How And Why The Options Landscape Has Changed In Australia
OpenMarkets | Jun 08, 2017 12:27
Originally published by OpenMarkets
Although the Australian options market as we know it commenced operations in February 1976, options have been around for many hundreds of years. In fact, the tulip mania of the seventeenth century is an early example of options trading. At this time, tulips became a symbol of affluence across Europe and the resultant hype caused tulip prices to rise exponentially; some bulbs were selling for more than 10 times the annual income of a skilled craftsman!
As prices skyrocketed, the middlemen (dealers) set up a system by which producers could buy the rights to owning tulip bulbs in advance and secure a definite buying price. In other words, call options on tulip bulbs.
Speculative interest in tulip bulb options led people to buy those options with everything they owned – craftsmen hocked their tools, and ordinary folk sold their food stores, household goods, even their homes and businesses! Like all speculative bubbles, it eventually burst, and the frenzy turned from a buying to selling. The price of tulip bulbs plummeted and most speculators were wiped out as their options became worthless. The Dutch economy collapsed and people lost their money, businesses and homes.
Fortunately, our modern system is a little more regulated than that of seventeenth century Holland – however, options still have the power to bring individual investors, and even large corporations to their knees, if not handled with due care. On the flipside, managed well, options can add value to investor portfolios.
h2 From vanilla to exotic/h2Many brokers are accredited with a level one derivatives accreditation, which allows them to advise on and/or implement basic option positions. They can:
- Sell options to close out a position
- Buy and sell warrants
- Exercise warrants and options
- Write covered call options.
Effectively, these are non-margined options – in other words, there is no additional margining requirement throughout the life of the option. A set value is charged, paid for upfront.
OpenMarkets, like many brokers, has systems in place to ensure that all sold to open options positions are covered by stock owned by the client.
For example, a client wishes to implement a 'covered call' option on 1000 Commonwealth Bank Of Australia (AX:CBA) shares. Those CBA shares must first be paid for, settled, and on the clients’ HIN, and then lodged with ASX Clearing House (by the sponsoring broker) as 'collateral' before you can write the covered call. They must maintain a 1:1 relationship with the call options – i.e. there can only be 1000, or fewer call options, purchased.
The system automatically rejects a trade that is not covered by an owned security.
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In the case of the more exotic naked option (which requires level two derivatives accreditation), the seller of an option contract does not own any, or enough, of the underlying security to act as protection against adverse price movements. Using the example above, if the options holder did not own the CBA shares and the market moved against them, they’d be required to purchase and deliver to other party the shares regardless of price. If the investor had sold a naked call option on the CBA shares, it carries unlimited risk. While that might not seem too bad on 1,000 CBA shares, consider the impact of naked calls on more speculative stocks at larger parcel sizes.
While it’s possible to mathematically calculate the risk involved with a naked sold put, where the largest risk is the stock price falling to zero, there is no risk matrix or mathematical solution to measure risk for the naked sold call.
See ASX's website on buying options.
h2 The changing Australian landcsape/h2Anecdotal evidence suggests that options trading in Australia is on the wane; this is supported by the data presented in figure one, which shows that both the number of trades and the value of options traded has declined. The value of options traded peaked during the GFC, while the volume peaked in 2011, just post the GFC.
Figure one: Options trading 2005-2016
Source: IRESS Broker Data
Since that time, several brokers have dropped their level two options trading business over due to risk and collateral requirements; it seems the ASX move to the global standard CME SPAN Margining (SPAN) to calculate collateral requirements had quite the impact. It dramatically increased some collateral requirements, particularly for riskier options strategies, making them less attractive to brokers and other market participants.
h2 New margining requirements/h2A margin is an amount calculated by ASX Clear which is required to cover the risk of financial loss on an options contract due to an adverse market movement. Simple options strategies such as a covered call don’t require margining because the stock is lodged as collateral. At the other end of the scale how can a margin be calculated for a strategy with unlimited loss?
Australia’s margining system was changed in December 2012. SPAN is considered to be the industry standard for portfolio risk assessment and is the official margin mechanism for more than 50 registered exchanges, clearing organisations, and other agencies worldwide. According to the CME Group (NASDAQ:CME) website:
“SPAN evaluates overall portfolio risk by calculating the worst possible loss that a portfolio of derivative and physical instruments might reasonably incur over a specified time period (typically one trading day). This is done by computing the gains and losses the portfolio would incur under different market conditions.”
In other words, margining is based on worst case scenarios, which for many exotic options strategies, increased margining requirements – and reduced the attractiveness of offering these strategies for a number of participants.
h2 Not my business/h2It is understood Pershing has implemented plans to de-risk its business by reducing its trading in naked options. Pershing clears trades for a number of Australia’s brokers, so this may have ramifications for each of them.
Other players have also pulled back from the riskier end of the options market; in late 2015, Morgan Stanley (NYSE:MS) stopped dealing with naked and unhedged option positions. Major options market makers Tibra and Optiver exited the Australian derivatives market a few years ago, citing lack of profitability of their respective businesses. Market makers play an essential role in options trading; they ensure traders can price and trade options by always being available to buy or sell as required.
Last, but definitely not least, while the demise of BBY seems to have resulted from a perfect storm of calamitous factors, there are many that consider BBY’s options book was a significant contributing factor.
There are cynics in the market who wish to remain anonymous that suggest ASX raised derivatives and market making trading costs some years ago when ChiX started hitting their equities profits. Add together the increased cost of doing business and the risks associated with more exotic option strategies…it’s hardly surprising that it’s becoming a less attractive proposition for some businesses.
h2 A good option/h2My intent was not to paint a negative picture of options – on the contrary, correctly managed option strategies can be very useful for share investors, particularly those managing their retirement money via an SMSF. There are strategies such as covered call writing that can earn an investor additional income from a ‘lazy’ share portfolio, or buying puts to protect the value of a share portfolio in the event of a market downturn.
h2 Covered calls or buy-write strategies/h2In a covered call, an investor holds a long position in an asset and writes (sells) call options on that same asset, usually over an equivalent number of shares. Similarly, a buy-write strategy is where an investor simultaneously buys shares and writes a call option contract over an equivalent number of shares. Slightly different strategies, with the same outcome – the investor can earn additional income from pocketing an unexercised premium, plus the premium can balance out any drop in the value of the underlying shareholding.
See ASX's website on options trading strategies and how they are used.
h2 Hedging risk/h2Buying puts is sometimes referred to as a protective put strategy; it protects against losses from decline in the value of the underlying share, but importantly, allows for capital appreciation if the share increases in value.
In other words, if the share price rises, the investor benefits (less the cost of the put options), and if the share price falls, the put increases in value to offset losses.
h2 Conclusion/h2Although there appear to be a range of obstacles that make options trading a little more challenging in the current environment, the basic tenets that make options trading a valuable portfolio management tool remain in play. It may be harder to implement strategies using more exotic option strategies although, given the risks inherent therein these should remain the domain of the experts.
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