Using options to hedge

This paper was written to assist in the management of risk for those not qualifying for a government pension who manage their own investments as self-funded retirees.  Because of the appalling low interest rates one must invest in a variety of equities and interest bearing securities to secure even a very modest self-funded pension.

This paper is an introduction to options which facilitate hedging strategies that protect investors from sharp falls. It can be regarded as purely educational and general in nature. Readers should not rely on the contents which may not suit individual investors. When contemplating hedging or using options interested parties should always consult a licenced professional. The paper will support one tutorial at the University of the 3^rd Age devoted to the management of risk.       

Introduction      

Options are used for a wide group of securities classified under the heading of derivatives. A derivative is anything that derives its value from something else, in this instance for options, from the underlying shares or share indexes. They are only risky when used improperly for purely speculative purposes or in naked trading. In the 2008 Global Financial Crisis mortgage backed securities and credit default swaps caused most of the problems. Options were largely blameless.  

Used properly, options can be useful tools to facilitate modest hedging and gain a small additional income. You can hedge against individual shares or your entire portfolio by buying an index put.

Similarly rises can also be covered without the need to buy any more shares by buying an indexed call. Professional fund managers routinely use indexed options, aimed at enhancing overall returns.  The options market can also influence the share market.  

At the end of the paper is a glossary of terms as a reference point although my aim is to explain comprehensively along the way. 

Options Market

Buyers and sellers take market positions in the underlying shares according to their assessment of likely trends. Contracts are for 100 shares. In Australia daily turnover fluctuates from around 500,000 up to a million. Additionally there is about 40,000 daily trades in indexed options which are traded at much higher values. Contract size is 1000 points plus an investor multiplier of 10, meaning it’s effectively $10 a point.   Option trading can exasperate trends in share prices and their indexes.

This happens when share prices are very close to the exercise prices at close proximity to maturity. Traders then will engage in buying and selling the underlying shares to improve their option outcomes. These activities can sometimes move prices by 1% or more. You can also gauge market sentiment by examining the put-call ratio. This is an indicator ratio that provides feedback about the trading volume of put (sell) options to call (purchase) options. The put-call ratio has long been viewed as an indicator of investor sentiment in the markets. At the moment it is bullish. 

Options Terminology -Options Contract

An agreement between buyers and sellers defining such terms as the underlying security and the exercise (strike) prices. There are 2 contract types, namely European, whose underlying shares or index can only be exercised on maturity and those called American where exercisment can occur at any time up until maturity.  

Description: 79.01 CALL OPTION EXPIRING 28-MAR-2018
Underlying asset: COMMONWEALTH BANK.
Expiry: 28 Mar 2018
Exercise Price: 79.010
Exercise style: European
Open Interest: 2,624
Contract size: 100 securities
Commenced Trading: 26 Apr 2017 

·      Call Option explanation

The above Call option gives the holder the right to buy, but not the obligation, the designated number of shares at the exercise (strike) price of $79.01 which will mature shortly. The exercise (strike) price is the price a share must go to or move above it before a position can be exercised for a profit. However, in all cases, because of the unexpired tine value it makes more senses to sell the share before maturity. Typically this current option would have been bought many months before when the share price was closer to $79.01 than when a buyer expecting its price to increase. The option is very likely to expire worthless but presently would have just a modest unexpired time value. .   

·      In or out of money

A call options is in-the-money if the share price is on or above the exercise (strike) price. A put option is in-the-money if the share price is at or below the strike price. The option can be sold at any time prior to expiration. In both cases options can always be sold prior to expiration when they will have a small unexpired time value.     
·            Putt Option a Put option confers a right, but not the obligation, to have bought, at expiration, at the exercise price, the shares which are the subject of the put option. That is, where shares are at or below the exercise (strike) price.

Description: 79.01 PUT OPTION EXPIRING 28-MAR-2018
Underlying asset: COMMONWEALTH BANK.
Expiry: 28 Mar 2018
Exercise Price: 79.010
Exercise style: European
Open Interest: 1,661
Contract size: 100 securities
Commenced Trading: 26 Apr 2017

·                Putt  Option explanation

This option also began trading on the ASX options market on the the 26th April 2017 but as a put option. A buyer, say in late January may have bought this Put option as insurance against a fall in the CBA share price. Rather than expire worthless, as is the case with the buyer of the call, the put option holder has partially hedged falls in the CBA share price after allowance for the initial premium paid.

For this option we can calculate the intrinsic value and the unexpired time value for a total of the option price as follows:

Intrinsic value: Exercise Price of $79.01 less current share price of $76.39 =$2.62.

One then adds the intrinsic value for time value unexpired, which is   18 cents. The option is currently trading at $2.80, so the time value differences continue to decay but will apply up until expiration.

Hence the time value is ex intrinsic value, a determinant of two variables (1) time remaining until expiration and (2) the closeness of the option exercise (strike) price to being in the money.
In summary options are in the money or out when they are at or compare favourably or not with their exercise (strike) price.

When specifying a particular option it is customary to refer to the strike price in lieu of the exercise price. 

Selling covered calls. 

The difference between a seller of calls and a covered seller is the latter holds already holds the shares in the options being sold. The seller also receives the premium paid by the buyer. To the extent the covered call seller receives premiums this could be regarded as a mild form of hedging against possible falls in the share price. The alternative is called naked trading and is not recommended. 

Hence a covered call is an options strategy to holds shares (what is called in the industry long positions) but sell options over those shares aimed at generating increased income. It can call also be known as a "buy-write".

In summary the position for covered call sellers is as follows:

Out of money options are likely to see their option expire worthless. 

In the money options can be bought back before expiry by sellers. For sellers there is always the possibility of selling another contact at a different exercise price, to recoup or even exceed the buyback cost.  

In and out of money is a common industry term to describe positions. In this case we are talking about an option where the exercise price has been reached or breached. In other words where the underlying shares or indexes exceeds exercise prices. 

When using European style options one is protected from being exercised just prior to dividends becoming due, as the style can only be excised on maturity on the exercisment date.   

Indexed options 
The exact same principles and contracts apply except except we substitute share indexes in lieu of individual share prices. The exercise price then becomes various index levels. A buyers of an index put can cover an entire portfolio as c insurance against a catastrophic market crash. 

However to ensure premiums are not prohibitive discounts can be deducted from the current index levels. 

Illustrative example Index put over S&P/ASX200
XJOZO7
Description: 5350.0 PUT OPTION EXPIRING 17-MAY-2018
Underlying asset: S&P/ASX200
Expiry: 17 May 2018
Exercise Price: 5,350
Exercise style: European
Contract size: $1000 / point
Commenced Trading: 17 Nov 2017

Explanation

The Buyer is desirous of cover for $400,000 over the portfolio. 
Note that by choosing an index exercise price of 5350 the buyer is prepared to wear as an excess a discount of 10% (545 points) since the index is presently trading at 5895, at the time of writing.  
The next step is to calculate how many contracts we have to enter into. This is calculated by dividing the cover required of $400,000 by the current index 5895 and applying the investment multiplier of 10. So we calculate a need to buy 7 contracts.  Under such contracts a specified number of dollars per point of $10 is to be applied. 
The cost at the time of writing is 32 cents per point, so the total cost for a 1000 point contract is $320 to which we must apply the investment  multiplier of 10 =$3200. Each contract then costs $3,200 for a total premium payable of $22,400.

However is there was to be very sharp correction of say 30% prior ton expiry the option purchase would afford hedging as follows:   

The intrinsic value of one contract would be 5350- 4127=1223 points @ multiplier of 10=$12, 230 per contract times 7 contracts =$85610

Less original cost  =                                 $22400
Hedging achieved                                     $63210
Fall in prices                                          $120.000
Loss absorbed in excess 10%                    $40,000
Less cost of cover                                    $22,400
Intrinsic value                                         $57, 600
Time value, the time value unexpired        $5,610
Index  now trading at 4127. 

Note that if the index rose instead of falling the put option does not inhibit any upside. Large scale catastrophic losses (GFC) render the insurance much more worthwhile. 

Final expiration of open positions.

To recap options cover varying time periods and buyers and sellers can elect to take positions any time prior to maturity. In the previous illustrative examples we assumed positions in late January and examined their likely result.

In other words to examine if these positions were likely to be in or out of the money on expiration on the 26th March 2018.

Those options that remain in the money will be automatically exercised on the 26th March and positions finalised by execution by brokers on behalf of their clients. If you elect to use options you will be required to sign a derivatives agreement with your on line or full service broker. Clients get BUY and Sell notifications at brokerage according to broker agreements. 

The market in options.

Just to recap there are 4 participants in the options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts.
·      Buying and selling options is very similar to shares in that you receive or pay a premium based on what is called a strike price under a particular share option contract, The premium is determined by factors inclusive of the share price, strike price and the time remaining until expiration of the contract.
·      An option contract typically represents 100 shares of the underlying shares. There are 2 types-American and European. Holders of the latter don’t have any rights until expiration.
·      The European Indexes are for 1000 points and an investor multiplier of 10 is applied.
·      Options materially affect share prices.

