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| Derivatives
Newsletter of
the Australian Investors' Association |
Issue
3: December 2002
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DERIVATIVESTable of Contents
3. Book Review by David Leihy Page 3 Welcome To DerivativesBy Neil A. Costa Welcome to the December 2002 edition of the Australian Investors' Association (AIA) newsletter on derivatives. The Australian Stock Exchange (ASX) has advised that it has added a new 'strategies' page to their excellent web site. You will find it at: http://www.asx.com.au/markets/l3/StrategyLibraryHome_AM3.shtm In this edition of Derivatives, we have three excellent articles - 'Hedging Your Portfolio Against Risk', by George Morgan, 'Trading With Structure', by Geoff Howie, and an article by Ian Keys in which he looks at two conservative strategies using covered call options. Louise Bedford's 'The Secret of Writing Options' is reviewed by David Leihy and we have our popular question and answer section. 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 . Finally, as this will be our final issue of Derivatives for 2002, we wish you a very Merry Christmas and a very prosperous 2003. Hedging Your Portfolio Against RiskBy George Morgan In the last two articles we have had a look at Individual Share Futures (ISF's) and a trade using them. Now I would like to talk about how to use them to protect yourself against a sell-off of the shares in your portfolio. 'Hedging' is a term that is often wrongly used. It means to seek to cancel out the risk in a situation, such as "hedging your bets". The term 'hedge fund' applies to a class of investment that has very little to do with hedging and so is a real misnomer. A hedge fund is actually a highly speculative fund that invests in virtually anything in order to make a profit. They are international and so are not highly regulated. They attract wealthy investors who are seeking a high risk, high reward strategy. Globally their combined assets reached a staggering US$600 billion in 2001. The traditional meaning of hedging is what the futures markets were originally designed for. For example, a wheat farmer can sell his crop of wheat on the futures market for a guaranteed price as he is planting it. Not only does this remove uncertainty in his return but also it enables him to borrow the funds to plant the wheat since the lender can be assured of his return also. Someone who sells his product overseas may also wish to protect himself against a falling US dollar. Unfortunately most hedgers in Australia, particularly in the US Dollar, tend to use 'Over the Counter' options which I believe are unnecessarily complex and expensive and rather hard to get out of. Once you have a hedge in place you are effectively locking in the price so that if the price moves in your favour you don't get the benefit. This brings us to the point - no one wants to be hedged when prices are moving in their favour. Therefore you need a hedge that is cheap and easy to get into and out of, depending on your view of the likely market movement. Let us go back to our example in the previous article. Remember that fateful June long week-end in 2001 when the Telstra share price was dealt a savage blow by a dose of earnings reality? The price closed on the Friday at $6.72 and opened on the next trading day at $6.28. Let us say you had 20,000 Telstra shares in your portfolio. You believe that it is not the whole market collapsing but only this specific stock. You ring your futures broker and place an order to sell 20 contracts of Telstra Share Futures and are filled at say, $6.18. In this case that is all you needed to do. You have effectively locked in that price for your shares. All you have to do is 'roll-over' your futures position to maintain the hedge. That means that before the futures contract expires and you are required to deliver your shares you simply buy the contracts back and sell the next futures contact. For example, if the first contract you sold was a September contract, sometime in September you would probably buy back that contract and simultaneously take a contract to sell in December. This maintains your hedge and keeps your hedge price approximately locked in. The only direct cost is the commission to get out of the expiring contracts and get into the longer dated ones. In this example that would have given a good result. Your Telstra share price would have been locked in at over $6.00, with the market price currently being at $4.52 as at the close of business on November 28th 2002. Around that date you may even decide that the share price has bottomed. You then lift your hedge by buying 20 Telstra Share Futures at $4.58. This gives you a gross profit of $32,000 before brokerage. You still own the shares and you still have received all the dividends payed by the company during the period. Of course, there is no free lunch. There are potential drawbacks to hedging. If the price of Telstra had bounced from there the result would have been very different. Let's say that some major good news for the company broke in the following weeks and the price jumped sharply. Here is the beauty of using pure futures to hedge. If this happens you simply close the position by having what is called a stop loss order resting with your broker. You might judge that if Telstra trades through $6.40 again you are wrong and the price is heading back up. It does so and your stop loss 'buy' order is filled at $6.45. You take a loss on your futures contacts of 27 cents or $5,400 plus Commission. This would be pretty much the worst case scenario. Another bad situation would be if the price fluctuated around the level you decided was critical to hedge. This would mean you would probably be placing and lifting the hedge quite a few times. This would chew money up in commissions and small losses until the price moved decisively one way or the other so you could either be fully hedged, or not hedged at all. Like most things in trading, Hedging requires that you form a view of what is likely to happen in the short to medium term. In my next article I will detail some advanced strategies using Individual Share Futures and take a close look at a few of their other features. 