Options for Success

Options for Success

YTE Magazine Mar/Apr 2011 
http://www.ytemagazine.com/news-latest/606-options-for-success

 

 

 

 

 

 

 

 

Investing successfully with options can become a reality for you, says Wai-Yee Chen.

Most people regard options as an aggressive trading tool. Some people even imagine that options traders sit at their desks pressing buy/sell buttons in a manic fashion during trading hours. Some are thought to have ‘made it’, while others lose more than they can afford.

That may be the image of an options trader, but is it the reality?

Consider the following choice of methods for purchasing a product you want – say the latest widescreen LED television. You could:
• Spend your own money to buy what you want (e.g. using EFTPOS or debit cards)
• Spend other people’s money first and have the enjoyment of the product now (e.g. using credit cards or loans)
• Spend a fraction of your money now for the right to buy later, if you choose to (e.g. a rent-and-buy scheme).

Those who hold traditional values may prefer the first method. Then there is another group of people, willing to pay more for the use of other people’s money. The third group may choose to give themselves more time to consider their purchase and spend a smaller amount now for similar enjoyment of the product.

There is a fourth method, where you can:
• Delay spending what you have and yet earn some money now, in compensation for the possibility of not being able to buy what you want. For this group, having the income now is as good as enjoying the product now.

I struggle to think of a merchant who offers this deal to consumers. However, there is a ‘market’ that offers you this method of buying. It lies in the purchase of shares. Investors who believe in the traditional values of using their own money and yet who are willing to chance owning a particular share, can benefit from this method of buying shares. There is no manic trading, and with correct money management, no losses larger than you have committed to spending to buy the shares you want.

This method is the selling or writing of put options to buy shares.

Let’s follow the journey of John, who would like to purchase 1000 shares in Wesfarmers Limited (WES.ASX), a diversified conglomerate listed on the Australian Stock Exchange. WES shares are trading currently at $32 per share.

From the four purchase methods mentioned previously outlined, the table shows the choices available to John for the buying of 1000 WES shares.

Notes:

1.Per share or per option contract. Prices of options (premiums) are for February 2011 expiry term for the strike price of $32.
2.Assumed a 70% gearing ratio.
3.Each option contract represents 1000 underlying share exposure. Each strategy is for one option contract.
4.$32 strike price – $1.00 premium received = $31 for 1000 shares
5.If share price falls, but up to a maximum of $32,000 where gearing is at 0%.
6.Margins can be funded by shares (margins increase as share price falls but estimated to be 10% of total exposure at the start).
7.Sellers of put options have the chance to buy the shares only if the counterparty chooses to exercise the contract to sell his/her shares.
In choosing the fourth method, John is not exposed to any more than the $32,000 a traditional investor would spend using the first method. Not only that, but he is getting paid ($1000) and may spend less on a future purchase ($31,000). Why aren’t there more investors using this method?

The biggest issue is the receipt of cash, which is a double-edged sword. While it’s positive, and good cash-flow management, it’s also a big temptation. Being paid by selling options is like being paid to take home a TV. Obviously, the more contracts you sell (or the more TVs you buy), the more cash you will take home. Does that make sense though? How many TVs can one have in one’s home, before something or someone explodes?

The next issue is that some investors have a fear of the unknown. They may hold the premise that ‘the risk you know is better than the one you don’t know’. While these fears are real and can be sometimes useful, they can be overcome quickly by reading and learning, through books and seminars. New, positive experiences can replace these fears.

Our brains are like very sophisticated, powerful computer systems. We can re-write our memory. By pressing the ‘save’ button after a positive experience, previous negative experiences can be over-written. As we build in more and more positive experiences, more and more negative ones are replaced. There then emerges a new image of an options investor – one who is a disciplined, smart money manager with traditional values.

Creating such an image and investing successfully with options can become a reality for you.

Wai-Yee Chen is the author of ‘OptionsWise: How to invest sensibly’. Wai-Yee regularly conducts seminars and shares her ideas about options on CNBC and Sky Business Channel. Her latest options strategies, information on her up-coming seminars and a copy of her book can be found and purchased at http://www.optionswise.wordpress.com.

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Do you prefer OST over BSL?

One Steel OST.ASX instead of Bluescope Steel BSL.ASX was John’s preference who wrote in a few days ago in reference to my recent options strategy on BSL titled “Bullish on steel demand” on CNBC.

Thanks for writing in, John!

Well, your comments has been the impetus for me to find out more about these two steel players.

This is a brief comparison of the two:

BSL is a higher risk play on steel demand upturn. It is still in -$25m loss this financial year whilst OST is expected to return a profit of $288m with a 5% dividend yield. OST is definitely the stronger player from a fundamental perspective. However, BSL is the one which is more leveraged to the recovery in steel demand especially with its exposure to the export markets like Asia and US, whilst OST is more local and its manufacturing business has been detracting from value.

How to choose? Which one to go for? Well, I see BSL as a shorter term trading play for the thematic of steel demand recovery, for income, and not necessary one for the portfolio (due to its higher risk and leveraged position) whilst OST will be the one I would position to buy the stock especially for the 6c dividend expected to be going ex in early September.

Both deserve a play. Let’s look at how we can do so with options.