Glossary of terms

A "buy-write" is selling a covered call.  
Call Option: gives the Buyer the right, but not the obligation, to buy a share or option index contract at an excise price within a specific time period.

Collateral – to be lodged by sellers as security.  
Contracts that sets out the agreement for Buyers and sellers covering option parameters.
Contract sizes – 100 shares or 1000 points by 10 for indexed options.
A covered call is an options strategy to holds a share (long position) and sell options on that same share aimed at generating increased income from the share held. A covered call is also called a "buy-write".
Exercise price is usually called the strike price.    
In and out of money will be determinants of whether or not the underlying share or index level reaches or exceeds exercise prices.  Outside of money is indicative current prices will render the option worthless on expiration.     
Option Style: An American option is an option that can be exercised any time prior to expiration or in other words anytime during its life. European options are exercisable only at maturity.
Putt Option
A Put option confers a right, but not the obligation, to have bought, at expiration, at the exercise price, the shares which are the subject of the put option. Subject to share prices below or at the exercise (strike)  price.
Time Value of options
The time value is ex intrinsic value, a determinant of two variables (1) time remaining until expiration and (2) the closeness of the option exercise (strike) price to being in the money.
Investment Multiplier
Under a contract a specified number of dollars per point when using European Index Options. Usually $10

Lindsay Byrnes -Value Investing 2018

The rains in Africa - Angel City Chorale

At our next concert of the Open Door Choir we intend to sing this number inclusive of the man made sound effects. By rubbing the hands to commence, then for different sections begin to click their fingers at varying intensities, followed by varying stomps, you can emulate perfectly a storm. 

Governance and Accounting standards in Australia

 

Introduction

 

In Australia the information in published accounts is highly regulated in accordance with comprehensive legislative and professional bodies that issue standards and guidance. In addition the ASX (Australian Stock Exchange) provides rules for listed entities which come under the provisions of contact law. Whilst the ASX also issues a number of non- binding suggestions, nevertheless they have been almost unanimously adopted. Hence the format of Reports for most publically listed entities is very similar.

From my experience the Australian approach which tends to favour descriptive principles rather than a prescriptive approach favoured by the US is far more effective. People tend to respond more ethically if one is required to use one’s imagination. In other words applying a broadly based principled approach as opposed to being prescriptive which risks dissolving into a purely box ticking compliance approach.  

 

The principal legislative requirements are contained in the Corporations Act 2001 whose provisions are enforced by ASIC.  (Australian Securities & Investment Commission). ASIC is involved in surveillance, investigation and enforcement of the financial reporting requirements.  

The Act gives legal effect to auditing standards requiring auditors to adhere to the ethical standards laid down by the Accounting Professional and Ethical Standards Board (APESB).

Input by professional bodies.

In turn professional accounting bodies also enforce expected professional standards and integrity from their members.

For instance, our largest accounting body, namely CPA Australia,  last year reported 94% of members met all professional standards and requirements or had minor non-compliance issues which were resolved before the review was finalised; and that 6 per cent of members reviewed showed a level on non-compliance where follow-up action was required. All such matters were resolved after follow-up action. These results were similar to the previous year.    

Advocacy & research- Governance Institute of Australia. 

The Institute champion’s ethics in business and for its members who may be employed as governance professionals or legal counsels in larger organizations. The institute provides consultative services pertaining to governance strategies and solutions aimed at not only ensuring a company conducts its affairs ethically, but also can evolve, grow and succeed by adopting enhanced risk management practices.

The institute engages with government on any proposed legislative and regulatory reform.  

 Financial Reporting Council.

The FRC appoints members to the Accounting Standards Board in Australia, and has listed its aims to reduce the cost of capital and ensure Australian entities can compete effectively overseas. Its principal thrust is to maintain investor confidence and to ensure accounts are clearly stated and easy to understand. Its annual report is presented to the Federal Treasurer.  

The ASIC Act however limits the FRC’s ability to act directly in relation to setting accounting standards which becomes the responsibility of the Australian Standards Board.

Rather the role of the FRC is to monitor Australian accounting, auditing and assurance standards to ensure their relevance to capital markets and reporting by the private and public sectors. 

Its principal role is to oversee auditing and assurance standards for world-wide use, whilst ensuring it continues to be best practice in Australia. However the technical know-how in achieving that aim is delegated to the standards Board.     

 

Accounting Standards Board in Australia.

Hence the actual drafting of accounting standards in Australia is governed by the Australian Accounting Standards Board.  The process involves continual review and commences with discussion papers for both internal and external consultative reviews with the various professional bodies. 