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. Trading With StructureBy Geoff Howie Before the commencement of futures trading most brokers will recommend that traders undergo some form of training process. This process must be solid, without short cuts and give the impression to the soon-to-be trader that, like most things in life, they must learn to walk before they can run. Whether the trader is looking to the share market, futures market or currency market he or she must learn a lesson or two before putting any of their money at risk. The most important lesson in trading is that the trader needs a plan. A trading plan should be a well written document, providing clear instructions to the trader should the market or markets being watched move in an anticipated or an unanticipated direction. While a trading plan may contain many elements, the private client
advisers at Man Financial Australia Limited believe that at minimum
it should at least contain the following characteristics: The trading plan is in fact a business plan and as most new, small businesses fail within their first five years of operation, your best efforts are required in the construction of a plan. As mentioned in the list, once a plan is established the plan must be sufficiently tested. In back testing, quite a few years of historical data for the relevant market(s) will be necessary. The trading plan will not prevent the trader from making losses but will help address the emotional aspects of trading. With a well-designed plan, trade entries and exits should not be based on the mental state of the trader, but on criteria established within the trading plan (provided the trader sticks to the plan). Aside from the trading plan, risk management, diversification, money management, the psychology of trading and discipline are also important components of the trading business. These will be examined in more detail in forthcoming bulletins. Geoff Howie is a futures and foreign exchange adviser at Man Financial. Futures trading involves the potential for both profits and losses. Geoff can be contacted at: GHowie@manfinancial.com.au Outperform Today - Conservative ReturnsBy Ian Keys Last month I outlined a Bullish trading strategy for NAB. I hope to outline how it turned out in the next 2 months, however the bullish strategy did evolve through the flexibility of using 3 different options positions to produce a protected long position. This month, I want to look at 2 much more conservative ideas through the use of Writing Covered Calls. The 2 ideas below will still be well worth looking at when you read the December newsletter (prices when first implemented 14/11/02), Qantas and Amcor look to me like 2 of the best value BUYS in the market. Idea 1: QANTAS To enter the strategy: a) BUY 15060 QAN at $3.86= $58131 b) SELL 15 FEB $4.23 CALL OPTION CONTRACTS (.12 x 15k)= $1807 There are 2 possible outcomes: OUTCOME 1: The Stock finishes February (Expiry is the 27/02/03) above $4.23, you are forced to sell your stock at $4.23 and you keep the 12c option premium, therefore the total profit is outlined below: Profit on the sale of shares: $4.23 - $3.86 = .37 x 15000 = $5550 OUTCOME 2: If the Stock finishes February below $4.23, the strategy becomes an excellent yield play, as Qantas pay a dividend in March. Last year it was 8c Fully Franked for the half, this year it is likely to be higher. Therefore, the total profit is outlined below: Profit on Option Premium: $0.12 x 15000 = $1800 TOTAL PROFIT NET OF FRANKING = $3000 = 5.2%, OR 16.88% ANNUALISED, IF I USE A GROSSED UP RETURN, PROFIT = 6.06%, OR 19.7% ANNUALISED. The strategy appeals to me, as I think that Fundamentally, Qantas looks fantastic buying, it is one of the few Airlines globally with a balance sheet that will allow for significant expansion. RISK TO OWNING QANTAS: A war in the Middle East which would again put pressure on Long Haul Travel, and also produce a higher fuel price. OUTWEIGHED BY POSITIVES: Qantas now have an extremely strong cash flow business in the domestic market, with Virgin, there is a happy Duopoly that the Australian market has been able to sustain. I think that it would be a very aggressive move for another foreign airline to compete in our domestic market. Domestic traffic numbers are still high, and if fear subsides, Qantas should be able to increase prices. REMEMBER THAT IT IS ONLY A FEW SHORT MONTHS AGO THAT INSTITUTIONS WERE PREPARED TO PAY $4.20 FOR THIS STOCK IN A BOOKBUILD WORTH $800 MILLION. Idea 2: Amcor To enter the strategy: a) BUY 7000 AMC at $7.96= $55720 b) SELL 7 FEB $8.50 CALL OPTION CONTRACTS =(.20 x7k) $1400 There are 2 possible outcomes: OUTCOME 1: The Stock finishes February (Expiry is the 27/02/03) above $8.50, you are forced to sell your stock at $8.50 and you keep the 20c option premium, therefore the total profit is outlined below: Profit on the sale of shares: $8.50 - $7.96 = .54 x 7000 = $3780 OUTCOME 2: If the Stock finishes February below $8.50, the strategy also becomes an excellent yield play, as Amcor pay a dividend in March. Last year it was 14c Partially Franked for the half. Therefore, the total profit is outlined below: Profit on Option Premium: $0.20 x 7000 = $1400 TOTAL PROFIT NET OF FRANKING = $2380 = 4.3%, OR 14.67% ANNUALISED. A grossed up return is not given, see the note above. RISKS TO OWNING AMCOR: The major risk is that the market enters a new bull run