Options strategy for BSL and OST:

1. For those who have implemented the BSL strategy which was the selling of the BSL May $2 put for 12c (late Mar/early Apr) are already sitting on profits. This position can be closed off today (though no need to) by buying back for 8c (4c profit or 33% in about a week).

2. With OST, for those who want to buy the stock, but is willing to wait it out can implement this strategy:

Sell Aug $2.75 put for 40c (today’s theoretical) with OST last traded at $2.47.

If assigned on this position, investor buys shares at $2.35 (12c cheaper than buying them now); with 6c to be received soon, giving a 2.5% return soon after purchase; and would have earned extra interest on capital for 5 more months.

Happy investing!

Shall I say “I do”?

A fear of commitment need not stop you from potentially profitable trades.  

TraderPlus Issue 3 – Mar/Apr 2011

By OptionsWise author Wai-Yee Chen

Don’t fear commitment
 

The fear of commitment may be a bugbear for some and it’s often not just confined to relationships. Committing to buying a share can be as scary. Sometimes the decision to jump in to buy a share can evoke emotions that are as intense as committing to a relationship. Shall I or shall I not? Especially for a share that has plunged in large percentages. The tug of war of wanting to jump in and at the same time negotiating an equally real and opposing emotion of the “what ifs” certainly play havoc in the minds of investors.

How do you protect yourself from making a wrong decision in your commitment? How do you commit with an exit door prepared? How do you commit but not yet totally? These are some of the questions that may bug us before making a considered commitment. Though solutions may not come readily in life situations, in the investment domain the good news is these solutions already exist.

Often the more volatile a share is, the more we are drawn to it for its potential gains. One such volatile share that comes to mind is Macquarie Group. Its pre-GFC price was sub-$100; during the GFC its price was sub-$20 and now about three years after GFC; its price is sub-$36 having fallen 16% just three weeks ago. Fear of committing to such a volatile share? You bet. But there are strategies we can employ to allow us the exposure and yet be protected from those down swings. 

A common way of protecting capital and stopping losses for an investor is to sell the shares. Other than the cost of selling shares and the capital gains/loss implications, the biggest weakness of this solution is that it cannot be pre-executed. We can make a mental note, set alerts or even tell our broker of the intended price to exit to cut losses, but for it to be done, it has to be manually executed or sold, after the exit or alert price has been triggered. This post-event execution gives room to change of mind (talking ourselves out of taking losses) or the opportunity to lower the pre-determined stop loss price (which potentially widens losses). Even in situations where the investor has a mind of steel and is disciplined to stick with the original trading plan, the exit price of those shares still cannot be guaranteed; the share could gap down before reaching the exit or alert price.

What else can an investor do? Use options to manage downside risks. Options can take emotions, luck and human intervention out of the equation. Options strategies can pre-determine potential maximum losses and pre-set a guaranteed exit price for cutting losses. The investor buys the right to execute his wishes at the intended price for a later date. The two options strategies that achieve those objectives are the buying of call options and buying of puts (at the time of share purchase or for existing shares in the portfolio).

Buying of call options is often used by many traders as a way of gaining leverage to the underlying share by paying a fraction of the total price. The intention of the buyer is to trade a view cheaply and magnify the potential gain if the view turns out right; if not, a limited amount is lost.  However, for an investor who shares the positive view but is prepared to buy the shares as part of a portfolio, the buying or call to buy shares strategy protects capital by spending just a fraction at the first instance with the rest earning interest until required, plus giving the holder the right to walk away if the positive view does not eventuate.

What about a guaranteed exit price? Buying of put options over shares held is the only way an exit price can be guaranteed. The exit price is locked in before the share falls, with the payment of a premium. This strategy does increase the cost price of a share but if protection was not needed the shares are still intact. The investor would not have missed any dividends if there were any during the period and need not have endured the extra cost of re-buying the shares at a future undetermined price.

There is yet a third strategy in the options market that overcomes the cost of hedging above. Investors can be paid for making a commitment. This strategy is the selling or writing of put options. Instead of buying shares now, the investor merely commits to buying shares at a chosen price later if asked to do so and for this commitment, is paid a premium.

Strategies two and three above when used together, are most cost effective for gaining  exposure with protection to a share such as Macquarie Group, which is volatile, but attractively priced with the lure of a juicy upcoming dividend. This is the bull put spread strategy where the selling of put options is accompanied by a simultaneous buying of put options at a lower strike. With the share going ex-dividend in three months, the investor will be looking at a put spread for two months for the potential of buying the shares just in time for dividend. 

Below is a summary of the trade.

With the use of the bull put spread strategy above, instead of walking away from a commitment, an investor can now take the plunge with peace of mind and say, “I do,” confidently.

Bullish on steel demand

 

Airtime: // Tues. Mar. 29 2011 | 2:20 PM ET

Wai-Yee Chen, head Of derivatives at RBS Morgans, says investors can profit from an increase in steel demand through acquiring BlueScope Steel stock options.

Options Strategy: Sell BSL May $2.00 put for 12c

BSL last price $1.95

View: BSL to stay above $2 by May expiry

An income generation tool underpinned by a stock potentially recovering from a low base.

BSL just need to climb by 5c in 2 months. Not a big ask.