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
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
MARKET OPERATED BY
ASX. THIS BROCHURE
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
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
settlement which have arisen between the
STANDARD CALL AND PUT
EQUITY CALL AND PUT
various derivatives and equities markets.
Currently ASX has 2 generic derivatives
product groups which are actively traded:
options and warrants. Within each of these
product groups there are several variations.
The table shows the types of derivative
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
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
Some other possible scenarios for Joe's position:
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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