and we see significant cash flows rush back into aggressive cyclical stocks. OUTWEIGHED BY POSITIVES: Amcor have very strong cashflows and their business is Packaging: Food, Beverage and Tobacco products. They are now a truly global company and while there is uncertainty on the political and economic front, the stock will remain a favourite of the major buyers. EBIT for the 1st Quarter was up 47% so the benefits of the acquisitions cannot be ignored. CONCLUSION: PORTFOLIO THEORY - REDUCE RISK FURTHER BY OWNING BOTH STOCKS In order to reduce risk further, why not add a defensive stock to your portfolio that will not correlate in a highly positive manner with Qantas? AMCOR is the ideal stock according to the Modern Portfolio Theory, and all of my research suggests that the stock will outperform in any market conditions over the next 12 months. Qantas will significantly benefit as fear subsides, and if it doesn't, Amcor will continue to outperform The 2 stocks are correlated to reduce the overall risk of your portfolio, and a conservative Written Call strategy has been proven to reduce risk further. If you would like to see the proof, ring me to request the Merrill Lynch quantitative report. Both stocks are a "must have" for any portfolio. I have an excel spreadsheet depicting the strategy in a simpler format, and after costs, so please let me know if you would like to see the spreadsheet. I have research reports on both companies from both AEGIS and Merrill Lynch, please also give me a call if you would like the research. PLEASE CALL IAN KEYS at HARTLEYS ON 1800 688 488 WITH ANY QUESTIONS, OR EMAIL: ian_keys@hartleys.com.au. Ian Keys is an ASX Accredited Level 1 and 2 Derivatives Adviser. While the information contained in this newsletter has been prepared with all reasonable care from sources which Hartleys Limited ABN 67 009 136 029 believes are reliable, Hartleys does not give any representations or warranties as to the accuracy, reliability or completeness of the information and no responsibility or liability is accepted by Hartleys for any errors, omissions or misstatements however caused. Accordingly Hartleys, its related companies, officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to or arising in any way in connection with anything provided in or omitted from the newsletter or from any action taken in reliance on the newsletter to the full extent permitted by law. Any securities recommendation contained in this publication is unsolicited general information only. In issuing this newsletter it is not possible to take into account the investment objectives, financial situation or particular needs of any individual recipient. Investors should obtain individual financial advice from their Investment Advisor to determine whether recommendations contained in this publication are appropriate to their investment objectives, financial situation or particular needs before acting on such recommendations. Questions & AnswersBy Geoff Howie Q1. What are some resources that can help the novice trader? There is a number of good resources that will help prepare someone for trading futures markets. Some good books include: John J. Murphy - 'Technical Analysis in the Futures Market' At www.manfinancial.com.au there is an education section, under the link banner of Specialist Services that includes seven online courses. 'Futures 101' provides a good introduction to the futures market and trading, also providing websites of other educators in the industry. Book ReviewBy David Leihy Title: 'The Secret of Writing Options' Author: Louise Bedford With the equity market going sideways, the writing of options is one of the few safe and effective ways to generate income for those investors with a blue-chip portfolio or a margin loan drawing capacity. Most texts and experience on this subject come from the U.S.A. Now, an Australian text called 'The Secret of Writing Options', written by Louise Bedford, is available to guide local investors. Louise writes for Shares Magazine, runs seminars and training in share trading and options and has her own web site www.tradingsecrets.com.au The book provides detailed guidance on the business of writing covered calls and puts to generate income. Louise takes a conservative approach concentrating on practices to protect the investor from loss. Both writing options on existing stock and undertaking a 'buy and write' are covered in detail. This book is not intended for those wishing to trade options on the options market. The major topics covered by this 163-page book are: · the benefits of writing options; Learning the topic is assisted throughout the book by live examples drawn from the Australian equity market, well-structured chapters, review questions at the end of each chapter and a comprehensive glossary. Throughout the book, pithy trading secrets formatted in boxes summarise the essence of the process and its critical elements. Written originally in 1999, an update would now be useful. The occasional regression into 'broker speak' or use of technical terms not covered by the glossary could also be corrected. Overall, I found this text to be an excellent and practical guide to the writing of options and I recommend it for novice and experienced investors alike. David Leihy is a member of the AIA. This bulletin is produced by the: Australian Investors'
Association Disclaimer: Any views or opinions expressed are intended for information only. They may not necessarily be those of the AIA. The AIA is not an investment adviser and investment decisions should not be made based solely on the contents of this bulletin. Copyright: All rights reserved. No re-publication or copying in any way, including electronic means, may be made without the prior written consent of the AIA. |
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