UnderstandingLEPOs

UnderstandingLEPOs - LEPOs Low Exercise Price Options...

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Unformatted text preview: LEPOs Low Exercise Price Options Explanatory Booklet TERMINOLOGY CHANGES OLD TERM Options Clearing House Pty Ltd OCH ASXF Pty Ltd ASX Futures Exchange ASXF Exchange ASX Business Rules SCH Business Rules OCH Business Rules OCH Derivatives Clearing Rules OCH Clearing Rules ASXF Exchange Business Rules ASXF Business Rules Broker ASX PO Participating Organisation RIOT Non-Broker Participant (NBP) Limited Purpose NBP NSSP Non sponsoring settlement participant Security Securities Shares Derivative DTF or Derivatives Trading Facility Clearing Participant Only (currently derivatives only) Third Party Clearer Non-CHESS Approved Security Foreign Portal Dealer Participating ASX Security Participating Foreign Security Participating Foreign Exchange NEW TERM Australian Clearing House Pty Ltd ACH ASX ASX Market Rules ASTC Settlement Rules ACH Clearing Rules ASX Market Rules FSR ASX has changed its business framework for trading, clearing and settlement. As a result there have been changes to the terminology used in this document. ASX Market Participant or Market Participant (may also be a ACH Clearing Participant and/or ASTC Settlement Participant) Market Participant / Trading Participant (may also be a ACH Clearing Participant and/or ASTC Settlement Participant) ASX Market Participant or Market Participant (Trading Participant only for selected products) and Market Maker General Settlement Participant Specialist Settlement Participant Account Participant Financial Product (except for overseas products) Financial Product DTP or Derivatives Trading Platform Direct Clearing Participant General Clearing Participant Non-CS Approved Product Overseas Portal Dealer Participating ASX Traded Product Participating International Financial Product Participating Overseas Exchange For further details of the Financial Services Reform terminology changes, please visit www.asx.com.au/fsr.htm. LEPOs key features Name Description LEPO Low Exercise Price Option. A LEPO is like a forward purchase of shares for the buyer and a forward sale of shares for the seller. Note that the buyer of a LEPO does not obtain voting rights or dividends until the shares are acquired on exercise. Relatively high premium A low exercise price Relatively low outlay Ongoing margins are payable. A complete list is available on our website www.asx.com.au/optionsecurities 1,000 shares per contract, subject to usual adjustment for rights, bonus issues and other capital adjustment events. Spot (1month forward) plus quarterly expiries of which next 3 traded at any time. Maximum maturity is usually 9 months, although some classes of LEPOs have other maturities of up to 1 year. Leverage Cash efficient No risk of early exercise Physical delivery of shares on exercise Good proxy for share trading Ease of account opening Availability of offsets on some margins Ability to lodge non-cash collateral. Experienced investors who understand and accept the risks associated with leverage and derivatives. Leverage Margin payments. Characteristics Underlying shares Contact size Expiry cycles Benefits Suitable for Risks This material contains information only. ASX does not represent or warrant that it is complete or accurate. The information is for education purposes only and any advice should be sought from a professional adviser. If you are seeking advice (including a recommendation or opinion) about a financial product you should consult an Australian financial service licensee. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) suffered by anyone acting or refraining from acting as a result of this material is accepted by ASX. Copyright ASX Operations Pty Limited ABN 42 004 523 782. ("ASXO") 2000. All rights reserved. This publication should not be reproduced, stored in a retrieval system or transmitted in any form, whether in whole or in part, without the prior written consent of ASXO. Edition 6 printed June 2003. Contents Introduction What is a LEPO? Why trade LEPOs? Leverage Cash efficient Good proxy for share trading Physical delivery of shares No risk of early exercise Ease of account opening Offsets on margins for other options positions held Ability to lodge non-cash collateral against margin Which shares have LEPOs? Investing in a LEPO Examples Example 1 Comparison of a purchase of 1,000 NCP shares with the purchase of NCP LEPO Example 2 Comparison of a short sale of 1,000 NCP shares with the sale of NCP LEPO Getting Started Documentation Margins Collateral for risk margins Shares Bank guarantee Austraclear pledged securities Warrants Encumbered securities Offsets While the LEPO position is open How to track the value of your LEPO 8 9 9 9 10 10 10 10 10 10 10 11 11 7 5 5 6 5 2 3 4 4 4 5 5 5 5 Costs Margins Adjustment to the number of underlying shares Dividends and voting Closing out Exercise and settlement Differences between LEPOs and standard exchange traded options Risk profile Margining Contract specifications Index LEPOs What are Index LEPOs? Contract Value and Ticket Size Premium Exercise and cash Settlement Example 3 Exercise Margin Obligations Example 4 Cash for Risk Margin Using Securities as Collateral Example 5 Collateral for Risk Margin Offsetting Risk Margin Closing out the Index LEPO Example 6 Closing Out Risks Contract Specifications Glossary of terms Further Information ASX Contact Details 13 13 13 14 15 15 16 16 16 16 17 17 18 18 18 18 18 18 19 20 21 Back Cover ASX Infoline 1800 028 585 11 11 11 11 11 12 1 Introduction LEPOs are Low Exercise Price Options. This booklet outlines their main characteristics and the key factors that make them a useful addition to a well balanced investment portfolio. Information in this booklet is designed for people who want an overview of how LEPOs work. Information and booklets on other equity derivative products can be obtained from ASX. Details are listed at the back of this booklet, or you can down load them from the ASX website, at www.asx.com.au/ optionsbooklets ASX Infoline 1800 028 585 LEPOs are a more sophisticated style of option which may suit investors with broader risk profiles. This is because LEPOs involve the use of margins. If you are familiar with the booklet Understanding Option Trading, you will notice that this booklet builds on several of the concepts introduced in that publication. Before trading LEPOs we recommend that you discuss them with a sharebroker who is authorised to give advice on equities and equity derivatives. As with any financial instrument there is a degree of jargon that needs to be understood. Any new term will be defined as it is encountered but to assist in your understanding you may wish to refer to the Glossary of Terms. 2 The LEPO market has gained in popularity since its introduction in April 1995. The chart below demonstrates the number of contracts traded each quarter since inception. LEPO Volume 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 Q295 Q395 Q495 Q196 Q296 Q396 Q496 Q198 Q298 Q398 Q498 Q199 Q299 Q399 Q499 Q200 Q300 Q400 Q100 Q201 Q301 Q401 Q202 Q302 Q19 Q29 Q39 Q49 Q402 Q103 Q101 Q102 What is a LEPO? LEPO stands for Low Exercise Price Option. A LEPO is by definition a European call option with a 1 cent strike price. A LEPO is like a forward purchase of shares for the buyer and a forward sale of shares for the seller. As delivery and payment are deferred the LEPO investor is required to pay margins to take into consideration any change in price over time. Selling a LEPO When you sell a LEPO you commit to sell: an agreed number of shares to the buyer at a specified future date in return for receipt of the premium and exercise price. As with other options, the seller of a LEPO is only required to deliver the underlying shares if the buyer exercises the option. There are several things that LEPOs are not. They are not the same as buying or selling shares. Although the exposure with LEPOs is similar to owning the shares, you don't receive dividends directly. The value of the dividend is factored into the LEPO price. This is advantageous for investors who are unable to use franking credits. The key differences between standard exchange traded options (ETOs) and LEPOs are summarised for you in the section Differences between LEPOs and standard exchange traded options. LEPOs over the same underlying share are termed classes of LEPOs. For example all LEPOs listed over BHP Billiton Limited (BHP) shares, regardless of expiry date, form one class of LEPO. Buying a LEPO LEPOs are options to buy shares. When you buy a LEPO you obtain the right to buy: an agreed number of shares (1 contract usually equals 1,000 shares) at a specified future date in return for the payment of a premium and exercise price. ASX Infoline 1800 028 585 3 1 contract usually refers to 1,000 shares The main difference between a LEPO and a standard exchange traded option is that with a LEPO you don't pay the full amount of the premium upfront. Rather, with a LEPO you pay a margin during the life of the LEPO and pay the balance of the premium if and when you exercise your LEPO. The exercise price is usually 1 cent per share or $10 per contract. As with other options, you do not have to exercise your right to buy the shares. Because a LEPO is so deep in the money, purchasing a LEPO gives similar exposure to a stock purchase. The advantage of a LEPO over a stock purchase is that you only pay a margin upfront rather than the full stock value. It is important to note that the buyer of a LEPO is not obliged to exercise the option. The LEPO trader can elect to close out at any time prior to expiry by simply selling the same series as initially purchased, or buying the same series as initially sold. You pay an initial margin upfront and you pay daily margins during the life of the LEPO Why trade LEPOs? LEPOs can offer the experienced investor: the benefits of leverage a cash efficient method of trading no risk of early exercise physical delivery of shares on exercise a good proxy for share trading ease of account opening the availability of offsets on margins the ability to lodge non-cash collateral. Cash efficient LEPOs are cash efficient because of their leverage. Investors have a lower cash outlay for the same level of exposure to the market than with a direct investment in shares. Using a LEPO can be a cost-effective alternative to borrowing to fund a purchase of shares. If you were to borrow to buy LEPOs, various fees and charges may be payable if security is given to the lender. These benefits are outlined for you in greater detail below. ASX Infoline 1800 028 585 4 LEPOs provide a great way to leverage your share market position Leverage LEPOs provide a great way to LEverage your share-market POsition. LEPOs offer the benefits of leverage. For experienced investors, they provide a means of trading according to the investor's views about short-term movements in the underlying share price. LEPOs are leveraged because the investor only outlays a margin to a small proportion of the total share value. Movements in the share price lead to gains or losses on the LEPO which are only crystallised when the position is closed out or exercised. Because each LEPO corresponds to 1,000 shares, a 10 cent movement in the share price translates to a $100 movement in the LEPO profit or loss. Leverage has the effect of increasing both the profit potential and the risk profile of an investor's portfolio. Investors in LEPOs have a lower cash outlay for the same level of exposure to the market than with a direct investment in shares Good proxy for share trading Movements in LEPO premiums closely match movements in the underlying shares. This makes LEPOs a good substitute for share trading as the price of LEPOs is adjusted for dividends. Refer to the section Investing in a LEPO Examples for examples comparing share and LEPO values. Ease of account opening Account opening procedures are straightforward and do not involve lodgement of a large sum of money for investors. Access to the LEPO market is readily available. If you already have an exchange traded option account, you can use it for