Your Trading Edge – The truth about options

YTE logo

July 27th, 2011


The truth about options

Wai-Yee Chen takes a look at options from both sides, and how they can be a secret weapon for profitable trades.

 

It’s known for its notoriety. It earned its reputation from causing some lose homes or nest eggs. Some advisors even caution their clients to “never touch this thing”.

This “thing” which has attracted much negative press, is called options, a type of investment instrument which goes by the name of derivatives. Its key attribute is in attaching itself to other assets or shares to derive value. For a call option, it rises in value if the underlying rises and for a put options, it rises if the underlying falls in price. Moreover, options have use-by-dates.

These attributes of options and its flexibility in being able to be sold without first owning (or buying ) the options (nor its underlying asset) make it a very powerful weapon to be had for investors. Many use it to trade and gear and hence helped options gained the disrepute that it has. However, this same weapon can be used to protect against the onslaught of the volatile stock market and for extracting income. The secret in using any powerful weapon, options included, is in avoiding self-harm.

Most understand the common strategies of buying call options for a fraction of the price if one predicts the underlying asset to rise in price, hence wanting an option to buy the actual asset. On the other hand, one buys put options if reasonably expects the asset owned to fall in price and want an option to sell the asset. The most these buyers can lose is the small sum they paid for. If losses are mostly small and capped, how then did options get its bad rap?

It’s the other side of the contract, the sellers who received the payment. Buyers who paid to be in these contracts, expect the sellers to fulfil their promises. From the sellers’ perspective, the contract is a good deal as they are paid for their views; which happened to be the opposite of the buyers’. All they need to do is to ensure they fulfil the promise of the contracts. Well, this is exactly the hardest part of the deal, which often gets sellers unstuck. It’s human to like to be paid, but when it comes to fulfilling promises; it takes discipline, prior planning and sometimes forcing ourselves to keep them.

What are sellers promised to do anyway? For sellers of call options, their promise is to deliver or sell the underlying asset to the buyer. To invest sensibly is to hold the required underlying asset to be ready to sell them (generally positioned at a profit). For sellers of put options, their promise is to buy the underlying asset from the buyer. In both circumstances, if the sellers of those call and put options were not asked to fulfil their promises, they would have successfully extracted income from their asset or cash holdings. That’s the best outcome.

However, our rationale minds tell us that based on the law of probability, there will be times when sellers will be asked to do what they promised. Prudent sellers who neither intend to nor are able to fulfil those promises will need to ensure they are protected by exit clauses or not contract at all. Otherwise, they may just find themselves creating headlines!

To use options is sensible investing, it helps investors defend against the unwanted attacks of the stock market and the opportunity to be paid. However, its use must come with the discipline of and the ability to fulfil those contractual promises; otherwise one can move from being self-arm to self-harm.

Wai-Yee Chen of RBS Morgans has been advising in options for 15 years and is the author of ‘OptionsWise how to invest sensibly’.Wai-Yee regularly shares her unique options insights on CNBC and SKY and contributes regularly to YourTradingEdge and TraderPlus amongst others. If you want to invest in options strategically, contact Wai-Yee atwaiyee.chen@rbsmorgans.com or 0425 304 302.

http://www.ytemagazine.com/news-latest/689-the-truth-about-options
Advertisements

Be conservative on WOW with options

WOW has been sold down since providing a guidance of 2-6% growth in FY2012 to the market.

Lower margins and tougher retail environment are realities, but at $25.08 at the moment, how long will it stay at this level?

Moreover, there is a 65c fully franked dividend to be ex’d on 12 Sep.

WOW is known for its defensiveness. For those who want another level of defense, options can help to provide some downside cushion, with the guarantee of 65c dividend.

Options strategy:

Buy 1000 WOW at $25.08

sell 10 Sep $2551 call and

sell 10 Sep $2401 put

For a combined income of 53c per contract ($530 for 10 contracts)

Note: Multiple of 1000 shares with 10 options contracts above can be adjusted accordingly. For contract sizes above, total potential exposure to WOW is 2000 shares. $25,080 now and potentially spending additional $24,001 29 Sep 2011 = $49,081 in total capital required without gearing.

Scenario Analysis:

1) If WOW closes above $2551 on 29 Sep (expiry date), sell 1000 WOW at $2551 realising a capital gain of 43c + dividend of 65c + options income of 53c = $1.61 (6.4% in 29 days, before costs)

2) If WOW closes under $2401 on 29 Sep, buy another 1000 WOW at $24.01. Average purchase price for 2000 WOW is $24.55 (with $650 dividend earned)

3) If WOW closes between $2401 and $2551 on 29 Sep, holds on to 1000 WOW, income earned is 65c dividend + 53c options income = $1.18 (4.7% in 29 days, before costs)

What are the VIX and XVI saying, after the fall?

