You may protect your portfolio and take advantage of share market direction without selling your shares.
Due to Capital Gains Tax reasons (CGT), many long-term holders believe they are unable to take advantage of the regular swings in the share market, or even reduce their exposure when market downturns are staring them in the face.
With the use of Exchange Traded Options (ETOs), investors are able to protect their holdings and potentially increase their portfolio returns each year without buying or selling shares.
Exchange Traded Options – What are they?
An ETO is simply an instrument that allows the owner, the right, but not the obligation to buy or sell a particular share or index at a fixed price, up to a pre-determined date.
There are two types of ETOs available: Calls (the right to buy) and Puts (the right to sell).
Calls are very similar to deposits paid when you intend to acquire an asset e.g. a home. For example, the person who pays the deposit (Call) has the right, but not the obligation, to purchase the home for an agreed price up until an agreed date.
Puts, on the other hand may be compared to an insurance policy. Simply, the owner of the insurance policy (Put) may choose to make a claim and receive the agreed value for their damaged property.
One key difference to the home deposit and the insurance policy analogies above, is that ETOs are transferable and may be bought and sold without the need to buy or sell the underlying shares.
Typically, all ETOs have four main features:
Contract size – Each ASX company ETO generally represents exposure to 100 underlying shares.
Expiry day – ETOs have a limited life span and expire on standard expiry days set by the ASX. However, most may be exercised, or sold by the owner anytime up to and including the expiry date.
Exercise (or strike) price - The exercise price is the predetermined buying or selling price for the underlying shares or index.
Premium - Simply the price paid for the ETO.
Although sometimes viewed as speculative instruments, ETOs are in-fact tools often used by prudent investors to minimise risk.
For example, if Harry feels concerned his 1000 XYZ shares (currently trading at $29.24) may fall in value over the short term, he may choose to purchase ten Put ETOs (the right to sell) with an exercise price of $29.00 expiring in two months. Of course, the purchase of the Put involves paying a premium of perhaps 50 cents per share. At this moment Harry has now protected his XYZ shares to the value of $29.00 for the following two months at a cost of only 50 cents per share.
Should the XYZ shares rise in value or move sideways for the following two months, Harry’s Puts will expire worthless and the most he would have lost is 50 cents per share, or $500 plus brokerage.
However, should the shares fall in value to $25.80 the following month, Harry may either sell his Puts, now worth at the very least an intrinsic value of $3.20 ($29.00 - $25.80 = $3.20) and hold his shares awaiting a return in share price strength, or, exercise his Put options and sell his shares for $29.00, of course his true sale price will be $28.50 less the brokerage cost, because of the initial outlay of 50 cents per share.
ETOs may also be employed to gain leverage in rising markets.
In our previous example, Harry held approximately $29,240 of XYZ shares before they fell to a value of $25,800. Harry, now predicting a recovery for his XYZ shares wishes to buy another parcel of 1,000 shares, but does not currently have $25,800 to spend and nor does he wish to risk more than a thousand dollars. Therefore, he may instead purchase 10 Call ETOs (the right to buy) with a strike of $26.00 and leverage his position. In this scenario, Harry pays 60 cents per share (or $600 plus brokerage) for his 10 Calls expiring in two months. Should XYZ fall in value or trade sideways, the Calls will expire worthless and the most he will lose will be only 60 cents per share plus the initial brokerage. However, should XYZ move back to $29.00 by the expiry date then Harry’s Calls will have an intrinsic value of $3.00 ($29.00 - $26.00 = $3.00 less the brokerage). In this case, Harry will be able to sell his Calls and realise a profit of $2.40 per share ($3.00 sale price - $0.60 premium) or $2,400 less the brokerage cost.
Whether you wish to protect your portfolio, or increase your market exposure with the potential for profit, please contact Andrew Cox on 9263 5237.
Please note the above figures do not include brokerage, GST or ASX Exchange fees.
Investment Adviser / Accredited Derivatives Adviser
Tel: (08) 9263 5237
This information is general advice only, which has been prepared without taking account of your objectives, financial situation or needs; and because of that, you should, before acting on the advice, consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs.