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Unformatted text preview: What is a Derivative? brochure 3/7/00 5:05 PM Page 3 What is a Derivative? What is a Derivative? brochure 3/7/00 5:05 PM Page 4 THE DERIVATIVES DIVISION OF AUSTRALIAN STOCK EXCHANGE (ASX) IS RESPONSIBLE FOR What is a Derivative? A derivative is a financial product. Its value is derived from (hence the name) the value of another financial product. Types of derivatives include options, warrants and futures. An example of a derivative is an exchange traded option over BHP shares. The price of the BHP option is derived from the price of BHP shares. CONDUCTING THE EQUITY DERIVATIVE MARKET OPERATED BY ASX. THIS BROCHURE PROVIDES SOME INITIAL INFORMATION ON THE TYPES OF DERIVATIVES TRADED Who uses Derivatives? ON ASX AND HOW YOU CAN FIND OUT MORE. Derivatives are traded by both professional and retail investors. For these investors, equity derivatives such as warrants and options offer the opportunity to earn extra income from their shares or to protect the value of their existing shareholdings. There are many applications available to investors depending on the level of risk they are willing to accept. Stock and index options are widely used by professional investors to hedge their share portfolios. Using index options means investors can gain a broader exposure to the market, rather than just single securities. Speculators also use options and warrants to take advantage of the leverage they can offer. Why use Derivatives? The basic rule of investing is that higher expected returns are linked to higher risks. Therefore, derivatives are used as a risk management tool. That is, derivatives can expose you to more or less risk depending on how you use them. Options and warrants can help increase your exposure to a particular security, such as a share, or they help you to protect your position from a price fall. How can you use Derivatives? ASX's markets offer a range of equity option and warrant products which can help protect the value of securities or provide extra income. To find out more about which types of derivatives may be suitable for your investment needs, you should talk to your ASX accredited derivatives adviser. The Derivatives Division of ASX also has a range of explanatory booklets and courses available. Refer to the website at asx.com.au/derivatives or call ASX during business hours on 1800 028 585 to find out more. By developing ASX's derivative markets under the one banner, the Derivatives Division of ASX is able to take ASX DERIVATIVES DIVISION advantage of complementary benefits and efficiencies in the areas of trading, clearing and OPTIONS WARRANTS settlement which have arisen between the STANDARD CALL AND PUT EQUITY CALL AND PUT various derivatives and equities markets. FLEX INSTALMENT Currently ASX has 2 generic derivatives SPOT ENDOWMENT product groups which are actively traded: LONG TERM CAPPED options and warrants. Within each of these LEPOS INDEX product groups there are several variations. INDEX OPTIONS CAPITAL PLUS The table shows the types of derivative INDEX LEPOS LOW EXERCISE PRICE products traded on ASX. CURRENCY What is a Derivative? brochure 3/7/00 5:05 PM Page 5 What is an Option? An option contract is between two parties, and it conveys the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) underlying securities at a predetermined price on, or before, a predetermined date. For example, an ABC September $7.50 call option gives the holder the right (but not the obligation) to buy 1000 ABC shares at $7.50 each, on or before the expiry date in September. Why use Options? Buying a call option contract allows you to benefit from a rise in the price of the underlying security without having to buy the security itself. If you already own the underlying security, the sale of options may allow you to earn extra income. Buying a put option allows you to protect the value of securities you own should the price decline. Exchange traded options and warrants are the most popular types of derivatives contracts available on ASX's market. There are a couple of variations in addition to standard option contracts: Flex Options Flexible or FLEX options are option contracts which have the exercise price, expiry month and underlying security determined by the party seeking to have the series of options opened for trading. Flex options are mainly used by large institutions. Long Term Options Long term option contracts have expiry dates between 12 months and 3 years from the date they are listed. They enable investors to take a longer term view on the underlying security. LEPOs Low Exercise Price Options (otherwise known as LEPOs) are option contracts with a low exercise price (usually 1 cent). LEPOs allow you to profit from movements in the price of the underlying security without paying the full amount of the option premium upfront. Index Options Index options allow you to gain exposure to a particular index. Buyers of call index options, for example, can nominate an index level (exercise level) at which they can notionally ‘buy’ the index. Profit at expiry is determined by whether the exercise level is lower or higher than the actual closing level of the index on expiry. Index call and put options are cash settled on exercise or expiry. The exercise level and premium is expressed in points. Index LEPOs Index LEPOs are European call options over an index with a one point exercise price. Each point of the index has a set dollar value. The option premium on a LEPO is not paid in full up front and index LEPOs are cash settled, thus investors gain futures style exposure to the market with one transaction. What is a Derivative? brochure 3/7/00 5:05 PM Page 6 Using Options to increase sharemarket returns One of the simplest and most commonly used strategies for earning extra income from an existing share holding is called covered call writing. This strategy can be used where investors already own the underlying shares and believe share prices will remain relatively steady. Selling call options over these shares offers the opportunity to earn income (called premium income) from the sale of options while providing a level of protection for the shares if the share price should fall. At the same time, the investor is contractually bound to sell the shares at the agreed price if the call option is exercised. Let's look at an example. Say it's now September and Joe owns 1,000 ABC shares which he purchased for $4.00 per share. While Joe believes the share price will rise in the longer term, he thinks the share price will remain relatively steady for the next three months. Joe decides to write a December $4.50 call option and receives the premium income of $0.16 per share (total of $160 as there are 1,000 shares in a contract). If the share price rises, Joe will be happy to sell the shares at $4.50, and he will have received the premium income of $160 (less any fees and brokerage) as additional income. Some other possible scenarios for Joe's position: 1. 2. 3. The share price remains steady at $4.00 until expiry of the call option, which is the last Thursday in December. In this case it is unlikely the call option will be exercised as the taker can buy the share for $4.00 on the market rather than exercise the call option and pay $4.50. If the call option is not exercised, Joe will have earned $160 of premium income (less any fees and brokerage) and will keep his shares. The share price falls to $3.73 at expiry. If the share price falls, it is again very unlikely the call option will be exercised and Joe again earns $160 premium income (less fees and brokerage) and keeps his shares as well. The share price rises to $4.60. At $4.60 per share, the call option will most likely be exercised and Joe will be obliged to sell the 1,000 ABC shares for $4.50. While the market price for the shares is $4.60, Joe has effectively sold his shares for $4.66 per share (i.e. $4.50 + $0.16) less fees and brokerage. Trading and Investment Warrants A warrant is a financial instrument issued by banks and other institutions and traded on the equities market of ASX. Warrants allow considerable flexibility to the third party issuer to structure the warrant to meet a particular need in the market. This flexibility has made warrants a very popular derivative product for some retail investors. There are many different types of warrants available. Warrants may be used for both trading and investment purposes. A brief description of some of these are listed below: Equity Call and Put Warrants An equity call warrant gives the warrant holder the right to buy the underlying security at a particular price on, or before, a particular date. An equity put warrant gives the warrant holder the right to sell the underlying security at a particular price on, or sometimes before, a particular date. Instalment Warrants These warrants give holders the right to buy the underlying shares or instrument by payment of several instalments (usually two or three) during the life of the warrant. Instalment warrants are often covered warrants with the underlying instrument being held in trust/custody for the benefit of the holder. A common feature of instalment warrants is that the holder is entitled to any dividends or distributions and possible franking credits paid by the underlying instrument during the life of the warrant. Some instalments also pass on voting entitlements of the underlying instrument. An interest component is usually part of the payments due. What is a Derivative? brochure 3/7/00 5:05 PM Page 1 Endowment Warrants Endowment warrants are long term warrants typically with a 10 year life. The buyer of an endowment warrant initially pays an amount to the issuer and then has the right to buy the underlying securities on a particular date in the future. The outstanding amount of the underlying securities is set at the beginning of the warrant and this price is increased by an interest amount and reduced over the life of the warrant by any dividends and sometimes franking credits, which may be paid by the underlying security. Low Exercise Price Warrants A low exercise price warrant is usually an equity call warrant with an exercise price that is very low relative to the market price of the underlying instrument at the time of issue (e.g. 1 cent). These warrants are usually european style exercise. The buyer of a low exercise price warrant effectively pays the full value of the underlying instrument at the outset. Index Warrants Index warrants are linked to the performance of a share price index such as the All Ordinaries (price) Index or a foreign index. The exercise level is expressed in index points. The warrants are generally cash settled on exercise or expiry. For more information on the different types of warrants which are available and how you can use them, please read the ASX Derivatives Division publication Understanding Trading & Investment Warrants. How are Options traded? Exchange traded options are traded on a computerised market called the Derivatives Trading Facility (DTF). This system links brokers from around Australia and allows them to participate directly in the options market. The trading process is quite simple. A broker receives an order from a client and enters it into the DTF. Orders entered into the Central Order Book for a particular option series are traded in price time priority. This means the first order entered into the DTF at a particular price will be the first to trade, then the second and so on. This process is similar to the way the sharemarket trading system, SEATS, operates. If the order does not trade, it will remain in the DTF for the rest of the day or until it trades or is modified or removed by the broker. All orders lapse at the end of each day. Market makers provide buy and sell orders in certain series of options. However, if there are no orders in the system and the client still wishes to trade, the broker is able to request a price quote from a Market Maker who deals in that options class. How are Warrants traded? Warrants are traded on ASX's share trading system (known as SEATS) and settled on ASX's share settlement system (known as CHESS). The SEATS system allows interested investors to see what prices and quantities are available in the market before deciding to trade. The issuer of a particular warrant will usually ensure there is a buy and a sell order in the market to allow investors to get into and out of a position. Warrants have a 3 day settlement period which is the same as for transactions in the ASX's sharemarket. How to follow Option and Warrant prices Options and warrant trading information is published each day in The Australian Financial Review and The Australian newspapers. Prices and codes are available from our website asx.com.au/derivatives. Want to know more? The Derivatives Division of ASX provides a range of explanatory booklets on various products and also runs courses at introductory and more advanced levels. Copies of all booklets are available from our website at asx.com.au/derivatives, or for information call the Derivatives Division of ASX on 1800 028 585 or email us on [email protected] ...
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