Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 426

The options to gain equity exposure with less risk

After 11 consecutive positive months to August 2021, Australian stock indices will probably fall in September. Although the market has recovered well during the pandemic, it's a reminder that equity investors must tolerate short-term volatility. 

On average, the Australian stockmarket falls about one year in every four or five years. It has delivered a 10% fall at some stage every couple of years since 1950, including three falls over 50%:

  • 1 November 2007 to 6 March 2009, down 55%
  • 4 March 1974 to 30 September 1974 down 52%
  • 21 September 1987 to 11 November 1987 down 50%.

The ASX200 index fell over 30% at the start of COVID in March 2020. Will such falls happen again? Certainly.

Retail fund managers that offer a range of funds with different risks must include a statement in their offer documents advising clients how often a fund is expected to deliver negative returns. For example, Colonial First State includes this table, where Australian and global equities are given a ‘Very high’ risk label, meaning they are expected to lose money in six or more years in every 20.

However, there are investments on Australian stockmarkets that substantially limit downside risk while leaving much of the upside. This article explores options and convertible notes issued by many Listed Investment Companies (LICs) and defines the maximum loss possible.

(Options over specific stocks are also discussed at the end).

1. Options on LICs

The table below shows the range of LIC options listed on the ASX (and full disclosure, I own some of these options, although that should not be considered a recommendation).

This article explains how they work and for further details, see also the accompanying article by Rodney Lay. We both use the same example for consistency and it is the largest option issue in the market (other than Magellan Global which is not a usual option exercisable at a fixed price).

Perpetual Investments manages an equity LIC (ASX:PIC). In June 2021, PIC issued options (ASX:PICOA) to buy a share in PIC at $1.35 exercisable on or before 2 September 2022. 

Here is where the market stands at the time of writing (20 September 2021):

  1. The latest Net Tangible Assets (NTA) of PIC as at 17 September 2021 is stated as before tax at $1.43 and after tax at $1.35.
  2. The option to buy PIC at $1.35 was trading at $0.013. Note that is not 13 cents but 1.3 cents. That is, you could buy (subject to liquidity) 1 million options for $13,000, 100,000 options for $1,300 or 10,000 for $130 if on a tight budget. Plus brokerage.
  3. PIC itself (the underlying shares) are trading at $1.30/$1.31.
  4. So this option is slightly in-the-money based on both pre-tax and post-tax NTA, it has 12 months to run, and it costs 1.3 cents.

The most an investor can lose is 1.3 cents on each option, plus brokerage. An option gives the right but not the obligation to buy. If PIC is trading at less than $1.35 in a year and the investor logically does not exercise the option, the loss cannot be more than 1.3 cents per option.

However, this is not an option over the value of the index such as the ASX200. It is an option over a specific LIC, and it can trade at a discount to the NTA. So even if the market rises, if the discount widens, the option may go out-of-the-money.

This article makes no judgement about Perpetual Investments, a traditional value manager with a long history. This article is explaining options, not recommending managers.

The features of the following table include (with the PIC example on the second line):

  1. How long the option lasts, the expiry date. For an investor, the longer the better (the more time value).
  2. The price at which the option can be exercised, in this case, buying a share in a LIC.
  3. The current share price at time of writing.
  4. The current price at which the option itself is trading.
  5. The volume of outstanding options. If many options are exercised at cheap prices, holders of the underlying shares are diluted. Rodney Lay explains this in more detail.

As other examples, investors can:

  • Pay 14 cents per option for the right to buy WCM Global Growth (ASX:WQG) at $1.50 until 31 August 2022, and it is currently trading at $1.61.
  • Pay 1.3 cents to buy WAM Active (ASX:WAA) at $1.10 and it is now trading at $1.06.

Check the ASX website for latest NTAs and ensure the concept of dilution is understood.

Listed Investment Company Options

* 7.5% Discount to NAV, not comparable as not fixed exercise price.

Options give wary investors some skin in the game without committing the full share price. In fact, as the table shows, options often cost less than 1% of the current share price, although the relationship with the exercise price is most important. For example, MFF Capital (ASX:MFF) has an exercise price of $2.60 but MFF is already trading at $2.93 so the option is more expensive at $0.32. Options do not earn dividends until exercised into shares.


