •  Earn income from your shares
  • Index options
  • How options are traded.

Options are popular with traders and active investors because they provide leveraged exposure to profit from rising or falling share prices. But they can be a more complex instrument, so it is a good idea to take advantage of the free ASX options course, as well as the shares and warrants courses if you have not done them.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

© Copyright 2018 ASX Limited ABN 98 008 624 691. All rights reserved 2018.