The Board has 11 members including the Chair. The Chair is appointed by the Minister for Superannuation and Corporate Law. Members, are appointed by the Financial Reporting Council (FRC).

According to its latest report accounting standards have increasingly become internationalised to ensure consistency in their presentation. Currently the International Financial Reporting Standards (IFRS) has been adopted in over 100 countries, including China, European Union, India, Korea and New Zealand.

 

As time goes by

Our Open Door Singers choir resumes this year to night.

Here is a list ( thanks to Bryan) of most of the songs from last year.  

Adiemus

Any dream will do.

Ascot opening day

As time goes by

A whole new world

Beauty and the beast

Black Bird - Beatles

Blue moon

Bridge over Troubled Waters

Bring him home

Californian Dreaming

Candlelight Carol

Carol of the Birds

Celebrations

Change the world

Chariots Comin'

Circle of Life

Coran Fields

Daisy Daisy

Don't bring me down

Do you hear the people sing

Empty chair and empty table

Feliz Navidad

Fragile by Sting

Fransicus’s Christmas carol

Freedom is coming

Gershwin - They can't take that away

Gershwin - Lets call the whole thing off

Gershwin - S' Wonderfull

Gershwin - Who's got the last laugh now

Get me to the church on time

Ghosts riders.

God rest ye merry gentlemen

Hey hey hey she's having a baby

Here comes that day

He Lives in You

Homeward bound

I could have danced all night

I Have a Dream

I'm Dreaming of home

I'm gonna wash that man

It's a long way to Tipperary

I't don't mean a thing

I've got the music in me

Lanterns

La La Land

Lean on me

Les Miserables - Suddenly

Les Miserables -One day more

Les Miserables - I dream a dream

Les Miserables -The end of the day

Les Miserables -Master of the house

Let's Dance

Life on Mars

Mamma mia

Memories.

Monday Monday

My castle in the sky

On a starlit night

Once a jolly vagabond

One day I'll fly away

On the street where you live

Oh Happy day

Only Time

Other Side of the World

Pack up your troubles

Peace on Earth

Penny Lane

Perhaps love

Rolling in the deep

Rhythm of life

Rudolph the red nosed reindeer

Santa Clause is coming to town

Sausi Carol

Scarborough fair

Shosholoza

Silent night

Singing in the rain

Simply having a wonderfull Christmas time

Somewhere over the rainbow

Someone in the crowd

Sophia

So this is Christmas

South of the border down Mexico way

Summer night

That’s what friends are for.

The Bell of creation

The big yello taxi

The end of the day

The impossible dream

The lion sleeps tonight

The Little Drummer Boy

The Mahogany ship

The man in the mirror

The prayer

The Sound of silence

The Sussex Carol

There's nothing like a dame

The Way You Make Me Feel

The way your hot

Up there Cazaly

Viva La Vida

Vos Sur Chenin

Walking In The Air

We'll meet again

Wind Beneath My Wings

What a wonderful world

Why we sing

You'll never Walk Alone

You made me love you

You Raised Me Up

You’re my everything

Waltzing Matilda

Waterloo

Wings

With a little bit of luck

Wonders of love

Wouldn't be loverly

That certain warm hearted feeling

Suffering from a perennial crook back I nevertheless had come to manage it reasonably well with a daily exercise plan and ensuring I kept reasonably fit.  So, when the request came to share in the joy and excitement to attend the inauguration of the new Church in Malawi, funded by the Malawi Support Group I belonged to, it seemed natural enough to accept their invitation. All was well until just few days prior I encountered a severe back attack which only worsened on the night before I was due to depart. Going to bed early with severe nerve pain signals shooting down my legs, which ignored strong pain killers, I tossed and turned in a state of extreme anxiety wondering how I could possibly now undertake such a journey.  

Somehow in in the early morning hours I must have finally dozed off only to be awakened with what felt like a sudden jolt so that all that was present in my mind was an unexplainable warm hearted feeling. It didn’t last for long as the alarm intruded onto what must have been only a few seconds. The back continued as a problem but remarkably thereafter everything turned out very well as the warm heart of Africa carried me along in its wake.    

After visiting all of the local communities and attending the opening of the new church I had intended meeting up with my wife for a holiday. Our plan was to rendezvous at Heathrow, hopefully at around the same time, but presuming Anne would have a few hours wait.    

Flying from Australia, my wife, on arrival at Heathrow was to encounter a series of kind acts. Firstly from a young man who helped her with her luggage on to the transfer bus to my terminal, to another who gave up his seat and then in unloading her luggage at my terminal where we were to meet up.

