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

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

 

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.

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.