DERIVATIVES

Table of Contents

1. Introduction by Neil Costa
2. A Year For US Equities by Geoff Howie
3. The Next Big Thing - Individual Shares Futures Examined by George Morgan
4. Reduce Risk Through Selling Volatility by Ian Keys
5. Questions & Answers by Cathy Kovacs
6. Link to web site or download .pdf version

Welcome to Derivatives!

By Neil A. Costa

Welcome to the first edition of the Australian Investors' Association (AIA) newsletter on derivatives.

When many people hear the word 'derivatives' they often have a firmly held preconceived view of what derivatives mean to them. For the uninformed, it can mean gambling, or unduly risking one's hard earned capital. For others it is an opportunity to retain a share portfolio during a major bear market by buying put options. For still others it is the opportunity to supplement their income by either writing covered options or trading in share or other futures contracts.

It is often said that if you think education is expensive, try ignorance. This monthly newsletter is yet another great initiative of the AIA, and special thanks should go to Bob Andrew, Scott McKenzie, Silvana Eccles and many others for making it a reality. This newsletter represents a great opportunity for AIA members to be exposed to high quality information on derivatives.

Although each edition will be different in structure, we will always endeavour to ensure you receive quality articles from industry professionals as well as interested members, plus questions and answers. If you use derivatives in your investing or trading, please do not hesitate to submit an article for publication. The article can discuss how you use derivatives, or about a trade you have made - successful or otherwise. You may simply wish to ask a question, the answer to which will assist you and many other readers. If you would like to contribute, please send any articles or questions to me - neil@marketmasters.com.au or at www.marketmasters.com.au.

In this first edition, we have three excellent articles - 'A Year for U. S. Equity Markets' by Geoff Howie from Man Financial, 'The Next Big Thing - Individual Shares Futures Examined' by George Morgan from George Morgan Futures, and 'Reduce Risk Through Selling Volatility' by Ian Keys from Hartleys. We are also fortunate to have Cathy Kovacs from Macquarie Bank provide us with answers to three questions on the nature and trading of options.

I hope you find this, and each subsequent edition, very informative.

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A Year For U. S. Equities

By Geoff Howie

On Monday 17 September 2001, United States equity markets re-opened for trading following an unprecedented shutdown over four business days. Although the country was clearly standing tall following such a horrific act, major equity markets tumbled, with the Dow Jones finishing on the Monday down 7.3 percent at 8920 and the broader S&P 500 index closing down 4.9 percent at 1038.77. The selling wave continued for the entire week, with the Dow and S&P 500 making respective lows at 8062 and 944.75 by the Friday.

Following an initial recovery-type rally which was sustainability questioned by many market observers, the next six months saw the US equity indices continue to make steady gains. The US Federal Reserve supported the revival by aggressively loosening monetary policy. Familiar chart topping patterns then eventuated in mid March 2003. Corporate scandal, recession and globalization tensions began to have an increased impact on the US equity markets as the Dow and S&P 500 turned and continued within the bear trend that had been firmly established prior to September 11.

The Dow reached 7532 and the S&P 500 reached 775.68 on 24 July 2002. At the time these recent lows were made the US equity indices were trading dramatic ranges, albeit nervous ranges. These big session moves overworked many futures trading systems with the big price swings triggering more trade signals than normal. Participation in terms of volume of futures contracts on the Dow Jones, S&P 500 as well as the Nasdaq 100 futures picked up significantly in July.

To top off the increased trading signals, the attraction towards futures trading usually grows in times of excessive volatility. Futures provide a vehicle for traders to speculate on falling markets by taking short positions as well as speculate on rising markets by taking long positions. Traders can close positions once they perceive a fall or rise to be complete. The other important aspect of futures trading, particularly in volatile times, is leverage. Typically traders must have as an absolute minimum of three to 10 percent of the contract value in their futures trading account to hold a position, as stipulated by a futures exchange. For instance, presently the December 2002 E-mini S&P 500 is trading at 890.0. At USD $50 per 1.0 point, holding one position in this market is worth USD $44,500. Before taking a position in this market, traders dealing through Man Financial Australia Ltd are required to have at least USD $3,563 in their account (8% of the current worth of one contract). This is a risk measure, also referred to as an initial margin.

Stock market volatility in the past 10 weeks has held important implications for these risk measures in derivative markets across the world. With such large gains or losses made during one session, exchanges have to ensure that their portfolio analysis margining principles adequately cover these big moves. On 24 July 2002, the trading range (difference between the session's high and low) for the Dow Jones index was 671 points and the S&P 500 index was 70 points.

