What is options trading? 

Options trading

Options give active investors the flexibility and ability to protect, grow or diversify their position. With a number of strategies and jargon, options can appear complex however all options strategies work on the same principle. Options allow you to ‘lock in’ a future buy or sell price for an underlying security. The set price you agree on won’t change and it’s this fixed element that smart investors rely on.

Options can be used to: 

Earn income from your share portfolio

You can write options against shares you already own to earn additional income. Whilst this will generate income upfront from the premium, you’ll be obliged to deliver the shares at the agreed price if the option is exercised.

Generate wealth in rising and falling markets

As options are classed as either call or put options, you can generate wealth from rising and falling markets. You can profit from a call option in a rising market by locking in a buy price now and benefiting from the underlying security’s capital growth over time. Or alternatively you can benefits from a put option in a falling market, by locking in a high sale price before the security’s value falls.

Hedge against share price falls

Options can be used to offset potential falls in share prices by taking put options. This gives you the right to sell your shares at a pre-set price for the life of the option, no matter how low the share price may drop.

Working examples and case studies

Case study 1: From little things, big things grow

Ever wondered how you can buy stock cheaper than the current share price? In this article I will explain how you can increase returns than would have been achieved with a simple Options strategy while taking small profits along the way.​​

When I think of Options strategies that generate income, the one that comes to mind most prominently is the ‘Buy and Write'. This is when an investor buys stock and sells Call Options.

The Buy and Write is quite an unassuming strategy that has been used by institutional and retail investors over many years.

The Buy and Write strategy is a neutral to mildly bullish approach and can offer a 3-5% return in most quarters, which really adds up over time. The stock is purchased and the Options are sold (Calls), thereby this is an approach that suits a market that is steady or trending higher slightly.

Although the Buy and Write is a classic performer that has stood the test of time, a fantastic variation to this market champion is selling a ‘put’ option over a desired stock. Writing a Put may mean an investor buys the stock at a predetermined price and time.​

If we use the example of the stock XYZ, instead of buying 10,000 XYZ at $1.00 we could sell 100 XYZ March $1.00 Puts @ $0.05. Each option covers 100 shares. At expiry in March if the stock is trading below $1.00 we will be put (buy) the stock at $1.00. When the option was sold we received a premium of $0.05 ($500.00), and the combination of the two has effectively allowed us to enter the stock at $0.95. This is a 5% discount to simply buying the stock at the prevailing price at the time of the investment decision (in this example $1.00). It’s important to note if we are not exercised on our put we can repeat the process of writing puts, lowering our entry point to the stock and adding to the percentage of return.

These percentage advantages accumulate over time so that from the smallest investments, a bigger profit can grow.​​

Physically, we are long the stock at $1.00 and expect a dividend in June of $0.02, now we can write some Calls. For example:-

Sell 100 June $1.05 Calls @ $0.05. If at the end of June the stock is trading $1.03, the option expires worthless, and we bank the $0.05 premium received for writing the option. We also receive a $0.02 dividend and still own the stock.

So we can proceed to write another call. 100 XYZ Sept $1.05 call at $0.06. At expiry at the end of September, the stock finishes at $1.08, so our call is assigned and we sell stock at $1.05 (against our physical original position @ $1.00). We no longer have a stock position in XYZ.​​

If we had simply purchased the stock outright at $1.00 without the option strategy described above. The stock finishing at $1.08 at the end of September, would have only resulted in a profit of $0.08 plus dividend if we had sold the stock at that time. Without the sale – all profits are unrealised.

Tally of profits for the cumulative strategy we have traded

  • Receive premium for the Put = $0.05
  • Receive premium from the June Call = $0.05
  • Receive June dividend = $0.02
  • Receive premium from Sept Call = $0.06
  • This is a total of $0.18 across the strategy, which is equal to $1800.00 or 18%.
PriceBought 10000 XYZTotal $Used option strategiesTotal $
90-0.08-800.00+0.08+800.00
95-0.03-300.00+0.13+1300.00
100+0.02+200.00+0.18+1800.00
105+0.07+700.00+0.18+1800.00
110+0.12+1200.00+0.13+1300.00

In summation, the simple stock purchase resulting in a $0.10 profit is not bad. However, the option strategy has both enabled us to take small profits along the way and our profit is realised at the end of the strategy giving us capital to reinvest. Additionally, we have made $0.08 more using the Options, which is almost double the profit of the simple stock strategy.​​​​​​

Case study 2: Delta - your guiding light

The delta on an option is a member of a Greek family that determines the price of an option. More importantly, the delta is the rate the option price will move, given the change of the underlying stock/index.

