Restricting the trade universe

Options trading books for beginners typically follow a fairly well-worn path. Firstly, a call and a put option is explained. Then volatility is discected and the Black-Scholes model is discussed. Which leads perhaps to put-call parity and the greeks. Theory over, some multi-legged trades are considered. These have exotic names like “Iron Condor” and “Butterfly”. Armed with a few payoff disgrams, you are now ready to take on the world!

All this is fine but, if you are gonig to win in the ASX options market you need to focus on the key factors for success. One of these factors is “restricting the trading universe”. By this I mean ruling out what NOT to trade.

Australian options market

In comparison with the US market, the Australian market is defined by a few key factors:

  1. Trading and liquidity is concentrated in a few stocks e.g. XJO (the S&P/ASX 200 Index), BHP, the banks and Telstra. In comparison in the US there are many liquid symbols spanning different industries.  In addition to stock options there are also options on funds, commodites, FX and futures.
  2. When you trade, your counterpart is likely to be a market-maker. For a bit of explanation, “market-markers” are authorised by the ASX to quote buy and sell prices for options. They are obligated to quote prices for various strikes and expiries for a minium amount of time during the day. There is a higher probability of trading against a real person when trading in the US.
  3. Commissions are higher in Australia than in the US.

My trading guidelines

I suggest the following guidelines (with the proviso that its OK to break them with a good reason).

  1. Focus on liquid underlyings (e.g the name above). Spreads are typically tighter, which gives a fighting chance.
  2. Focus on the closest expiries (e.g. the next 3)
  3. Be careful with trades with three or more legs (e.g. condors and butterflies) esp if not on the XJO.
What I trade
  1. I exclusively trade XJO options with a heavy focus on the next 2 expiries which tend to be the most liquid.
  2. I am equally happy to be a buyer and a writer.
  3. I trade several strategies including straddles, strangles and unbalanced butterflies in addition to buying / writing single options.

Happy trading

Ed

Options Trading: Use an adviser or go it alone?

This is a fundamental point. I’ll present the arguments for both cases.

Use an adviser

There are a few very good reasons for using an ASX-accredited advisor:

  1. Trade Selection. An advisor will typically contact his clients periodically with trade recommendations. The quality of these recommendations can of course vary, but an experienced advisor is likely to come up with much better ideas than an inexperienced beginner. From a learning perspective, this can give the client a few ideas to focus on.
  2. Execution. Advisors can assist with placing orders into the market, which can itself be a little complicated for new traders (particularly if a trade has multiple “legs” i.e. two or more options are being simultaneously traded). Advisors who know their stuff will be aware of the nuances involved in getting the best price. Advisors will require clear instructions from the client but from there they take responsibility for any errors.
  3. Monitoring. Advisers will monitor the trade and recommend the optimimum time to close it to book profits or manage losses. In addition they can advise the client on managing their trades around dividends or corporate actions.
There are of course a few disadvantages of using an advisor. The most obvious is cost. Keep in mind that brokerage on options is typically higher than for shares. Use of an advisor increases the cost further.

Go it alone

An alternative is to use an online broker. The primary advantage of using an online broker is cost savings.  These savings can ultimately lead to a better bottom line, enabling better market timing (cost effectively scaling and out of trades) as well better risk mangement by cost-effectively hedging using additional options trades or stock. Discount brokers can also potentially offer research, information and portfolio analytics (e.g. calculate the option “greeks” for a particular position).
Disadvantage is obvious. You’re on your own.

 

Observations on Bank Hybrids

Generally I am skeptical of hybrids, particularly the highly structured preference shares issued by financials (mainly the big 4 banks).

I would never participate in a new issue as the are typically overpriced and trade poorly in the secondary market. They are sold in general to in a fairly unsophisticated manner based on yield, despite being complex securities.

It's important to note that while they may look like a fixed interest product (the holder receives regular payments and if all goes well a return of capital at a specified future date) they are more akin to equity. In periods of market distress (now) fixed interest securities as a group generally rise while equity-like hybrids fall. This is possibly due to investors switching From the hybrids into ordinary equity to capture the higher yields on offer. This is quite a disadvantage as they are not providing any diversification benefit to a portfolio. To verify this for yourself, check out WBC vs WBCPE (hybrid) and WBCHB (bond).

WBC

WBCPE (hybrid)

WBCHB (bond)

All three securities have declined over the last 12 months. The bond has done best and importantly has exhibited the lowest volatility and greatest degree of capital stability.

Having said all this there are some opportunities from time to time.