LEPOs as well, provided you complete the necessary documentation (see your broker). Physical delivery of shares When LEPOs are exercised, settlement is by physical delivery of shares rather than cash settlement. This provides an advantage where an investor wishes to acquire or dispose of shares. Natural links with CHESS mean that payment and delivery of shares following the exercise of a LEPO is as simple as a normal share transaction. Offsets on margins for other option positions held Investors can reduce their initial outlay to the extent that they have offsetting positions for options, whether the offsetting positions are in LEPOs or in ETOs. Only risk margins can be offset, mark to market margins cannot be offset. For an explanation of risk margins and mark to market margins see the section Margins in Getting started in this booklet. No risk of early exercise LEPOs provide a good complement to a share portfolio or a standard exchange traded options portfolio. Being European options, that is, only exercisable at expiry, they do not carry the risk of exercise before expiry. This can be helpful for traders who wish to lock in a sold position without the risk of early exercise. For example, holders of underlying shares may believe that the share value is likely to fall. By selling LEPOs they can make a profit if that view is correct, and can elect to close out the LEPO position at any time before expiry. With an American option, which is exercisable at any time prior to expiry, once the buyer exercises the option, it is too late for the seller to close out the position. Ability to lodge non-cash collateral against margin Investors can lodge a variety of securities with OCH instead of cash to satisfy their risk margin obligations. Details of acceptable securities are listed in the section on Collateral. A current list of eligible collateral can be found at www.asx.com.au/options/eligiblecollateral. Mark to market margins are payable in cash only, in order to permit refunds to investors during the life of the LEPO. ASX Infoline 1800 028 585 5 LEPOs are European style exercise. That is, you can only exercise at expiry Which shares have LEPOs? A complete list is available from the ASX website www.asx.com.au/optionsecurities Investing in a LEPO - examples NCP Share Price v NCP LEPO Price The chat below compares the actual prices of NCP shares and the May 2003 NCP LEPO premium between January and May 2003. The examples that follow compare trading shares with buying and selling LEPOS. In Example 1 the share and LEPO premium rise over the period, in Example 2 they fall. Note: The examples in this booklet are based on historical information and should not be relied upon as a representation as to the future performance of either the companies concerned, or LEPOs over shares in those companies. 13.00 12.50 12.00 11.50 11.00 10.50 10.00 9.50 9.00 NCP May LEPO NCP shares ASX Infoline 1800 028 585 6 17Jan03 7Feb03 14Feb03 28Feb03 7Mar03 7Apr03 17Apr03 24Apr03 2May03 9May03 16May03 14Mar03 28Mar03 3Jan03 10Jan03 31Jan03 31Jan03 21Feb03 21Mar03 11Apr03 Example 1 Comparison of a purchase of 1,000 NCP shares with the purchase of May 2003 NCP LEPO. Example 1 compares the purchase of 1,000 NCP shares and the purchase of 1 LEPO when the market rises as expected. Investing in the Date BUYING 1,000 SHARES Purchase price = $10.65 Buy 1,000 NCP @ $10.65 $10,650 shares would have returned $798 or around 7%, while investing in the LEPO would have returned $820 or around 85%. The lower initial outlay results in leveraged returns on the LEPO. Transaction costs such as brokerage are also likely to be lower on the LEPO trade. BUYING A LEPO Premium = $10,740 per contract or $10.74 per share 11 April 17 April Risk margin (@ 9% of $10,650) Total initial outlay LEPO price $10.97 Risk margin (@9%) = $980 ($980 $958) Mark to market margin ($10,740 $10,970) Daily settlement ($230 $22) LEPO price $11.41 Risk margin (@9%) = $1,019 ($1,019 $980) Mark to market margin ($11,410 $10,970) Daily settlement ($440 $39) $958 (pay) $958 (pay) Share price @ $10.89 $22 $230 $208 (pay) (return) (receive) ASX Infoline 1800 028 585 24 April Share price @ $11.32 $39 $440 $401 (pay) (return) (return) 7 2 May Share price @ $11.12 LEPO price $11.18 Risk margin (@9%) = $1,001 ($1,001 $1,019) $18 Mark to market margin ($11,180 $11,410) $230 Daily settlement ($230 $18) $212 LEPO price $11.24 Risk margin (@9%) = $1,008 ($1,008 $1,001) $7 Mark to market margin ($11,240 $11,180) $60 Daily settlement ($60 $7) $53 $11,520 Sell LEPO @ $11.56 Risk margin reversed Mark to market reversed ($11,240 $10,740) LEPO gross profit ($11,560 $10,740) Daily settlement ($1008 $500 + $820) LEPO value less LEPO value No cost of funding Total profit $820 (return) (pay) (pay) 9 May Share price @ $11.20 (pay) (return) (return) 16 May Sell shares @ $11.52 $1008 $500 $820 $1,328 $11,560 $10,740 (return) (pay) (return) (return) Total profit $870 Cost of funding Adjusted profit $72 $798 Notes and assumptions: 1. Based on actual share prices for NCP in the period April to May 2003. 2. Does not include dividends or imputation credits which would improve share trader's position. 3. Does not include any interest earnt on the risk margin which would improve LEPO trader's position slightly. 4. Risk margin assumed in this example is 9% of the current share price. This represents the largest likely daily movement in the value of the underlying share. For more information refer to the booklet "Understanding Margin Obligations". 5. "Pay " means the amount the investor pays. "Return" means the amount the investor receives. 6. Margins are payable/refundable daily. The examples depict weekly margins for brevity. 7. "Cost of Funding" refers to the interest cost associated with borrowing the purchase price of the shares. No cost of funding is shown for LEPOs, since any interest earnt would substantially offset any interest on a borrowing to fund the LEPO transaction. Interest rate: 7% pa. 8. Cash used for initial margin. 9. LEPO price for the day doesn't change after the trade is executed. 