In addition to initial margins, exchanges and their member brokerage houses must also ensure that traders hold additional funds in their futures account or hold enough adequate liquid assets as a back up to their trading activity. Traders also need to be fully aware of risks associated with trading, and as the disclaimer states, are certain that trading derivatives suits their personal circumstances as well as general financial affairs.

It is now a year on from the September 11 attack and the Dow Jones and S&P 500 Index are still in bear market mode. Traders will be challenged within the coming months to see if the lows posted on 24 July 2002 can hold. It is going to take even longer to determine when the bears are done.

Geoff can be contacted at: GHowie@manfinancial.com.au Geoff Howie is a futures and foreign exchange advisor at Man Financial. Futures trading involves the potential for both profits and losses.

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The Next Big Thing - Individual Share futures Examined

By George Morgan

There is a Financial Product trading quietly at the moment, just waiting to be discovered by the investment community. It is futures contracts on a parcel of shares in any one of the top twenty stocks on the Australian Stock Exchange. These contracts are called Individual Share Futures (ISF's) and are traded on the electronic trading platform of the Sydney Futures Exchange, much the same way as the shares themselves are traded on the ASX platform SEATS. As a share investor or trader you may not know much about Futures. I hope that the enormous potential in this product will soon become apparent as I explain them fully.

Firstly, what actually is a Futures Contract?

It is really quite simple. A futures contract is a contract to buy or sell something. In this case it is a parcel of 1,000 shares in one of the big companies, let's say BHP. The delivery date on the contract is set at some time in the future, but the price is fixed now. Very simple, but from this simple concept has grown a very powerful investment vehicle. Traders open an account with a futures broker and they can either deal in the contacts directly from their computer or over the phone. An active share trader will find many advantages in trading these contracts. Let's look at a few of them.

Get a Little Leverage in Your Life

Every investor knows what leverage or gearing is and most realise that you need a certain degree of it to really make good returns. Leverage enables you to control the full value of an asset without having to pay for it completely. You normally put up some proportion of the asset's value and borrow the rest. If you want to buy 1,000 BHP share at $10.00 a margin lending account will lend you 60 per cent of the value of the shares and so you put down $4,000 and borrow $6,000 to own the shares. You pay interest on the $6,000 you have borrowed and get any dividends payed by the company. If the price of the shares goes up to, say $11.00, you make the full paper profit of $1,000. This equates to a 10 per cent gain in the share price but a 25 per cent gain for you, since you only paid $4,000. Let's say after a month you sell out and take the profit.

If you buy a BHP Share Futures Contact for the same 1,000 BHP shares at $10.00 you don't actually own them but rather you have agreed to take delivery of them and pay the full price at a set date in the future. You have to lodge a security deposit, called a 'margin', of $775. You pay no interest on the remaining $9,225 of value of the shares. If the price goes up to $11.00 you can then sell your Futures Contract at that price and you earn a $1,000 profit that represents a 129 per cent gain. Obviously increased leverage is a powerful tool but it should be used wisely as it can also create a larger percentage loss if the shares go down.

Liquidity

Another major factor in favour of the futures markets is that generally they are very liquid. This means they have a high volume of trades and so it is always easy to get in or out in an instant. Normally if you have relatively limited funds and wish to trade shares you find yourself at the small end of the market. You are typically limited to companies whose shares are trading in the 10 cent to 50 cent range. While these shares can show good movement they are typically rather thinly traded. This lack of liquidity means that you may get caught in a situation where it costs you a couple of cents movement in the share price just to get out.

What Happens if the Market Falls

Let's say that instead of going up to $10.00 the price of BHP shares actually falls to $9.00. If you bought you would be showing a loss, but perhaps you may have correctly anticipated the drop. This will illustrate one of the real advantages of using ISF's to trade the big stocks.

I said earlier that a Futures Contract is a contract to buy or sell. You can enter a contract to sell the shares and deliver them in the future at a price agreed on today. Obviously if you think the price is going down and so it is too expensive today you can take a contract to sell at today's high price. Of course if you still have the contract open you will have to deliver the shares on the day and be paid the full price of the contract, not the market price on the day. So you could buy the shares at the prevailing market price of $9.00 and then deliver them and be paid the $10.00 thus making $1,000 profit on the falling price. In practice you simply buy back the contract at $9.00 and make the same profit. Of course if BHP goes up to $11.00 you would buy back your contract at a $1,000 loss.