Sky News Business Monday 8 Aug 2011 10.10am

Reporting on Australian Options Actions week ended 5 Aug 2011

1. VIX at 32%

The widely watched CBOE Volatility Index VIX, which is commonly known as the “investor fear gauge”closed at 32 on Friday 5 August in the US. That wasn’t the highest reading. It spiked to a recent all time high of 39.25 during the day. The biggest one day jump though was on Thursday in the US following the over 500 point plunge where volatility jumped by 29% in just one day.

Well, 39.25 intra-day high seemed high, but even that is not the all time record. The recent all time intra-day high was at 48 arrived at last year, during the 21 May 2010 market plunge due to the outbreak of the Greek  crisis (The all time record would be during the financial crisis in Mar 2009, where VIX reached as high as 53). The reading we are seeing at the moment is still not the highest. But to put it in perspective, the 32 reading at the close is compared to a benign average in the month of July of 19.22. That is a big spike in a month.

2. XVI closed at 31.86

Bringing us back closer to home,  the Australian VIX which is the XVI on Friday was at 31.86, that’s a spike of 26% from the day before, just 3% shy of the VIX’s 29% jump. Is this reading the highest for Australia? No. The last time the XJO fell to the all time low was during the same greek crisis when the XJO tanked to the lowest then of 4175 points. At that level, the XVI was at 33.22 and peaked two days later to 34.23 (after the market has recovered from the low).

With the current reading of the XJO after Friday sitting at 4105 (below the last low) and yet with a XVI of 31.86 (still not as high as the last higher low), like the US, we may not have seen the peak yet with volatility. However, we need to remember that VIX or XVI are volatility gauges.  It can either stay elevated for a period of time or it can spike before or after market has seen the bottom, it’s not necessarily a predictor of a turn in the market. What we know though is that volatility is not yet over. Whether it will be as high as the last reading or make a new high, we can only stay posted.

Where were the bears and bulls on Aug 5th?

With the S&P/ASX200 (XJO) falling 4% on Friday 5 August, the Australian options market experienced one of the highest volumes in a day with more than 1.5m options traded.

The 1.5m equity options traded on Friday was a 95% increase from the day before. This is a big jump compared to volume in equities, which were higher by (only) 34% in comparison.

I was expecting a very bearish overall put call ratio on equity options on the whole due to fall in the market, but it came in at 1.68 times, showing that puts on equities definitely dominated trades on Friday, but there were still some nibbling of equity calls options for individual shares.

In terms of the index options, it was a bit more bearish with the put call ratio on index options coming in at 2 times, with 2 index puts index options traded for every 1 call index options.

Some of the bears and bulls on Friday were:

Ranked by the worst put/call ratios (3 or 4 times more puts than calls) and in the order of the highest puts volume traded, the options bears were all over WPL, MQG, AMP and QBE in descending order.

On the calls side, with the ranking of the best calls to puts ratios (1 to 2 calls traded for every put) and in the order of the highest calls volume traded, some optimism were seen in NCM, STO, IPL, OSH; with AMC and AIO and BXB the low volume picks.

 

Bullish On Rio Tinto

Chen Wai Yee, Head of Derivatives – Asian Desk at RBS
Morgans, believes in Rio’s diversified business and strong cashflow.

Bullish On Rio Tinto.

http://plus.cnbc.com/rssvideosearch/action/player/id/3000036460/code/cnbcplayershare

A trade on RIO’s results.

– expecting a strong first half with good cash flow (Latest post market close: it reported slightly before US$8b consensus)

– speculation of on market buy backs of the PLC shares

A trade of a fallen share price.

– share price has fallen 6.5% in 2 weeks

– at a 40% discount to its NPV of $110

– In the previous 2 times when it fell to the $77/$76 ish level, it bounced back up an average of of 10% in 3- 4 weeks

Options Strategy:

Selling options to capture high volatility in the stock for higher income.

Sell $76 Sep put for $2.25 per contract

The key question the person needs to ask him/herself BEFORE executing this trade is:

Am I happy to buy RIO at $73.75 (below $74)

If the answer if yes, go for it. That will be the worst case scenario for this trade.

For those who have a higher risk appetite, a more aggressive trade is to:

sell Sep $77 put to receive higher premium of $2.60 per contract

Breakeven will be $74.40

How to make money?

– close off early, if trend is right as put value will drop, and
lock in profit by buying back the position. This is recommended in a volatile environment. Profit locked in is definitely safer
– like wise close off early, if it doesn’t work out to take small
losses
– Last alternative is leave it till Sep and if RIO stays above $76,
then you would earn the maximum profit of $2.25 per contract