Keep investment options open

EXCHANGE Traded Equity Options began operating in Australia in 1976 and, since that time, have grown considerably both in volume and in the number of stocks over which they are based.

While in some instances regarded as speculative, not all options strategies involve considerable risk. In fact, options can be an extremely useful form of risk-management in a way that enhances overall portfolio returns.

Put simply, an option is a right (but not an obligation) to buy, or sell, an underlying stock at a specified price on or before some future date. A call option gives the option holder the right to buy an underlying share, whereas a put option gives the option holder the right to sell an underlying share.

For example, if an investor buys 1 x TLS May 02 $5.75 call, this gives them the right to buy 1,000 Telstra shares at $5.75 on or before May 2002. Each option contract ordinarily represents 1,000 shares of an underlying security.

For this right, the investor pays a premium. Calculating this premium is a little complex, however the following factors determine its value:

p current price of the underlying security;

p exercise or strike price;

p time to expiry;

p interest rates;

p volatility; and

p dividends.

By virtue of the fact that options are limited by an expiry date, they are said to be a wasting asset. Since that is the case, why not consider selling options?

The covered call

A covered call involves the selling of an option over stock currently held.

For example, having purchased Telstra shares at $5.25, an investor believes that, at the current price of $5.65, Telstra has reached a short-term high and is likely to either hold or decline from current levels over the next few months.

Keen to earn some extra income, and being indifferent between selling or holding their shares at the current market price, our investor elects to sell 1 x TLS May 02 $5.75 call option for a premium of 15 cents, and in doing so receives $150 (1,000 x 15 cents) for the option. The investor then lodges their Telstra shares as collateral cover. The likely outcome at option expiry is as follows:

p if Telstra closes above $5.75, the option is exercised and the investor effectively sells their shares at $5.75, however the investor keeps the premium earned; or

p Telstra closes below $5.75, the investor keeps their shares and also the premium.

The diagram (above) depicts the strategy’s pay off – the red line representing the effect of the covered call and the blue line the effect without an option strategy.

A cost/benefit analysis is readily discernible from the diagram.

The effect of covered call is to give away benefits at prices higher than the exercise price plus the value of the option premium ($5.75 plus $0.15 equals $5.90), however for prices below this point you receive the benefit of the premium.

Why use this strategy when the upside is limited?

One might ask the question why it is more beneficial to take all the upside possible. This highlights the most fundamental qualification when constructing an options strategy – investors should firstly formulate a view of the likely future price movements of the underlying share. It is from this that an option strategy may be tailored to suit the specific views of the investor.

Remember that our investor had formed a view of the likely movement of Telstra shares over a certain period of time. In fact, option strategies may be used to accommodate the view of almost any pattern of likely stock price movement.

While needing to have a view of the future price of a share, investors also should be aware of other implications an option strategy may have. For example, if they are exercised, will they have to sell their shares and consequently trigger probable capital gains tax obligations?

Having assessed the implications of a particular strategy, and comfortable with all possible outcomes, the next step is execution, an equally important component of the process.

While simple strategies such as the covered call are easily transacted, some are more complex and involve the simultaneous buying and/or selling of calls, puts and underlying stock.

In this respect, many investors value the advice and execution skills offered by an accredited derivatives adviser. In most cases, these advisers will have the type of software designed to ascertain fair value of options, which is crucial to pricing any strategy. They will also be able to assist you in determining whether options are appropriate for you given your needs and circumstances.