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!

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Options Question: Aussie XVI is at 12.16, what does it mean?

Options Question:

Hi Wai-Yee, I noticed the Aussie VIX dropped down to 12.16 today. How long could it stay at these levels ? From our previous talks I have been watching it each day and see its come down from 20 last month. What are your thoughts about the Aussie VIX and the ASX 200. Kind Regards Jon.

Wai-Yee replies:

Hi Jon,

You have brought up a very interesting topic. 

At a reading of 12.16 on 10 Dec, the XVI was at an all-time low! The obvious flow-on question then is, what does it mean for the XJO, which you have asked also.

 What is XVI?

 The XVI (or short for the S&P/ASX 200 Volatility Index), for those who have not been following, is the Australian VIX Index, launched by the ASX not too long ago. It is liken to the popular CBOE VIX index which is widely followed as the “fear gauge” of the stock market. VIX or XVI for us, measures the volatility of the Index. The market convention is that if volatility is high ie. VIX is high, then there is increased uncertainty in the market and markets tend to fall, hence fear is high and vice versa.

 Now, what we have is an all-time low XVI, which means there is a lack of the fear factor in the market currently. Does it mean that the market is bullish? This is what we will try to find out by looking at the XJO from different angles from the options perspective.

 We experienced the most recent high of 4815 on the XJO on 5 November. On that day, the XVI was at 18.29. On 10 Dec, despite the XJO having a reading of only 4750 (high of the day), the XVI was at the lowest point of 12.16. If I could show you the chart (coundn’t get it posted), you will see two spikes, the latest one with a lower peak, at the moment. This is indicating that the market is now more sanguine than a month before, eventhough we are not quite at the last high of above 4800 level. This is a bullish indicator.

Another indicator to look at is the Put/Call Ratio.  What is Put/Call Ratio?

 It’s a measurement of the number of puts versus the number of calls traded. It’s a division of Puts over Calls. A reading of greater than 1, signify more puts bought than calls on the underlying.

For those who don’t follow the Put/Call Ratio on XJO, it’s quite common for the XJO’s ratio to be greater than one, as institutions or investors buy the XJO Puts for portfolio protection.

The Put/Call Ratio for the XJO at the week ending 5 November (when the XJO hit a high of 4815) was at 1.83. Last week, when the XVI was at the lowest point of 12.16, the Put/Call ratio of the XJO has reduced to 1.17. Again, if I could show you the chart, you will see the gradual decline of the ratio in the last month, though the market is still not at the high it was a month ago. This is a very bullish indicator for the XJO. 

The reading of the current low 1.17  is indicating that institutions/investors/traders are taking positions in the market without hedging or not taking as much protection as normal. This is demonstrating that they have a bullish view of the market and do not think protection necessary at this juncture. Whether this turns out to be a prudent stand, we shall see, but this is the thinking of the market at the moment.

 The two indicators above are signalling to us that market participants do think the market is heading higher. If I were to cast a larger net and look at the market  as a whole as well (a part from options indicators), where the market has been and how it has been performing, I do agree with the general consensus, that we are heading higher for now; but, it would do so at a snail pace, in contrast to a rocket up performance. So, patience is required to make money in this market.

 Well, as stock markets are prone to doing what we don’t expect it to do, do check in again, for changing market conditions.

I hope this has been helpful, but remember, this is only my view, it is not necessarily RBS Morgans’ and that I can’t give advice in this forum and I can be wrong!

Have a Merry Christmas and enjoy the ride up!

Wai-Yee

Options Question: Synthetic Covered Call

Question from reader:
I’ve been reading up all the different types of options strategies, my goodness there’s no shortage and some pretty wild names (iron condor comes to mind). I came across a synthetic covered call strategy. You purchase long dated deep in the money calls rather than the underlying stock as your cover (I guess its like swimming half-naked). The motivation is that the position requires less capital than a traditional covered call. I was wondering your opinion on such a strategy as I’m curious as to how the execution would occur if you assigned for the calls you’ve written, and also how the margin requirements might work (or work against you). I guess you would also need to keep the cash close at hand in case you are assigned, which kind of defeats the purpose of the strategy (in my mind) since the whole idea is to free your money to spread around into other investments (rather than being tied up in the covered position).

Wai-Yee:
You are exactly right about swimming half naked. Unless one owns the underlying share, one can never be guaranteed of full cover, due to the following reasons:

1. Dividends. One can be out-of-pocket with the dividend amount and it can be very painful especially over a high dividend paying stock like the banks. eg. a $1 dividend payout per share translates to a loss of $1000 per contract.

In this trade, the trader who opened the position is not entitled to receive any dividend (from the bought call) but is obligated to deliver stock cum-dividend (from the short call) if assigned on the last day of cum-dividend.

2. Another problem with this strategy is the delivery of franking credit attached to the cum-dividend stock, not only that the trader need to pay out -of -pocket the dividend amount, but the franking credit attached to it as well. Even if the trader can recover the dividend, franking credit is never priced in in options pricing. Its an additional out-of -pocket amount. This risk can never be covered by an option position (no matter how deep In the money the call option is), it can only be eliminated by the holding of the underlying share.

3. Corporate actions can throw this strategy off. Eg an underlying share announces an off market buy back during the term of this strategy. Often a large component of the buy back consists of franking credit in addition to a smaller capital component. The trader could be caught assigned (via the short call) to deliver shares cum-entitlement on the last day, and to make matter worse this pain can be prolonged as the trader may not find out the exact amount of this “pain” is (the franking credit component) until 45 days after shares have gone ex-entitlement.

This list is not exhaustive. In short, they sound good in theory, but in practice, it’s riddled with problems. The trader in this strategy is still swimming partially naked. (Read my article on Swimming Naked in YTE Magazine Sep/Oct 2010 Issue, posted on 1 Oct 2010)

Traders who choose to undertake this strategy need to be aware that actual losses incurred in this trade can be more than the spread. It’s not for a portfolio investor. Only the aggressive should venture.