10. Brokerage costs are not included in the example. Example 2 Comparison of a short sale of 1,000 NCP shares with the sale of May 2003 NCP LEPO. Example 2 compares the short sale of 1,000 NCP shares and the sale of 1 LEPO when the market falls as expected. Short selling the Date SHORT SELLING 1,000 SHARES Sale price = $10.99 Sell 1,000 NCP @ $10.99 $10,990 shares returned $756 or about 7% on the amount invested while the sale of the LEPO returned $790 or about 80%. Once again the low initial outlay on the LEPO results in leveraged returns. Transaction costs are also likely to be lower on the LEPO trade. SELLING A LEPO Premium = $11,140 per contract or $11.14 per share 7 Feb 14 Feb ASX Infoline 1800 028 585 Risk margin (@ 9% of $10,990) Total initial payment LEPO price $10.90 Risk margin (@9%) = $967 ($967 $989) Mark to market margin ($10,900 $11,140) Daily settlement ($22 + $240) LEPO price $10.82 Risk margin (@9%) = $958 ($958 $967) Mark to market margin ($10,820 $10,900) Daily settlement ($9 + $80) $989 (pay) $989 (pay) Share price @ $10.75 $22 $240 $262 (return) (return) (return) 8 21 Feb Share price @ $10.65 $9 $80 $89 (return) (return) (return) 28 Feb Buy shares @ $10.19 $10,190 Buy LEPO @ $10.35 Risk margin reversed Mark to market reversed ($10,820 $11,140) LEPO gross profit ($10,350 $11,140) Daily settlement ($958 $320 + $790) LEPO value 7 Feb less LEPO value 28 Feb No cost of funding Total profit $958 $320 $790 $1,428 $11,140 $10,350 (return) (pay) (return) (return) Total profit $800 Cost of funding Adjusted profit $44 $756 $790 Notes and assumptions: As for previous example, except dates used are February 2003. Getting started Documentation Starting to trade LEPOs is easy. Once you have decided that LEPOs are suitable you simply need to: sign a client agreement with your broker to act as your broker for LEPO transactions sign a Risk Disclosure Declaration obtained through your broker make arrangements with your broker to lodge cash or collateral to cover your risk margin obligations. Margins The margining process for all options including LEPOs, is quite sophisticated. A full outline of the margining process is given in the ASX publication Understanding Margin Obligations, which can be downloaded from the ASX website, at www.asx.com.au/margins In this section a simplified outline of the margining requirements for LEPOs is given. The Total Margin payable by both the buyer and seller of the LEPO comprises two parts, the risk margin (otherwise known as initial margin) and the mark to market margin. An outline of each appears in the table. ASX Infoline 1800 028 585 9 TOTAL MARGIN = RISK MARGIN + MARK TO MARKET MARGIN Risk Margin Description This is levied against both the buyer and the seller of the LEPO and is calculated as a percentage of the value of the underlying shares. Mark to Market Margin As the value of the LEPO moves, a mark to market margin is levied against the party whose position is in loss (debit margin) in favour of the other party whose position is gaining (credit margin). Allow investors to profit from favourable movements in the value of the LEPO, and require them to make incremental payments of any losses. Changes with the market value of the LEPO. For every 10 cent rise in the value of one LEPO contract, the seller of the LEPO is required to pay $100*. Conversely the buyer will receive a $100 credit. Cash only. Why are they required? They are held by OCH and act as a security bond to ensure that an investor's obligations to the market are met. OCH sets the percentage level for the risk margin based on past performance of the underlying share price. This percentage level is maintained as the value of the underlying share changes. Cash or any of the other collateral accepted by OCH for standard ETOs. OCH pays interest on risk margins that are covered with cash. Risk margins may be offset with margins from ordinary ETOs. Risk margins are payable the day after the LEPO position is opened and are maintained for the life of the LEPO. How are they determined? How can they be paid? Payments of interest Offsets Offsets are not applicable to mark to market margins. Mark to market margins are only charged when the value of the LEPO changes. They are payable the day after the value changes. When are they paid? * assumes contract size is normally 1,000 shares. Collateral for risk margins Instead of paying the risk margin in cash, investors may lodge other collateral. This section outlines the types of collateral which are currently accepted. This can change. For an updated list of acceptable collateral, consult your broker or www.asx.com.au/options/eligiblecollateral Offsets The risk margin payable for a LEPO can be reduced if the LEPO buyer or seller has offsetting LEPO or standard exchange traded option positions. OCH will only calculate the net risk margin. For example, if an investor sells a BHP LEPO and has purchased a BHP call, the risk margin payable will be reduced. The following table shows how offsets apply to exchange traded option (ETO) and LEPO positions in the same class. LEPO Position Bought Bought Bought Sold Sold Sold Offset applies where Investor has sold a call ETO Investor has purchased a put ETO Investor has sold a LEPO Investor has purchased a call ETO Investor has sold a put ETO Investor has purchased a LEPO Shares Shares are usually valued at 70% of current market value for collateral purposes. The shares which currently are acceptable include shares of the companies over which exchange traded options are available. Included in these are all shares which currently have LEPOs. Bank guarantee A number of banks are approved by OCH for bank guarantees. Collateral cover will be given up to the full face value of any guarantee lodged. Austraclear pledged securities ASX Infoline 1800 028 585 The following securities are currently acceptable: Bank Negotiable Certificates of Deposit Bank Transferable Certificates of Deposit Non-bank Promissory Notes or Certificates of Deposit Bank Bills of Exchange Non-bank Bills of Exchange. The margin required reflects the net position of all the investor's options and LEPOs. The