Register here to receive the Firstlinks weekly newsletter for free

2. LIC Convertible Notes

Convertible notes are debt instruments which can be converted into shares under certain conditions. They are not common on the ASX but some have emerged. The advantage of these notes is that investors can treat them as fixed income bonds, and the share price gain is a bonus if it pays off.

For example, Flagship Investment (ASX:FSI) has issued a $20 million note (ASX:FSIGA) with the following terms. Again, I am not recommending either the note or the manager, just showing how it works:

  • Total offer size: $20 million
  • Offer price: $2.70 per note
  • Interest rate: 5.50% paid quarterly until Step Up date of 30 September 2024
  • After Step Up date if not redeemed, rate increases to 6.50%
  • 1 Convertible Note converts to 1 ordinary share
  • Maturity date of 1 October 2026 (5 years) if not converted or redeemed earlier
  • Loan-to-value (LTV) cap of 50%. Coupon steps up 2% and dividends cannot be paid on FSI if this level is breached.

The investor buys a note for $2.70 that ranks ahead of ordinary shareholders. The note pays 5.5% for the first three years with the right to convert each note into a share in FSI, which is currently trading at $2.45. The notes are unsecured debt of the issuer which has a current market value of about $60 million, although FSI could borrow up to 50% of the value of FSI.

Which means FSI could halve in value and noteholder should be covered, assuming no other problems with FSI. The terms above are a summary to illustrate the point.

Here is the range of listed notes available. The notes issued by NAOS are trading above their issue price so the yield on the notes has fallen.

Listed Investment Company Convertible Notes

* lists on 29/9/21, coupon steps up to 6.5% after 2024.

The current range of convertible notes is small as other issues have already matured so investors may need to wait for new issues (and Clime matures soon so it is probably not worth bothering with given its low liquidity). The three others listed in the table are recent issues and new opportunities do arrive.

3. Listed options on specific stocks

In addition, a wide range of options are traded across dozens of stocks with different strike prices and terms, mainly by professional traders, as previously explained in this article, while this article showed how to use options to protect downside. This professional pricing and trading of options using implied volatility is beyond the scope of this article.

 

Thanks to Rodney Lay of RRMetrics and Hayden Nicholson of Bell Potter for some of the data in this article, although errors remain my responsibility.

Graham Hand is Managing Editor of Firstlinks. The author owns some of the investments described in this article, but this is not a recommendation and investors must do their own research. As the Rodney Lay article shows in more detail, options have many characteristics and react to market conditions in different ways. This article is general information and does not consider the circumstances of any individual.

 

3 Comments
Allan
September 26, 2021

"[...] ...one of the old farmers told me never sell any shares in Wesfarmers. [...]" Someone has to sell some of them for others to be able to buy 'em, remembering that even Wesfarmers will openly sell shares in itself if and whenever it wants/needs to raise capital.

Graham Hand
September 24, 2021

I should also mention the Convertible Bond CVCG although the option value into CVC shares is so 'out of the money' that is has little or no value (exercise price $3.40, shares $2.20). It is now essentially a fixed rate bond, currently trading around 96 to 97 (wide spread, little liquidity).

From the 2018 Prospectus.

• Interest payment – Quarterly paying, floating rate with a margin of 3.75% over the 90-day BBSW;
• Maturity – 22 June 2023 (if not already redeemed or converted);
• Convertibility – convertible into Ordinary Shares upon notice at a fixed Conversion Price (subject to adjustment for certain dilutionary and other capital transactions). The Conversion Price is initially set at $3.40.
. Gearing ratio covenant of 40%.

