Louise Bedford says: “This week on our Trading Mentor Program, Chris Tate and I have asked Evan McQuire from https://www.mfam.com.au/ to be our guest, as we’re looking at options. They’re fascinating little beasts. I like them so much I wrote a book on them! Evan has been our friend for years, and he’s our ‘go to’ bloke when it comes to making money from option trading. I know you’re going to love what he has to say here…”
One of the most profitable businesses in the world is insurance companies. In fact, Warren Buffet himself moved into the insurance business after he closed all his textiles businesses. His insurance business GEICO has been the foundation of his investments, which has now grown into a personal net worth of over $87 billion.
Starting an insurance business is obviously not something that just anybody can do. However, did you know that you can become an insurance seller for stocks on the stock market using exchange traded options? The barriers to entry are low, the premiums are high and there are a range of options for you to earn an income by selling insurance. One great example of this is options over the ASX200.
Towards the end of 2017, the ASX introduced Exchange Traded Options (ETO’s) for the SPDR S&P ASX 200 (STW) Exchange Traded Fund (ETF). This is great news for investors looking to earn extra income from their STW holding.
New investors that wish to earn an income by selling options may find ETO’s over ETF’s rather than single stock have lower risk, since it allows better diversification than single stock.
Before we run through a couple of examples, let’s look at the main features of options and the Street tracks SPDR ASX 200 ETF.
What is an Exchange Traded Option (ETO)?
An Exchange Traded Option is a derivative instrument that is traded on the Australian Options Market which is part of the ASX. There are two types of options available to traders and investors.
A call option gives the buyer (or taker) the right to buy an underlying stock at a specific price (strike price) by a specific date (expiry).
A put option gives the buyer (or taker) the right to sell an underlying stock at a specific price (strike price) by a specific date (expiry).
An investor or trader can also do the reverse where a seller (or writer) of a call option has the right to sell the underlying stock at a specific price by a specific date (expiry) and the seller (or writer) of a put option has the right to buy the underlying at a specific price by a specific date (expiry).
It is important to know that 1 options contract = 100 of the underlying and STW options are European style options (not American) so your position can not be exercised or assigned before the expiry date of the options contract.
To generate a monthly income, we are acting as the seller, not the buyer of options.
What is an Exchange Traded Fund (ETF)?
An Exchange Traded Fund is an investment fund that is traded on a stock exchange. There are many different types of ETF’s but the SPDR ASX 200 ETF (STW) looks to closely match (before fees and expenses) the performance of the S&P ASX 200. An investor that owns STW basically has exposure to the top 200 stocks without having to purchase each security to gain exposure to the index. Investors that own STW will experience the ups and downs of the overall market and will also be entitled to distributions that are paid quarterly.
Let’s look at a couple of examples of options trades that can be used on STW
Example 1 – Selling calls (also known as the covered call) on STW.
You own 1000 STW and the price of the ETF has risen quite nicely over the past few weeks. However, you also believe that the price of STW may not move much higher and perhaps the price may fall so you decide that now is a good time to sell a call option on your holding of STW. Currently STW options have expiry months of June, September, January and March.
STW is trading at $56.88 and you sell 10 STW June $57.00 calls for 75 cents. This means that you have received 75 cents x 1000 units, or $750 in premium.
Let’s look at a couple of possible outcomes from example 1
If your prediction about STW was correct, and the ETF is trading below the strike price of $57.00 when the option expires, you have kept the premium of 75 cents and you still own 1000 STW. The premium you received you get to keep as income.
If STW is trading above the strike price of $57.00 at expiry, your options position would have been exercised and your 1000 STW have been sold at $57.00. You have kept the 75 cents in premium you received so you have sold 1000 STW for $57.75.
Example 2 – Selling puts (also known as writing options naked) on STW.
You would like to buy STW but believe you can do so at a lower price. By selling puts to acquire STW you are comfortable to buy the ETF at the strike price of the options you have sold and receive premium as well. Again, STW options have expiry months of June, September, January and March.
STW is trading at $56.88 and you sell 10 STW June $56.50 puts for 45 cents. This means that you have received 45 cents x 1000 = $450
(Note: selling call or put options naked will result in margins that will be applied by the ASX until the position is closed)
Selling puts is the same as selling an insurance contract for the underlying asset, STW. For a more thorough explanation of put options, read about how you can become an insurance seller on the stock market with put options.
Let’s look at a couple of possible outcomes from example 2
If STW is trading below the strike price of $56.50 at expiry, your options position would have been assigned and you have bought 1000 STW at $56.50. You have kept the 45 cents in premium you received so you have bought 1000 STW at $56.05.
If STW is trading above the strike price of $56.50 at expiry you have kept the 45 cents in premium you received. The option expires worthless and you keep the premium as income.
The above strategies provide a brief insight into trading options on STW and there are many other ways to trade options for income or hedging purposes. If you would like to learn more about how our years of experience can help you with generating an income using options please contact Evan McQuire at MF and Co. Asset Management.
*Above examples do not take into consideration brokerage and exchange fees
GENERAL ADVICE WARNING
This is general advice only. MF & Co Asset Management has not considered your personal financial needs, objectives or current situation. This information is not an offer, solicitation, or a recommendation for any financial product unless expressly stated. You should seek professional investment advice before making any investment decision.