above table details the impact for some simple combinations only. OCH calls and refunds margins directly from your Clearing participant. The Clearing participant is responsible for calling margins from you and may require you to pay margins above those which it must pay OCH. 10 Warrants Some Instalment Warrants have been approved as acceptable collateral. Instalments are usually valued at 60% of current market value for collateral purposes. Encumbered Securities Under certain circumstances encumbered securities may be used to cover the LEPO risk margin. Consult your broker or ASX for more information. Collateral cover will be allowed to the extent of the mark to market value of the security. OCH may give less than 100% cover in certain circumstances. OCH accepts cash and other forms of collateral to cover the risk margin While the LEPO position is open Once you are trading LEPOs there are a number of factors to be aware of: you need to know how to track the value of your LEPO positions you will need to understand the costs of LEPO trading you will be required to pay margins and you may be eligible to receive refunds of margin in some circumstances, there will be an adjustment to the number of underlying shares. Adjustment to the number of underlying shares If there is a rights issue, bonus issue, reconstruction or other event, the number of underlying shares that the LEPO refers to may change. Adjustments are generally the same as for standard exchange traded options. More information about adjustments can be found at www.asx.com.au/options/contract adjustments Dividends and voting The buyer of a LEPO does not receive dividends on the underlying shares until the shares are transferred after exercise. Nor does the buyer obtain any voting rights in relation to the shares until that time. How to track the value of your LEPO Current LEPO prices are available from your broker. Details of the previous day's trading are published daily in The Australian and The Australian Financial Review and on the internet at www.asx.com.au/options ASX Infoline 1800 028 585 Closing out The LEPO trader can elect to close out at any time prior to expiry, by simply selling the same series as initially purchased, or buying the same series as initially sold. In each case the total profit (or loss) (before allowing for costs) will be the difference between the premium of the LEPO in the initial transaction and the premium of the LEPO in the closing transaction. Margins will be reversed and any surplus (or deficit) will be credited (or debited) back to the investor the day after close out. 11 Costs One LEPO contract usually represents 1,000 shares, but the investor only outlays a small margin as compared to the value of the shares. Brokerage is payable at a flat rate or based on the full premium. For more information contact your stockbroker. Margins As mentioned earlier, throughout the life of the LEPO, margins may be payable by both the buyer and the seller. Refer to the section on Margins in Getting Started in this booklet for an overview of margins. Exercise and settlement LEPOs are a European style option contract and so can only be exercised on the last trading day of the LEPO before they expire. Exercise is not automatic, unless arrangements have been made with your broker for automatic exercise. Exercising a LEPO is a simple procedure. Trade Date Day 2 If you are the buyer of a LEPO, you notify your broker that you wish to take delivery of the underlying shares. The broker delivers an exercise notice to OCH no later than 7pm or such other time as OCH determines (check with your broker before expiry) on the last trading day before they expire. This generates an automatic SEATS transaction for the transfer of the underlying shares with the Trade Date as the effective date. You, the buyer of the LEPO, must pay the balance of the premium to your broker. You are refunded the amount of any excess margin payments. Settlement is via CHESS with T + 3 settlement. Shares are delivered on Day 3. ASX Infoline 1800 028 585 Day 3 12 The LEPO should be either exercised or closed out prior to expiry. The seller of the LEPO must deliver the specified number of underlying shares if assigned an exercised LEPO contract. Brokerage may be payable on the securities transaction. Differences between LEPOs and standard exchange traded options LEPOs are different from standard ETOs because LEPOs: are only available as call options are European style options, meaning they are exercisable on the last trading day before they expire, while standard ETO's are American style options exercisable at any time before expiry have a very low exercise price and a much higher premium close to the initial value of the underlying shares the subject of the LEPO have only one exercise price per expiry month, unlike other options which offer a range of exercise prices do not require an amount equal to the full premium to be paid on purchase. Instead the buyer pays a margin which represents a small percentage of the value of the underlying shares involve ongoing margin payments from both seller and buyer of the option. Margining Refer to the section Margins in Getting Started in this booklet for an explanation of margins on LEPOs. The margining system is different for LEPOs than for normal exchange traded options. Normally the buyer of an option pays an amount equal to the full premium at the time the option is purchased and the seller can either use cash or acceptable forms of collateral to meet their margin obligations. LEPOs are quite different. Both the buyer and the seller of a LEPO pay margins and non-cash collateral can be used to cover only part of these margins. ASX Infoline 1800 028 585 13 LEPO risk profile Risk profile The ASX booklet Understanding Options Trading explains how the risk profile of the buyer and seller of a standard option are different, with the buyer having a limited downside and the seller having a potentially unlimited loss position (unless they own the shares or an offsetting option position). In the case of LEPOs, the buyer has a higher risk profile than they would with a standard exchange traded option because the premium is larger. However the risk is still limited to the full amount of the LEPO premium. The seller of the LEPO has the same potentially unlimited loss position as the seller of a standard exchange traded call option. Contract Specifications Name Underlying shares Security code LEPO Low Exercise Price Option. A complete list is available on our website www.asx.com.au/optionsecurities The first three characters will be the ASX code, eg. BHP, the fourth character the expiry month eg. K=May, and the fifth character will always be numeric. 