What does this mean for today’s topic - Price Discovery?

Well if we can predict how the price of an option will move in relation to the stock/index, we can have a healthy expectation on how and when our orders will be filled in the market.

The Delta is represented in mathematical terms between 0-1. Options that are in the money have a delta of 1, options that are well out of the money have a lesser rating of say 0.1. As the options moves closer to being in the money the delta will increase.

So what does this mean? Well an option with a rating of 1 will move cent for cent to the underlying stock/Index. If the stock moves 1 cent, then so does the option.

​If the option has a Delta of 0.5 and the underlying moves a cent, the option will move 1/2 a cent.​

If the option has a delta of 0.1 and the underlying moves a cent the option will move 1/10 of a cent.

One important point needs to be made. As calls and puts are polar opposites this is reflected in the delta as well. Calls have positive deltas and puts have negative deltas. For example if the underlying rises the value of the call will increase, the put will decrease.

Example​​​

We are looking to buy some TLS calls
​+1 TLS NOV/500 call Stock is at $5.70 Options Bid 70-72 offer Delta 0.92
​If we bid 71 the stock price falls to 5.67
​Expect a fill​​​

+1 TLS NOV/570 call Stock is at $5.70 Options Bid 2.5-3.5 offer Delta 0.39
​If we bid 3 the stock price falls to 5.67
​Expect a fill

We are looking to buy a TLS calls Put
+1 TLS NOV/480 put Stock is at $5.70 Options Bid 12-13 offer Delta 0.92
​If we bid 12.5 the stock price rises to 5.72
​Expect a fill

So as you can see from the above examples can create more certainty around you fills for further details contact your broker or the ASX.

Case study 3: Married put​

In current times the market has fallen 8 - 8.5%. Some of our Blue Chip stocks are starting to look attractive, and with most banks approaching a grossed up dividend return of 8%, with upside potential, an investor may find themselves in an investment conundrum.

On one hand you have Blue Chip shares recently discounted with grossed up dividends of around 8%, versus volatility and uncertainty from overseas markets on the other hand.

What if an investor could take advantage of a great dividend yield and the upward movements of a stock and remove any downside risk? Enter the Married Put strategy.

A Married Put strategy is when you Buy Stock/Buy Put Options. It is used when the investor is bullish on the stock long term but is worried about short term uncertainty.

For example:

We buy 1,000 XYZ Bank shares @ 31.50
We buy 10 XYZ Bank January 3150 Put @ 1.60
Total Cost:
- Stock $31,500 (1000 x $31.50)
- Option $1,600 (10 x 100 x 1.60)
Total cost of strategy $33,100

Using the above example the maximum loss that could occur is $1600, being the cost of the Put premium. The maximum gain is theoretically unlimited and the break-even is at $33.10 (Put price $1.60 plus stock purchase price).

Where to Now?

Let's look at some scenarios.

At expiry:-
If the stock is trading at $28.00, things haven't worked out as planned, but it could have been worse, much worse. Without the Put protection the losses would have been $3500.00 (31.50-28*1000). With the put protection it is a $1600.00 loss which is the cost of the Put.

What are my choices if I want out?​​​​

The position could be left as is and the Put would exercise in the money (position becomes Sell 1000 shares @ $31.50). You are also long 1,000 shares @ $31.50 so they would match off and nett to zero. For every cent lost on the physical below the entry price, the equal and opposite gain would be made on the Put.

If the investor is still happy to keep the stock (i.e. long term view is still bullish), the stock could be held and the 10 XYZ Bank Jan 3150 Put @ $3.50 (Value $3,500) sold. At this point the downside protection of the Put is removed. Or the put could be rolled e.g. Sell the 10 XYZ Bank January 3150 Puts and Buy say 10 XYZ Bank June Puts. There would be an additional cost here.