ANZPA will mandatorily convert in Dec 16 at a 1% discount if not redeemed. Currently they are trading at a margin of about 3.9% to bills (i.e. based on a bill rate of 2.1% the yield to maturity is c.6.0% – note this will fluctuate as bills move). I like it under $99 and like it more under $98. I would reassess these levels if ANZ trades below c.$25. It is a very liquid issue having $1.7bn of securities outstanding.

If there is interest I will write about another opportunity. Let me know in the comments.

Good luck

Ed

 

A few thoughts on gold 6 April 2013

Introduction

If in 1900 you bought an ounce of gold for USD21, you would have made 75 times your money. That’s a return of 4% pa, or approximately the same as inflation over the same period (i.e. terrible). By comparison the All Ordinaries total return was approx 13.3%pa. This occurred despite the period containing many negative events – several wars, the great depression, the 2008 financial crisis etc.

My point is that gold, being absolutely the safest asset around (having thousands of years history of holding value) has a very low expected return in the absence of a severe economic crisis. However, if such a crisis occurs, it is invaluable (ask anyone who has lived through the many hyperinflations of the last 113 years).

The Economic Crisis of 2008 and the aftermath

A result of the economic crisis is that major too big to fail banks (i.e. the large US and European banks) are effectively insolvent and can only limp along with the benefit of actions taken by governments. The effect of ZIRP and QE is that asset prices are inflated which masks the impairment of the bank’s assets. While interest rates remain at near zero banks can gain a healthy profit borrowing at low levels and buying bonds which have continued to increase in price. The chart below shows the US 10 year bond yield. Lower yields = higher price.

bonds

The US federal reserve targets bond rates through QE. The purpose is to inflate bond prices, generating profits for banks and underpinning their ability to operate. In addition low interest rates supports price of risky assets (eg residential real estate and stocks) which makes people feel wealthier and more likely to spend. The chart below shows the S&P since 2008.

stocks

Clearly, its working. However, in the medium to long term the risk is that people question the value of the US dollar with all this money being printed. The key barometer of this risk is the price of gold. The chart below shows the price of gold since 2008.

gold

Put simply, its vital that public perception of gold be kept at low levels. If gold is exploding then it is a sign that the US dollar is failing. In that circumstances the bond market, and the stock market, will fall. The gig is up. So far, the government are doing a great job through a number of means, one being manipulation of information. I will post at a later time more comprehensively, but suffice to say that the mainstream media is relentlessly negative on gold. So much so was that in a recent seminar of high net worth US investors, all but one raised their hand when asked “is gold in a bubble?”.

Conclusion

Those interested the markets typically pay attention to stock prices. However I would argue bond prices and gold prices are of equal or greater importance. It is vital for the future of the economic system that gold prices do not rise at a parabolic rate nor do they rise in a way where there is excessive levels of public participation. Either occurance brings into question the value of the US dollar and the ability of the US to continue its low interest rate policy.

Tools I use

Just a brief post to outline some of the tools I use:

1. My charting software of choice is Amibroker (http://www.amibroker.com). Fantastic value, very easy to use and also quite customisable.

2. I use and recommend Premium Data (http://www.premiumdata.net) for end of day data for stocks, options, futures and FX. High quality data, delivered in a timely fashion. Customer service is very prompt.

3. For monitoring the market intraday I use Spark (http://www.iguana2.com.au/spark). It is more expensive than some competitors, but very customisable with good intra-day charting.

Weekend action 9-11 June: implications for Australian investors

Over the weekend a rescue was announced for Spanish banks. China also released data that was interpreted by the markets as broadly ambiguous (eg inflation data indicated that the economy may be cooling more than expected).

After the obligatory bounce reality set in. All key risk markets reversed eg the S&P (ES futures) moved from +1% to -1.5% on heavy volume with major US financials dropping 5-7% from open. Oil moved from +3% to -3%. EUR gave back all of its 180 pip rise and more. The S&P Volatility Index (VIX) closed at 23.56, +2.33 but not as high as a week ago.

Charts

Implications for Australian investors

Generally, the market has welcomed bailouts (with good reason – the punchbowl is being passed around so the party can continue). The extremely negative response to ‘good’ news is concerning. My opinion is that, ‘risk’ is going to underperform until there is some definitive progress made in Europe (read: massive coordinated intervention on a scale required to deal with the problems). It is also likely that the newsflow will be unsympathetic (eg I expect on other countries to demand assistance without austerity, which in the first instance is likely to be rejected).

I do believe that defensive, low beta equities (utilities, property trusts, and defensive industrials ) will continue to outperform as investors seek lower risk income and defensive characteristics in an environment of declining cash rates.

