Option Series Pt 2 – Aust Shareholders Association

posted on July 25th, 2013 by Bellmont Research Team

Options Series Part 2In the last edition of Equity I introduced some basic option concepts and in part two of this series I hope to build on those. As with any new concept options take time to understand, however if you stick with me you will discover some invaluable risk management tools that you can use for your own portfolio.

Selling Options

In the July edition we looked at call and put options and considered the examples of managing cash flow and tax obligations for individual share holdings. This is only one side of the story. We will now turn our attention to strategies involving selling options.

When selling an option you effectively become the ‘underwriter’ to the obligations of the contract. In return for agreeing to meet these obligations you receive a payment. The concept of selling options is similar to the example of an insurance company. Let’s say you purchase comprehensive car insurance from QBE which costs $1000 for a year’s cover. QBE receive the $1000 payment but is required to meet the obligations that are set out in the policy. The gain for QBE is they get to keep the $1000 even if you do not have an accident. In this example QBE is a theoretical “options seller”.

Let’s build on this concept and consider a hypothetical scenario of selling a call option.

Richard has 2000 BHP shares which he purchased at $21 four years ago. He is happy holding the stock but would like to sell only if the price moves up to $35. While he is waiting for the price to head towards $35 he decides to sell September $35 BHP call options. Richard has effectively put a cap on his stock at $35 and will be obliged to sell at this level even if BHP is at a higher price.

For agreeing to this obligation he receives a guaranteed payment of $1,500. Richard has two outcomes; if BHP is above $35 he will sell his stock and keep the $1,500 payment, if BHP is below $35 he keeps his stock as well as the $1,500. The gain for Richard is that he gets to keep the $1,500 regardless of the BHP share price. Having received an income of $1,500 over three months Richard could potentially generate $6,000 over 12 months if BHP continues to remain below $35.

Index Options

In all my examples so far in this series I have considered scenarios involving individual share holdings. However most investors will not limit themselves to three or four holdings, instead they generally have a portfolio of stocks. The more stocks held however the more expensive it becomes to use individual options. There is an alternative – index options, which can be used as a simple cost effective approach for a portfolio of stocks.

Let’s consider an example of index options within a portfolio.

I will start by putting into context the scenario faced by John. He has a $250,000 portfolio comprised of 18 stocks and the ASX 200 has recently fallen 5% to 4800. John is nervous that the market will continue to move down but is reluctant to sell before dividend season. He decides to protect his portfolio with index options so he purchases 5 September 4800 ASX 200 Index Puts for a cost of $3000. In one simple, cost effective transaction John has limited the downside on his portfolio and locked in his upcoming dividends. John’s alternative to index options would have been to purchase put options for each of his stocks resulting in 18 separate transactions and a considerably higher cost price.

A common question I receive regarding index options is: who is willing to sell these options to me? The concept is exactly the same as when you buy or sell shares. For example, you may have a valid reason to buy CBA shares while at the same time someone else may have an opposing reason to sell CBA. This supply and demand creates a market for the stock. The same is true for index options. In fact index options are the most liquid options market on the ASX. In the month of May alone, over half a billion dollars’ worth of index options were transacted.

In this article I have introduced two new concepts of selling options and index options. In the next edition I will join both concepts together and explain how to sell index options over your portfolio to generate income and lower volatility.

This article only covers two of the many possible uses for options. If you wish to expand your knowledge on options and option strategies join one of our regular webinars.

ASA Equity August


Options Series Part 2 excerpt

Full magazine – ASA Equity Magazine: August

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