Option Series Pt. 1 – Aust Shareholders Association

posted on June 18th, 2013 by Bellmont Research Team

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Weighed down by complexity, investors have turned a blind eye to the risk management benefits of the ASX options market. Over the next three editions of Equity Magazine I hope to introduce you to options and show how they can be used within an investment portfolio to reduce volatility and lower your risk profile. Stick with me and by the end of the article you may discover strategies that you didn’t even know were possible.

An option is a contract between two parties to exchange shares at a given price and date. To illustrate this concept let’s consider a hypothetical situation between John and Tom. John is going on a holiday in three months time and wants to sell his 10,000 Telstra shares to pay for his trip. He also happens to know his good friend Tom wants to buy 10,000 Telstra shares. They get together and agree that Tom will buy John’s shares in three months time for a price of $5.00. This is a basic illustration of an options contract. Thankfully the ASX make this a simple process by eliminating the need to search for and negotiate with other investors.

An option is a contract between two parties to exchange shares at a given price and date. To illustrate this concept let’s consider a hypothetical situation between John and Tom. John is going on a holiday in three months time and wants to sell his 10,000 Telstra shares to pay for his trip. He also happens to know his good friend Tom wants to buy 10,000 Telstra shares. They get together and agree that Tom will buy John’s shares in three months time for a price of $5.00. This is a basic illustration of an options contract. Thankfully the ASX make this a simple process by eliminating the need to search for and negotiate with other investors.

In Australia, options, just like shares are traded on the ASX who provide a regulated market in which all buyers and sellers can participate in a fair and transparent environment. Options are available over Australia’s top shares and indices with the ASX setting the predetermined levels and expiry dates. The ASX is also the counterparty to all the options contracts. In our example above this means that John does not have to worry about Tom paying him for his shares. The ASX will pay John and in turn will ensure that they receive the money from Tom, in fact they do not even have to know each other for this transaction to still take place.

There are two types of options, calls and puts. Call options give the buyer the right, but not the obligation, to buy the underlying shares at a predetermined price on or before a predetermined date. Put options give the buyer the right, but not the obligation, to sell the underlying shares at a predetermined price or of before a predetermined date.

Options are best understood by looking at examples. I will start first with a put option.

Bob purchased 1000 shares in ANZ, CBA and WBC in June 2012 and has watched his shares increase substantially over the past 10 months. Bob looks at his shares every afternoon and has recently become concerned that there might soon be a pull back from the current high prices.

Bob has a dilemma. He would like to sell at these prices however he is reluctant to because of the tax consequences of only holding his shares for 10 months. Rather than selling his shares Bob decides to purchase July put options on each of his bank holdings allowing him to postpone the sale of his shares till July while locking in his sell price at today’s prices.

The Numbers:

option1

For a cost of $1850 Bob has been able to insure his shares against a fall in price and has significantly reduced his tax bill as he can now sell his shares in July, 12 months after he purchased them.

Let’s also consider the example of Wendy who uses call options to solve a common problem.

Wendy is selling an investment property and wants to use the proceeds of the sale to purchase some shares in BHP, RIO and WPL. However, Wendy has a dilemma. The settlement on her property is not for another six weeks in which time she believes the price of each stock will be much higher than what they are today. To solve this dilemma Wendy decides to buy call options on each company with an expiry in two months time.

The Numbers:

option2For a cost of only $1950 Wendy has locked in today’s prices and has delayed the payment of those shares by two months. By postponing the payment of her shares Wendy has provided time for her property to settle allowing her to use the proceeds to pay for her shares, while at the same time she is able to benefit from any increase in the share price.

As we have seen in the previous examples options can be a great risk management tool for long term investors. In the next edition I will build on some of the concepts introduced in this article and I will look at how options can be used to reduce your portfolio’s volatility.

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