I also believe that gold priced in AUD is likely to outperform over the medium term (1-3 years). Currently markets are only holding together because of of a belief that the central banks will intervene if required (i.e. the Bernake Put). Action over this weekend strongly implies that words alone are not going to have the desired affect for too much longer and actions, on a significant scale, are required to stabilise markets. This is positive for gold.

Happy investing

Ed

PS Please read the site disclaimer.

ASX market comment 1 June 2012

May was a bad month on the ASX, with the market down 7.3% (worst month since May 2010 … May strikes again!). I’m sure many investors are keen to turn the page into June!

Yesterday the market put in a decent showing with the XJO down a measly 12 points (-0.3% to 4064). Hardly significant or meaningful. However what got me thinking was some comments I received that the market “felt” a lot worse than it actually was. So I decided to examine the performance of the most liquid stocks (average value traded per day of over $5m). There are 111 such stocks. I then looked at the performance of the 20 “riskiest” stocks (measured by beta) vs the 20 most “defensive” stocks. The results summarise in the chart below:

Fairly remarkable. On a day when the market was essentially flat, risky stocks returned -2.9%, while defensives were unchanged. (Outperfomers included TLS and the banks).

Reasons I can suggest for this:

  1. The macro environment is obviously poor (negative headlines everywhere, Chinese data at 11am was also perceived negatively).
  2. The equity market is pricing in further interest rate cuts. In this environment defensive stocks will outperform handily.

I would suggest defensive stocks could be accumulated on weakness. On my watch list are property trusts and utilities that pay quarterly or semi-annual distributions in the last week of June (most of them but not for example WDC). I will also be looking at liquid industrial stocks that pay dividends in August and early September (eg TLS, CCL, WOW, AMC, ANN). Its important that the stock should be very defensive … this excludes mining, mining services, energy, consumer discretionary and media stocks for example.

I won’t be rushing though – last night the S&P 500 was -2.5%, the worst performance in 7 months. So there’s probably time to get set …

Happy investing

Ed

PS Investing and trading involves risk. Please read the site disclaimer.

Friday, I’m in love with you

Relentless bad news

Right now, investors have to get used to a relentless torrent of bad news. One minute its weak Chinese data. The next its the possibility of the Greeks exiting the Euro. Or Spanish bond yields climbing over 6%. In the past few years we’ve really witnessed all kinds of trials … from tsunamis and volcanic ash clouds to debates over raising the US debt ceiling and talk over bailouts ….  The mood is definately subdued and financial press is continuously “glass half empty” (in Australia that is … watch US financial TV and you will find hopium is everywhere .. but that’s another story).

The Aussie market gets the wobbles

Most Aussie investors know that we take the lead from overseas – historically the US, but now also Europe and China. And for whatever reason, the worst news of all seems to be delivered over the weekend! So in a risk averse environment (now), Friday is often a dud day on the ASX as “the market” anticipates various weekend crises. Come Monday, the market can see a good “catch up” rally if the anticipated bad news doesn’t occur.

So I’ve turned my mind as how to profit from these situations using options. There are a couple of strategies. I’ll work through an example now.

Case study – BHP on Friday 18 May

On the Thursday 17th of May, the US market was weak, with the S&P 500 closing down 1.5%. Following this poor showing, and anticipating further carnage over the weekend, the ASX was down 2.7%. One of the worst stocks was BHP, which closed at $31.46 (- 4.0%).

The chart below shows BHP with the relevant data highligted. Click on the chart to open it in a new window.

The effect of this drop was that volatility increased significantly. The composite implied volatility for BHP rose from 30.3% to 36.5%. As can be seen from the chart below, volatility over 30% is relatively high (but certainly not unprecedented).

Suggested trade

In order to exploit this increase in implied volatility, one strategy is to sell a strangle. I chose to sell $35 call options and $26 put options for a combined credit of 54c per contract, excluding brokerage. Based on 50 contracts, this resulted in a credit of $2700 to my account, before brokerage and fees of $30. I required $17,000 available margin to do this strangle. The diagram below shows the payoff at expiry on 28 June 2012. More technically minded readers will note that the implied volatility for the put is 54% and for the call is 33%.