1,000 shares per contract, subject to usual adjustments for rights, bonus issues and other capital adjustment events. 1 cent. European, ie. exercisable only on the last trading before expiry day. 1 cent per share. Call option only. Same expiry months as options stock class. Thursday preceding the last Friday of the settlement month or, if the Thursday falls on a public holiday, the last business day before expiry day. The Thursday before the last Friday in the expiry month unless OCH determines another day. 10.00am to 12.30pm; 2.00pm to 4.15pm; late trading 4.15pm to 5.00pm and overseas trading in accordance with the ASX Business Rules. Physical delivery of the underlying shares. Contract size ASX Infoline 1800 028 585 Tick size Exercise style Exercise price Type Contract months Last trading day 14 Expiry day Trading hours Settlement Index LEPOs An Index is based on the prices of the shares of major listed companies, weighted according to market capitalisation. Index LEPOs give forward style exposure to the sharemarket. They allow investors to execute investment and risk management strategies at a low cost. For cost-effective exposure to the broad market, Index LEPOs provide many opportunities for the smart investor. added leverage improve cash management by using a fraction of the cost of share trading to gain exposure to the broad market. hedging control market risk, help protect your share portfolio from an expected decline in the broad market. lower transaction costs obtain broad sharemarket exposure with lower transaction costs then a direct investment in shares. affordability tailor exposure to your requirements. At a value of $10 per point Index LEPOs can be tailored to the requirements of smaller investors and institutions alike. efficiency minimise risk margin by offsetting against other exchange traded index option positions. Any net credit premium margin can be used to offset the risk margin for Index LEPOs. convenience listing on ASX provides: access via the wide network of ASX brokers also providing sharemarket and option and warrant services. capability to conveniently utilise securities for margin collateral using ASX's CHESS system. trading convenience by using the same, proven and internationally accepted Derivatives Trading Facility on which stock options are traded. To fully capitalise on the opportunities, it is important to have a sound understanding of the concepts and risks involved. Index LEPOs are likely to suit experienced investors who understand and accept the risks associated with leverage and derivatives. The principles of buying and selling share LEPOs also apply to index LEPOs. What are Index LEPOs? An Index LEPO is a European call option over an Index with a 1 point strike price. Buyers of Index LEPOs notionally buy the underlying Index on the expiry date. Sellers of Index LEPOs commit to notionally selling the index on the expiry date. For buyers, profit at expiry depends on whether the level of the underlying Index on the expiry date (less the 1 point strike price) is greater than the premium1. For sellers, profit depends on whether the level of the underlying Index on the expiry date (less the 1 point strike price) is less than the premium2. ASX Infoline 1800 028 585 15 1 The amount of the profit will also depend on transaction costs, including exchange fees and broker commission. 2 Again, the amount of the profit will also depend on transaction costs. Contract value and tick size Index LEPOs are quoted in whole numbers of points. Each point of the index has a value of $10. This means that the minimum price fluctuation, or tick size, is $10. Investors should note that the value of an Index LEPO may depend on a number of factors and not just the level of the index. The Index LEPO price may not move completely in line with movements in the underlying Index. not based on the closing index level. As the stocks in the index open, the first traded price of each stock is recorded. Once all stocks in the index have opened, an index calculation is made using these opening prices. This process is called the Opening Price Index Calculation (OPIC). Shortly afterwards the OPIC is confirmed to the Exchange and the Clearing House and announced to the market. This method of calculating the index level for settling index LEPOs is used by several major exchanges internationally. It is regarded as an effective way to manage potential volatility around the expiry of index options and futures contracts. Index LEPOs cannot be exercised before the expiry date. Investors should note that if they do not exercise the Index LEPO, or do not trade out of their position before the expiry date, they will lose their premium without receiving any amount from the seller. Example 3 Exercise Let's say a buyer purchases a March Index LEPO with a premium of 3344. To simplify the example, it does not include exchange fees, broker commission, or the effect of margins. Assume that the OPIC on the expiry date is 3360. This means that the Settlement Amount will be $33,590 ($10 x (3360 points index 1 point strike)). So the buyer will receive a net amount calculated as follows: Example 3 Premium Settlement Amount Profit (3344 points x $10) (3359 points x $10) $33,440 $33,590 Premium ASX Infoline 1800 028 585 As with all options, the buyer of an Index LEPO has an obligation to pay the premium, whether or not the buyer exercises. However, because the full premium amount is effectively deferred until expiry, and because the exercise price is very low (1 point), an Index LEPO has an economic effect similar to a forward purchase of the index for the buyer and a forward sale of the index for the seller. Unlike standard options, the buyer of an Index LEPO does not effectively pay the full amount of the premium up front. This is because the margining system for LEPOs allows the value of the premium to be offset by the mark to market value of the LEPO. When the Index LEPO is exercised, the buyer effectively pays the balance of the premium. Please refer to Example 3 to see how exercise works. 