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

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

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.