Kevin
September 23, 2021

Thanks,can we have more articles on options, it is always useful to have increased knowledge on this subject.
When the state exchanges had lectures on Tuesday afternoons I tried to attend as many as I could.I don't know if they still have them.They had an options guy explaining options,I was in awe.I didn't take it all in but the examples he used,and the risks were amazing.I think that was probably mid 1990s.
On a different note, as time reduces risks, my Wesfarmers annual report arrived yesterday.I still like paper in my hand to read.A quick look at the chairman's message as company values etc are explained.Once in a while the growth is pointed out,I think the last time was the AGM in 2015 or16. $1000 had grown to a bit over $300K from 1984.
Now that $1K has grown to $669K,reinvesting all dividends ,compounding at 19% yearly.Sometimes you just have to think WOW.
I have heard the company called the Australian Berkshire Hathaway.Way back when ,2002 I think, one of the old farmers told me never sell any shares in Wesfarmers.I think he was the son or grandson of one of the original farmers that put in £1 in 1914 to start the farmers co-op.Wise words,I am glad I listened to him

 

Leave a Comment:

     

RELATED ARTICLES

8 ways LIC bonus options can benefit investors

Finding opportunities in listed global funds

The merits of investing in LICs at a discount

banner

Most viewed in recent weeks

Welcome to Firstlinks Edition 433 with weekend update

There’s this story about a group of US Air Force generals in World War II who try to figure out ways to protect fighter bombers (and their crew) by examining the location of bullet holes on returning planes. Mapping the location of these holes, the generals quickly come to the conclusion that the areas with the most holes should be prioritised for additional armour.

  • 11 November 2021

Why has Australia slipped down the global super ranks?

Australia appears to be slipping from the pantheon of global superstar pension systems, with a recent report placing us sixth. A review of an earlier report, which had Australia in bronze position, points to some reasons why, and what might need to happen to regain our former glory.

Welcome to Firstlinks Edition 431 with weekend update

House prices have risen at the fastest pace for 33 years, but what actually happened in 1988, and why is 2021 different? Here's a clue: the stockmarket crashed 50% between September and November 1987. Looking ahead, where did house prices head in the following years, 1989 to 1991?

  • 28 October 2021

How to help people with retirement spending decisions

Super funds will soon be required to offer retirement income strategies for members in decumulation. With uncertain returns, uncertain timelines, and different goals, it's possibly “the hardest, nastiest problem in finance".

Tips when taking large withdrawals from super

You want to take a lump sum from your super, but what's the best way? Should it come from you or your spouse, or the pension or accumulation account. There is a welcome flexibility to select the best outcome.

“Trust your instinct” Hamish Douglass in conversation with Sir Frank Lowy AC

Sir Frank shares his story, including his journey from war-torn Europe, identifying opportunities, key character traits necessary for business success, and the importance of remaining paranoid yet optimistic.

Latest Updates

Investment strategies

Charlie Munger and stock picks at the Sohn Conference

The Sohn Australia Conference brings together leading fund managers to chose their highest conviction stock in a 10-minute pitch. Here are their 2021 selections with Charlie Munger's wisdom as the star feature.

Interviews

John Woods on diversification using asset allocation

All fund managers now claim to take ESG factors into account, but a multi-asset ethical fund will look quite different from a mainstream fund. Faced with low fixed income returns, alternatives have a bigger role.

SMSF strategies

Don't believe the SMSF statistics on investment allocation

The ATO's data on SMSF asset allocation is as much as 27 months out-of-date and categories such as cash and global investments are reported incorrectly. We should question the motives of some who quote the numbers.

Investment strategies

Highlights of reader tips for young investors

In this second part on the reader responses with advice to younger people, we have selected a dozen highlights, but there are so many quality contributions that a full list of comments is also attached.

Investment strategies

Four climate themes offer investors the next big thing

Climate-related companies will experience exponential growth driven by consumer demand and government action. Investors who identify the right companies will benefit from four themes which will last decades.

Investment strategies

Inflation remains transitory due to strong long-term trends

There is momentum to stop calling inflation 'transitory' but this overlooks deep-seated trends. A longer-term view will see companies like ARB, Reece, Macquarie Telecom and CSL more valuable in a decade.

Infrastructure

Infrastructure and the road to recovery

Infrastructure assets experienced varying fortunes during the pandemic, from less travel at airports to strong activity in communications. On the road to recovery, what role does infrastructure play in a portfolio?

Economy

The three prices that everyone should worry about

Among the myriad of numbers that bombard us every day, three prices matter greatly to the world economy. Recent changes in these prices help to understand the potential for a global recovery and interest rates.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.