November 27, 2023

How to invest in equity derivatives

Equity derivatives provide an opportunity to seek enhanced income returns from share investments, while managing risk and providing portfolio hedging

Equity derivatives can deliver enhanced returns

Equity derivatives can be used for many reasons, from enhancing income returns in an equity portfolio to risk reduction and portfolio hedging. This article provides information about several common strategies that can be used, as well as some ways to implement these strategies through both exchange traded options and tailored product solutions that are available to wholesale investors.

Equity options have two tools, call options, and put options. Investors typically look to sell options to generate income or buy options to reduce risk and hedge portfolios.

Yield enhancement

Two common strategies for enhancing the yield of a portfolio include selling covered calls and selling puts, commonly known as a short put strategy. When selling options investors aim to generate income to help enhance their portfolio yield.

Covered calls: Wholesale Investors who have an existing stock portfolio can look to sell call options to seek to improve the yield on their portfolio. By selling a call option, investors are committing to selling their current stock, usually at a level higher than or equal to the current market value for that security on a predetermined date. In return for that commitment, they receive a premium which is received in addition to the dividend yield that security may offer.

The trade-off for receiving the enhanced yield is that investors limit the upside from the security chosen. The upside is limited to the reference level they have chosen. Therefore, investors should choose a reference level they are comfortable selling their shares at. The closer the reference level is to the current market value, the higher the income received from the sold call.

Short puts: Wholesale investors who are interested in purchasing shares, usually equal to or below the current market value can choose to sell a put option, meaning they are committing to buying the chosen stock at a level of their choice on a predetermined maturity date. In return for that commitment, investors receive an income from the buyer of the put. Should the value of the stock not trade below the chosen reference level, the investor will not be required to buy the stock and keeps the income received from the sold put option.

Investors should choose a security that they are comfortable to own at the nominated reference level. If the stock falls below that level at maturity they will be required to buy the stock regardless of the lower prevailing market value, resulting in a capital loss. Investors can then choose to sell the security or hold the security and wait for its market value to improve, while receiving any dividends the stock offers during the holding period.

Combining these strategies: Investors may look to combine the two strategies by selling puts to buy the stock at a desired level. Once they have purchased the stock, they look to sell covered calls to sell the security at a desired level to seek an enhanced income on the same stock.  The risk for investors is that the underlying stock purchased declines in value, which would result in a capital loss if sold.

Hedging strategies

These strategies can be used to help reduce portfolio volatility and involve buying puts or call options. When buying options, investors need to pay a premium for the benefit of reducing risk.

Long put: Investors who want to reduce some of the downside risks in their portfolio can look to purchase a put option. This is commonly referred to as a long-put strategy and involves choosing a reference level where they wish to protect their stock against declines. Here, investors have the option to sell their stock at the nominated reference level regardless of what their share value does. They pay a premium for the benefit of reducing downside risk.

The reference level needs to match or be below the current share price and the closer it is to the current market value, the higher the cost of the put option. In other words, if the investor wants to cap their losses at 95% of the purchase price it will cost more than limiting the loss at 90% of the purchase price.

The outcome of this strategy is that if the value of the shares rise, the investor benefits from the rise of their share value. However, the cost of the put option will reduce the net profit.

Long call: This strategy involves an investor purchasing a call option by nominating a reference price they are prepared to buy the stock at. Should the value of the underlying stock increase, the buyer of the call option can purchase the stock at the reference level nominated and can then elect to sell the shares at the prevailing market value. They could also choose to continue to hold the shares after the maturity date if they believe that there is the possibility of future growth and dividend payment. Note that investors are not entitled to dividends during the period of the call option, only those that are paid after they have exercised the call and purchased the stock.

The cost of buying the call option is usually a fraction of the cost of owning the equivalent number of shares. The benefit of using a long call over owning the shares directly is that the maximum loss is the cost of the purchased call option, which means even if the share value declines heavily, losses are potentially reduced.

Conclusion 

Option strategies can offer benefits for investors who are prepared to study the intricacies of the products. Exchange traded options are available to both retail and wholesale clients through the nabtrade platform. However, this is limited to purchasing options and covered call strategies.

Investors who are interested in yield enhancement via NERTI need to be wholesale registered, for further reading on this investment approach click here.

 

Important Information

Intended for wholesale only

The information contained in this article is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, we recommend that you consider whether it is appropriate for your circumstances and that you seek independent legal, financial and taxation advice before acting on any of this information.

NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686. The nabtrade service (nabtrade) is the information, trading and settlement service provided by WealthHub Securities Limited ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities). WealthHub Securities is wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL No. 230686 (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer. WealthHub Securities is not an authorised deposit-taking institution, and its obligations do not represent deposits or liabilities of NAB. You may be exposed to investment risk, including loss of income and principal invested.

©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686. ©2023  WealthHub Securities Limited ABN 83 089 718 249 AFSL No. 230704

The information contained in this article is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. NAB does not guarantee the accuracy or reliability of any information in this article which is stated or provided by a third party. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article. You may be exposed to investment risk, including loss of income and principal invested.

You should consider the relevant Product Disclosure Statement (PDS), Information Memorandum (IM) or other disclosure document and Financial Services Guide (available on request) before deciding whether to acquire, or to continue to hold, any of our products.

All information in this article is intended to be accessed by the following persons ‘Wholesale Clients’ as defined by the Corporations Act. This article should not be construed as a recommendation to acquire or dispose of any investments.

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