If the stock is trading at $35.00, things have worked well. You are up $1900.00 (35.00-31.50-1.60 x 1000). At this point the investor may feel that the Put is no longer needed and it would lapse worthless.

Remember that if the investor is not comfortable with this strategy they can sell the stock and Put at any time to exit the position.​​

Also there is a great variation to the Married Put which is the Leveraged Married Put where some Margin Lenders will lend the full value of the stock if the Put is in place.

The Married Put is a simple and effective strategy that gives investors the ability to stay in the market through times of short-term uncertainty. If anything, it gives the investor some time to make a measured decision at a cost that is far outweighed by the profit potential. In the event that an incorrect decision is made, the cost of that is limited to the cost of the option.

Case study 4: Protect the value of your blue-chip share portfolio by buying XJO S&P/ASX 200 put options​

Historically the market spends more time moving in an upward direction (bull market), than in a downward trend (bear market).​​​​

That's good news for investors, as over time the bull market will win out in duration and the longer you hold your Blue-chip portfolio the greater the chance of positive returns. On the flip side, the longer you hold your Blue-chip portfolio, the greater the chances are that you will encounter a correction. In my opinion the below are representative:

Standard Correction 10%
Major Correction 10-20%
Crash - greater than 20%

We insure our house.
We insure our car.
We insure ourselves.
Some people even insure their pets...

Could we insure our blue-chip portfolio?​​​​

Yes we can with XJO S&P/ASX 200 Put Options (commonly called XJOs).

What is an XJO option?

Regarded as the leading benchmark by professional investors for broad movements in the Australian Stock Market, the S&P/ASX 200 index reflects the price of the largest 200 stocks on the ASX and accounts for 80% of market turnover.

An XJO Option is an option over this index

Like all other options, they have Calls and Puts, they can be bought and sold prior expiry, they have an expiry date and a strike. The positions are managed just like stock options EXCEPT for a few differences. These options are ALWAYS European style which means they can only be exercised on the Expiry date.​​​​​

They are traded in points, not dollars and cents.

They have a tick value of $10.

They are cash settled on expiry, which is when profit or loss is actually realised.

The settlement Price expiry is the opening price of the index on the day of expiry.

When would we take this insurance?

If an investor thought there was a high chance of a decent market correction of 5-10%.​​​​​​​

Like with most options, if the investor believed the underlying asset was to fall they would look buy a Put to cover it.

1 XJO Put roughly covers a $50,000 portfolio, so to cover this position adequately you could trade the following example:

On the 8 September 2014 - the current index level is 5600

We have a Blue-chip portfolio with a market value of $100,000 with a dividend return of 4% ($4,000).

On the 8/9/2014 we buy two lots of the XJO Nov 5600 Puts @ 110 points

The premium cost of this option purchase is $2,200 (two options x 110 (premium) x tick value ($10))

On the 19 October the market falls in the below brackets:

Market fallCost to portfolioPortfolio valueXJO protection gains Net difference
-10%$10,000$90,000+11,200+1,200
-20%$20,000$80,000+22,400+2,400
-30%$30,000$70,000+33,600+3,600

The XJO protection directly mirrors the fall in the market in this example because we have purchased the option at the strike that is exactly the same as the index level. The protection is calculated (5600 x 10%) x tick ($10) x the number of options (2). The same calculation can be used for any percentage correction in this example.

​​Too good to be true - where's the catch?

Not many investors would have all 200 stocks in their physical portfolio, or even ONLY blue-chip stocks. So unlike Single Stock Options (SSO) it will be rare that your portfolio could be matched exactly evenly to the stocks that the XJO represents. In the event of a correction your physical portfolio could fall more or less than the cover provided by the options you hold.

In the event that no correction occurs during the life of the Put cover, then the premium paid would be lost as the option expires worthless (if the index is above 5600 at expiry). In order to continue cover, another Put position would need to be purchased which would involve recurring outlays to afford protection. Over time this could become costly. Investors could use the dividends received on an annual basis to help fund the use of protections strategies like this. In the example above the $4000 dividend return would more than adequately cover the cost of the option purchased ($2,200).

In summation, options give you options. You may not have to liquidate your portfolio with the rest of the herd at a great loss.

Further reading:
Tell-tale trading patterns
​Support & resistance

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