16 Exercise and cash settlement Because investors cannot actually buy or sell an Index directly, Index LEPOs are cash settled on exercise. The Index LEPO settlement price is based on the opening price of each stock in the underlying index on the morning of the expiry date. It is (15 points x $10) $150 Unlike standard options, the buyer of an Index LEPO does not effectively pay the full amount of the premium up front Margin Obligations Because LEPOs are forward style products, both buyers and sellers must pay risk margin and any mark to market margin during the life of the LEPO. This makes them different from standard options (including Index Options), where only sellers are required to pay margins. Buyers and sellers of Index LEPOs should note that they must use cash to make any mark to market margin payment. This is because OCH pays cash for any mark to market margin refunds. Example 4 shows how margins work for Index LEPOs. To simplify the example, it does not take account of exchange fees or broker commission. The example also assumes that the Index LEPO price does not change between execution of the trade and close of trading on that day. Example 4 Index LEPO cash flow using cash for margin On 15 December an investor buys one March Index LEPO. The LEPO is trading at 3344, so the contract price is $33,440 (3344 x $10). The Index is at 3320. ASX Infoline 1800 028 585 Example 4 Date Price3 Risk Margin Net Mark to Market Margin Nil Daily Cash Flow4 17 15 Dec LEPO 3344 Index 3320 LEPO 3341 Index 3316 $996.00 (@ 3% of $33,200) $994.80 (@ 3% of $33160) Net $1.20 (return) ($996.00 $994.80) $996.30 (@ 3% of $33,210) Net $1.50 (pay) ($994.80 $996.30) $996.00 (pay) 16 Dec $30 (pay) ($33,410 $33,440) $28.80 (pay) 17 Dec LEPO 3346 Index 3321 $50 (return) ($33,460 $33,410) $48.50 (return) Buyers and sellers of Index LEPOs should note that they must use cash to make any mark to market margin payment 3 Closing price on relevant date. 4 "Pay" means the amount the investor pays. "Return" means the amount the investor receives. Using Securities as Collateral One of the benefits of trading Index LEPOs is that investors can use existing securities portfolios to cover risk margin. OCH will allow up to 70% of the value of securities lodged with it to cover risk margins. A current list of eligible collateral can be found on the ASX website at www.asx.com.au/options/eligiblecollateral For more detail on collateral, please refer to the ASX publication, Understanding Margin Obligations or speak to your Level Two Accredited Derivatives Adviser. ASX Infoline 1800 028 585 Closing out the Index LEPO Investors who wish to realise a profit early, or realise a loss, can "close out" their position. A buyer of an Index LEPO would close it out by selling an Index LEPO on the same terms. Conversely, a seller would buy an Index LEPO. Example 6 Closing out an Index LEPO Take the investor in Example 4. Assume that on 15 March the Index is at 3320 and the March index is at 3323. The buyer wants to realise their loss by closing out the contract. Ignoring fees and commissions, the buyer has made a loss of 21 points (3323-3344). In cash terms, the investor's loss is $210 (21x$10). 18 Example 5 shows how the investor in Example 4 could lodge equities as collateral and reduce cash outlay. Example 5 Index LEPO cash flows using collateral to cover risk margin Assume that the buyer in Example 4 has equities lodged with OCH. Assume also that, throughout the period shown in the example, the equities have a market value of at least $2,000. The buyer can use approximately 70% of the market value ($1,400) to cover risk margin. Because the highest risk margin for this period is $996.30, the investor is fully covered for risk margin. Risks An Index LEPO has a different risk profile from a standard option over the Index. As the exercise price of LEPO is only 1 point, buyers cannot limit their risk to a smaller premium value, as is possible with standard options which are not so deep in the money. LEPOs will also respond to the passage of time and changes in market volatility in a different way from options which are not deep in the money. Unlike ordinary options, the buyer of an Index LEPO is liable to daily margin calls throughout the life of the Index LEPO. As with ordinary call options, the seller has a potentially unlimited loss position. Index LEPOs are likely to suit a sophisticated investor who fully understands the risks associated with a leveraged product. You should consult with a Level Two Accredited Derivatives Adviser before trading Index LEPOs. Offsetting Risk Margin Investors in Index LEPOs can reduce the amount of risk margin by offsetting them against other exchange traded option positions. Any net credit premium margin can be used to offset the risk margin for Index LEPOs. Contract Specifications Name Underlying Index Contract size Tick Size Exercise style Type Contract Months Expiry Day Last Trading Day Settlement Settlement Day Trading Hours Index LEPO Low Exercise Price Option. 