Concurrently on arriving from South Africa, I had to catch a driverless train (a bit unnerving) to collect my luggage from the pick-up terminal.   

As planned I had reached into my pocket to make the call to find Anne’s location when a jolt went through my head. I looked up and there she was walking towards me.  Having recently experienced the warm heart of Africa maybe there was need to be surprised.       

Walking in the shadows of the Fisherman

Just for the sake of clarity, can I introduce Jesus as a stranger, (since I’m not at all  keen on the idea of a personal saviour ) just as I imagine he came to those fishermen so long ago. Also it seems to me, for the most part, so he remained to a large degree, even to his disciples.

 

So I think we can say in essence Jesus (as opposed to the crucified Christ) is only known to us by way of a collection of his remarkable sayings and principally the loose narrative of his brief ministry.

 

But how can one not be drawn to his words. For me they resemble explosive bullets which shatter the conscious minds status quo and invite a new form of enquiry. So I might posit at the outset, from my perspective, the higher self gets a high dose of adrenaline to shape that ongoing creation of which we are a part. At least I would like to think about it like that as one ponders the relevance to day of those ancient thoughts.   

 

Many passages come to mind but none more so than the parable of the “Good Samaritan”, etched as it is into everyday language. One can imagine then the shock of the audience as Jesus attributed the noble act to the much hated Samaritans. That would have been extraordinarily radical, given the deep seated tribal animosity ingrained in society then. Even today, don’t you agree how easy it is for racial prejudice to bubble up in conversations of fear expressed by otherwise remarkably fine people.  And so it was with many of his sayings and parables.

     

For the scriptures (NT) talks of an extraordinary teacher, one who does not indulge in abstract ideas, or engage intellectually but rather is focussed at a practical level on the expansion of good works and compassion in preparedness for the long awaited messianic kingdom. One can’t help but notice this thematic, in his exhortation to show compassion, in forgiveness and in not being judgmental. Notice the judgemental aspect only creeps into the narrative due to its unmistakable eschatological roots. This is evident in the warning bells prior to a soon to arise messianic kingdom. This new world order is defined in the Sermon on the Mount.  

  

But I think one must acknowledge this eschaton was never possible as we understand the cosmos today. However this does not detract from the wisdom and practicality of his teachings. Nor does it preclude us from proclaiming “the Christ” as in his divinity in death, to add another vital link to our spiritual self. Nor does it lessen in any way his impact on humanity as the guiding light out of darkness we attribute to “the Christ”.  

In fact I believe the opposite is true. As a fully human Jesus, this complements the divine risen Christ as a cosmic force for the greater good and a telos for ongoing creation.

But the ideas of the second coming and all that entails as in judgements needs to be jettisoned in my view from mainstream thinking. Surely the idea that GOD needs to return or indeed such event occurred in the first instance can be jettisoned. Such an event seems entirely unnecessary with what is visible and known in the Universe and how the divine or greater good can co- exist independent of supernatural events.  Of course I am not ridiculing such concepts, only questioning why we need to believe such things, and posit that their origins in my view arise from mistranslations.              

Hence over time I feel one can anticipate the dismantling of such unnecessary rituals and so called statements of faith such as reciting the current Creed, with its reference to such things as the 3^rd day, right hand side, judgements and so forth. This idea of judgment, as I outlined previously (as a forewarning to the imminent messianic kingdom) has led, I believe, to many bad sermons.

 

So it is, that the Christ comes to us today as the lone stranger, executed with few around to lend any support, but continues on now for ever in divine cosmic memory as an extraordinary man. So I see that extension to the kingdom is now being realised and expressed as an extension in humanity’s higher self. So that his divinity, I posit, is after his death and not before. For my question is how could it be so essential that we must believe he was God on earth? One again I am not ridiculing those who do. But he talks about his Father and even at times his brothers and sisters. What I find puzzling is that we go to these extraordinary efforts to maintain credence to this idea, even though paradoxically in the first early Christian communities such diversity of views were common place.

 

So in summary I see room to relax dogmas with more emphasis on what you do. I think it means we can talk about Jesus, the extraordinary Man, who was not GOD on earth, but became the risen Christ. But a counter view to that is fine, so long as we don’t make that a prerequisite of calling oneself a Christian. I have deliberately refrained from mentioning the Trinity, but by now I think you would have gathered my views. The more we seek to complicate the wonderful legacy of Jesus the greater risk we have of failing to walk in his shoes as the great fisherman for humanity he remains.