When you enter a contract to sell in the future, it is called going 'short'. Entering a contract to buy is called going 'long'. It is equally easy to do either.

The ability to go short is a key concept in futures trading When trading the shares themselves, going short is a lot harder than buying since the broker has to lend you the shares. Some brokers either actively discourage the practice or simply don't do it. This has the effect of locking the share trader into being a bull and always looking for the market to go up, and we know that just doesn't happen. There is an old saying that the market goes up by the stairs and down by the elevator. Short trades often happen a lot more quickly than long ones. We are now starting to talk like a futures trader and so here is something that all traders love to hear:

Low Transaction Costs

Buying and selling $10,000 worth of BHP on the futures market will cost you $21.50 brokerage in and the same to get out, plus GST and with no Stamp Duty. This equates to a very low 0.215 per cent, which isn't bad at all.

Movers and Shakers

Another problem an active trader may face is when you buy a particular share and it just goes to sleep. This can be frustrating and if you have bought options, either puts or calls, it can cost your real money, as you watch the time decay bleed value from the option's premium. This rarely happens when you trade ISF's because the shares they cover are the movers and shakers of the Australian Stock Exchange. They are the large capitalisation stocks and provide a great trading medium because they are volatile and thus provide opportunities on the long and short side of the market. They can be too expensive to be traded outright by many investors but using Individual Share Futures give the leverage to trade them in meaningful quantities.

In the next issue I will discuss strategies to use Individual Share Futures for trading and for protecting your portfolio against a market fall.

George Morgan is the Managing Director of George Morgan Futures and has been a trader since 1983. The company is a specialist private client futures broker and trading house and George can be contacted by email to george@gmfutures.com.au or visit their web site at www.gmfutures.com.au.

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Reduce Risk Through Selling Volatility

By Ian Keys

Global equities are currently experiencing a bear market which has lasted for the past 2 and a half years. Investors are increasingly looking at selling options as a method of enhancing the returns on their portfolios. Merrill Lynch last week released a report outlining the benefits of writing options. This 13-year study showed that risk can be significantly reduced by selling options (volatility).

The 2 most common methods of selling options are outlined below:

- 2 METHODS:

METHOD 1- Writing Covered Calls
COMMONWEALTH BANK PRICE = $31.00 (29/08/02)

BUY 2000 CBA SHARES @ $31.00 = $62000 investment
SELL 2 CBA OCT $31.50 CALL $0.77 x 2000 = $1540 PREMIUM INCOME

Scenario 1: CBA finish October Below $31.00 - You keep your stock, and the premium income = 2.4% (14.8% annualised), CBA pay their next dividend in February, so there will be plenty of time to write another option when this one expires. We aim to manage our exposure, and obtain dividends for the benefit of the FRANKING CREDITS.

METHOD 2- Writing Put Options
WESTPAC PRICE = $15.20 (29/08/02)

SELL 4 WBC OCT $15.00 PUTS $0.25 x 1000 = $1000

Scenario 1: WBC finishes October above $15.00 YOU DO NOT BUY STOCK AND KEEP $1000 PREMIUM INCOME.
Scenario 2: WBC finishes October below $15 YOU ARE FORCED TO BUY THE STOCK AT $15.00 AND KEEP $1000 PREMIUM INCOME.
This strategy is only to be used if the investor intends to BUY stock (Targeted Buy). Some investors without sufficient knowledge are seduced by the potential leverage created by this strategy. You must have sufficient capital to purchase stock if required.

*** Of Course there would be brokerage involved in real world examples of the above strategies.

A NEW ACADEMIC STUDY

Professor Robert Whaley from the Faqua School of Business, Duke University has recently undertaken a study of the return enhancement from the passive overwriting (Covered Call Writing) on the S & P 500 index in the USA. Data was collected from the Chicago Board of Options Exchange (CBOE) from 1998 - 2002.

The study compares:

1. A passive holding in the S & P 500 index.

2. The CBOE BXM Index - which tracks the performance of a passive overwriting strategy (sell slightly out-of-the-money call options monthly against the index, as soon as they are exercised, or expire worthless, write another call option).

3. The CBOE BXM Index USING LEVERAGE (eg Margin Lending to buy the stocks in the S & P, and still writing calls as above)

THE RESULTS

The returns from 1 (the S & P Index) and 2 (Covered Writing) were similar over 14 years from 1998 - 2002. Covered Writing underperformed during the tech bubble of the late 1990's, however it has now caught the index.