5 A complete list is available on our website www.asx.com.au/ optionsecurities $10 times the underlying Index. Quoted as the number of points of the underlying Index. The minimum fluctuation is 1.0 index point. European ie. exercisable only on the last trading day. Call options only. Calendar quarters. The third Friday of the contract month, providing this is a trading day. The trading day prior to the expiry date. Index LEPOs are cash settled using the opening price index calculation (OPIC) on expiry day. The second business day following the last Trading Day. 6:00am to 5:00pm and 5:30pm to 8:00pm (Sydney time). ASX Infoline 1800 028 585 19 5 ASX may change the contract specifications. Glossary of terms Adjustments are made when certain events occur that may affect the value of the underlying securities. Examples of adjustments include changing the number of shares per contract and/or the exercise price of options in the event of a new issue or a reorganisation of capital by the issuer of the underlying securities. American refers to an option that is exercisable at any time prior to expiry. Brokerage a fee or commission payable to a sharebroker for buying or selling on your behalf. ASX Infoline 1800 028 585 LEPO an acronym for Low Exercise Price Option. Leverage because a single LEPO contract corresponds to 1,000 shares, movements in share price are multiplied or "leveraged" by a factor of 1,000 when calculating changes to the LEPO's value. Margins amounts of collateral required to be lodged with OCH from time to time to secure the obligations of each party to the LEPO contract. Mark to market the daily revaluation of positions to current market values from the previous day's closing price. Mark to market margins must always be cash settled. OCH an acronym for Options Clearing House, the clearing house for most derivative transactions conducted on ASX. Offsets a reduction in margin requirements as a result of holding positions in LEPOs or options of the same class. Option a contract which confers on the buyer the right but not the obligation to buy or sell a security or other asset. Physical delivery settlement results in the transfer of ownership of shares. Can be contrasted with cash settlement in which a payment is made instead of a transfer occurring. Premium the price of an option contract. This is the price as agreed between the buyer and seller. Put an option which gives the right to sell the underlying shares. Risk margin an amount representing the largest most likely daily move in the value of an option or LEPO based on an historical study and current market conditions. Short selling the practice of agreeing to sell shares without owning the shares at the time the sale contract is entered into. Call an option that gives the right to buy the underlying shares. CHESS an acronym for Clearing House Electronic Sub-Register System. Close out a transaction in which a party liquidates a position by entering into the opposite position, eg. the buyer of a LEPO closes out by selling a LEPO of the same class and expiry date. Collateral security used to meet margin obligations. Can be cash, shares or other securities. Derivative a financial agreement where the value of the rights of the parties is derived from, or varies according to, the value of another asset or the level of a rate or index and where at least one party could be required to provide cash or other consideration during or at the termination of the contract. ETO an acronym for exchange traded option. European refers to an option that is only exercisable at expiry. Exercise price the price at which the underlying shares may be bought or sold on the exercise of the option. In the case of LEPO's the exercise price is a nominal amount. Expiry date the date on which all unexercised options in a particular series expire. 20 Further information For ASX explanatory booklets on options, phone 1800 028 585 or download the booklets from the ASX website www.asx.com.au/ optionsbooklets Explanatory booklets on warrants and futures are also available. Options trading workshop The workshop is highly practical with a hands on approach. A comprehensive set of course notes is included. On completion of the workshop you will understand how to: generate income from your shares protect your shares from falls make money without owning shares look at trades in term of risk and return use professional pricing models that you can access free take into account the tax implications of trading. Courses Getting started in options the essentials of options investing is a practical 3 hour course where audience participation is encouraged, with an interactive question and answer format. No prior knowledge of ASX's Options Market is necessary. However it is assumed that those attending have a working knowledge of the sharemarket. The course is designed to provide participants with a practical knowledge of how to formulate and analyse different trading strategies and the different risk management techniques. The course is also available in Distance Education format. Earn extra income using options the essentials of option writing On completion of this course you will: understand how to profit in flat markets using a variety of premium selling strategies know when to use strategies ranging from covered calls to ratio spreads, and more importantly when not to learn how to calculate returns, what stocks to look for and how to manage your positions once they are established. Profiting from market movements the art of straddles, strangles and spreads On completion of the course you will: understand how to exploit moves in both the market averages and individual stocks learn when to straddle the market, when to spread and when not to learn how to effectively manage your positions once established and more. Online and Self-Learning Courses You may prefer to complete these courses in your own time at a pace that suits you. Some options courses are available online, and include interactive exercises that will aid your learning and a quiz at the end of each section to show your progress. Self-learning kits are also available for the courses. ASX Infoline 1800 028 585 21 Website www.asx.com.au/courses Email options@asx.com.au Phone 1800 028 585 Post ASX Investor Education, Level 7, 20 Bridge Street, Sydney NSW 2000 ASX infoline: 1800 028 858 Website: www.asx.com.au/lepos ...
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This note was uploaded on 08/30/2009 for the course FINM 3405 taught by Professor Philipgray during the Three '09 term at Queensland.

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