Summary of this trade

A credit of $2670 is received when initiating this trade. At expiry, the full credit is kept provided BHP remains within the range $26 to $35. So in essence when we initiate this trade we want two thing to happen:

  • Realised volatility to decline. Simplistically this means we want the stock to go “sideways”. Of course “sideways” is a relative thing … but as a rule of thumb if the stock ranged between $30.50 and $32.50 in the two weeks following the trade, that would be fine
  • Implied volatility to decline. If the market become less anxious, and the stock moves sideways or increases, implied volatility will usually decline. As an option seller this is good for us. Lower implied volatility means that the options will depreciate.

Trade mangement

This is not a “set and forget” trade. When we set out to do the trade, we had in mind a desire that the stock move sideways and implied volatility decline. If either of these things don’t happen we will have to take action. One thing we can do is buy back both the options and close the trade. One guide as to when to buy back the options is when either option doubles in value. So in this case we received 27c per option. A good guide is to consider corrective action when either option is over 54c.

Outcome

Its impossible to know what will happen to this trade, since it expires on 28 June 2012. However, one week later the results have been very good. Composite implied volatility has dropped from 36% to around 30%. BHP was relatively stable over the week, closing at $31.61 (+0.5%). As a result the spread has depreciated by about 60% to around 22c. We can book a profit of $1540 if we buy back the options. Or alternatively hold the position and hopefully accrue further gains.

Happy investing!

Ed

PS Option trades can involves losses. Please read the site disclaimer.

Excellent Opportunities in ETOs

Introduction

Current market conditions give great opportunities for options traders. Recent volatility, as well as the fear prevailing in the market means that volatility (historical, forecast and implied) is high relative to recent levels.

Today I’m looking at a calendar spread on BHP. This is a bearish play (aligned with my view on the market and BHP) with limited risk.

The trade

I’m looking at buying 100 $28 puts expiring on 26 July 2012 (76.5c) and selling the same number of puts expiring on 28 June 2012 (52.5c). Each option contract is over 100 shares in BHP. Total cost is $2,400 plus commission. My risk is limited to my initial investment so there should be no margin requirements. My expectation for placing this trade is that BHP will decline and trade around $28 during June. I’ll look to close the trade on or before expiry of the June option.

Profit potential

Below is a graph showing the estimated profit on 28 June 2011 (when the short option expires) for a range of BHP prices. Ive assumed $60 brokerage (the cheapest discount brokerage available). Click on the graph below to open in a new window.

Maximum profit is c.$9,000 is BHP is exactly $28 at expiry. The spread is profitable for BHP prices between $25.25 and $31.50. More technically minded reader might note there is a potential edge from buying the July option on a volatility of 41.1% and selling the June option on a volatility of 44.6%.

Advantages of this trade

  1. Limited risk of $2,460 with potential profit of up to $9,000.
  2. The spread is profitable over a wide range ($25.25 to $31.50). So even if I’m wrong on my opinion of BHP I still might do OK.
  3. BHP options are amongst the most liquid so I’m more likely to get fair prices when entering and exiting the trades.

Follow up

I’m going to treat this trade as a paper trade, and will conduct a post-trade analysis after it closes.

Ed

PS Please read the disclaimer before trading any action.

Postscript

On Monday 21 May following this post the spread was trading at c.21c. This will form the entry price for the purpose of tracking the trade and undertaking post-trade analysis.

ASX Macro View Week Ending 18 May

Since my last review in Feb, the S&P/ASX 200 (XJO) has slumped after attempting to break out to the upside though the 4400 level. For much of this period the market was in a slow grind, with little impulsive price action (positive or negative).

Since peaking at 4449 on 1 May, the XJO has sold off aggressively and is currently at 4047.  In the week ending 18 May, the market was down 5.6% in broad-based selling. Only the utilities sector escaped the carnage (+2.12%), however this was aided by the takeover offer for Hastings Diversified (HDF), up 12.8% for the week. Biggest loser among the largecaps was Toll Holdings (TOL) down 23.2%.

Why the drop?

The market has caught the nerves due to uncertainties in Europe (again). In addition, admission of over $2bn in trading losses by JP Morgan has not assisted confidence.

It should be noted that May and June are historically weak months, as 3 of the big 4 banks have gone ex-dividend and underperformers are typically aggressively sold as investors realise tax losses.

Where to from here?

I see weakness with an approximate target of c.3800 by 30 June. A lot obviously depends on the resolution (or lack thereof) to the European problems.

I think rallies will be short lived and could be viewed as selling or shorting opportunities.

Chart

Below is a weekly chart of the XJO since the market peaked in 2007. We are still in a secular bear market with the rally from the March 2009 lows essentially stalled and the market remaining approximately 40% off its all time highs in November 2011. Click on the chart to open it in a new window.

Ed

PS Please read the disclaimer before taking any action.