The Risk (as reported by annualised volatility) was SUBSTANTIALLY LOWER for the Covered Writing strategy. This translates to a substantially better risk / return pay-off.

The exciting outcome of the study was that if the investor was comfortable with the original level of risk of the S & P 500 index, the covered writing strategy could be leveraged up to receive higher returns for the same level of risk as the unleveraged index. Over 13 years, the Leveraged Covered Writing Strategy (3) outperformed the S & P 500 Index (1) by an average of 3.8% annually during the 13 years of available data.

WHY LOWER RISK?

INVESTORS OVERPAY FOR VOLATILITY: The extra value that the Covered Writing Strategy adds over the long term is that Implied Volatility (Volatility implied by the option premium traded) has traditionally traded at a premium to subsequent Realised Volatility (actual volatility of the stock / index over the month that the option is open).
THOSE BUYING LEVERAGED POSITIONS TRADITIONALLY OVERPAY. The only times in history when the reverse is true and realised volatility has had the opportunity to trade above Implied volatility is during times when the market has Boomed. One reason is that option sellers must hold the hedge / stock, or be prepared to buy stock if they are writing Puts.

CONCLUSION:

The Covered Writing Strategy is capable of providing better risk return characteristics than the market over the long term - GENERATING ALPHA.

Professor Whaley and Merrill Lynch also outlined single stock opportunities. Within single stocks, the outperformance can be enhanced, especially for those investors who do not want to limit the upside on their entire portfolios.

This is the perfect market to be WRITING OPTIONS, let me know when you find the next raging bull market and I will stop writing options! A selective approach is the best approach.

If you would like to receive a full copy of the Merrill Lynch report, or if you have any further questions, please give me a call on 1800 688 488.

Ian Keys is an ASX Accredited Level 1 and 2 Derivatives Advisor with Hartleys

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Questions & Answers

By Cathy Kovacs

Q1. What is Intrinsic Value and Time Value when referring to options?

Intrinsic Value is simply the share price less the exercise price - this is the "real value" of the option, or the amount by with the option is "in-the money".

Any additional value in the option price that can not be attributed to the Intrinsic Value is referred to as Time Value. Time Value is the extra cost paid for the probablity that the option will be in the money at the option's maturity. This means that as the option approaches expiry the Time.

An Example

XYZ share is trading at $10.00
An XYZ $9.50 call option is trading at $0.75 cents with 3 months to expiry.

Intrinsic Value = $10.00 - $9.50 = $0.50
Time Value = $0.75 - $0.50 = $0.25

Q2. I have heard an option referred to as a Wasting Asset. Will you please explain what this means?

Following on from the previous example the Time Value of an option will decrease as the option approaches expiry. On the expiry date the option will only have Intrinsic Value and no Time Value. So the $0.25 Time Value will decrease to $0.00 and on the expiry date the option will be worth $0.50 if the share is still trading at $10.00.

If you buy an out of the money option it will only have time value. If the option remains out of the money until expiry the time value will fall (at an increasing rate) until expiry, when the option will be worthless - hence a wasting asset.

Q3. When an individual goes into options for the first time is it advisable to own the underlying share?

People trade options for a variety of reasons.

1. Leverage - to benefit from share price movements with a limited initial outlay
2. Risk Management - to lock in a sale price (using put options) or writing call options.

If you are simply buying a call or put - a long call or long put strategy, it would not be necessary to own the underlying security, since all you are risking is the initial premium that you would pay for the option itself.

However, if you were writing or selling call options - a short call strategy, it may be advisable for the investor to hold the underlying security.

When an individual goes into options for the first time it is only advisable to own the underlying share when selling or "writing" a call option. The reason for this is that the seller of a call option sells the "option to sell an underlying share", therefore they are obliged to make the sale of the stock if "exercised" by the option holder.

This obligation opens the call option seller to possible losses if they are forced to sell the stock at a price below the current market price (exercised sold call option), and as a result of not owning the stock they are forced to buy the stock in the market at a higher price.

Holding the stock in a written put position - short put strategy, will not limit you losses at all if the stock moves against you.

Combination strategies are a little bit more complicated and the need to hold the stock would need to be examined for each specific strategy.

Cathy Kovacs is a Division Director in the Equity Markets Group of Macquarie Bank.

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