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Derivatives Market Hong Kong Exchanges and Clearing Ltd. Aug 2001

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  1. Derivatives MarketHong Kong Exchanges and Clearing Ltd.Aug 2001 Applications of Stock Futures and Options(SFO)

  2. SFO Seminar • Briefing • SFO Concept • Advantages of Trading SFO • How to Apply SFO to Attain Investment Objectives? • Feasible SFO Strategies • Features of Exchange Traded SFO Contracts • Risks and Points to Note in SFO Trades • Q &A • Appendix-Available SFO in HKEx

  3. Briefing • Stock futures contracts have been trading since Mar 1995. • Stock options contracts have been trading since Sept 1995. • SFO development: • Aug 6, 2001 • stock options trading is migrated from the Traded OPtions System (TOPS) to HKATS( i.e.trading on the same electronic platform with stock futures and other derivatives) • Aug 27, 2001 • contract multiplier for stock futures reduces to the board lot size of the underlying stock • more SFO contracts available for trading in HKEx

  4. SFO Concept(1) Stock Options An agreement gives the buyer the right to buy or sell an underlying instrument Specifying: on or before a future date (expiry date), at an exercise price (strike), to buy (call) or sell (put) a specific amount of shares Stock Futures A legally binding agreement to buy or sell an underlying instrument Specifying: on a future date (expiry date), at a contract price, to buy (long) or sell (short) a specific amount of shares

  5. SFO Concept(2) • Stock Options • The buyer buys: • a call option with the right to purchase stocks • a put option with the right to sell stocks • The seller sells: • a call option with the obligation to sell the stocks when being exercised • a put option with the obligation to purchase the stocks when being exercised Stock Futures The buyer: • buys (long position) stock futures The seller: • sells (short position) stock futures

  6. SFO Concept(3) • Stock Options • buyer pays a premium to buy the option • seller receives the premium and is required to deposit a margin at the same time • On or before the expiry: • buyer can sell or exercise the option, or let it expire worthless • seller can buy the option to close out position, or fulfill contract requirements if the option sold is exercised Stock Futures Both buyer and seller must deposit margins • open positions are subject to daily mark to market • if an account balance falls below the maintenance margin level, an additional deposit is required(margin call)

  7. Long Short PNL PNL Buyer Seller Stock Price on Expiry Stock Price on Expiry The PNL Analysis of Futures Positions

  8. Buyer Buyer Call Put PNL PNL Stock Price on Expiry Seller Seller PNL PNL Stock Price on Expiry The PNL Analysis of Options Positions Stock Price on Expiry Stock Price on Expiry

  9. Advantages of Trading SFO(1) • Feasible to combine trades with the underlying stocks • Effective to hedge stocks and other derivatives • Possible to catch investment opportunity based on individual stock performance • Flexible to apply in bullish, bearish, volatile, and stagnant (options) markets • Convenient to short selling • by shorting stock futures or calls, or buying puts to catch profits from a price fall

  10. Advantages of Trading SFO(2) • Cost effective money management tool • trading stock futures or shorting options is required to deposit margins, while buying options is required to pay the premium • Providing market liquidity and connectivity • Lower currency exposure for offshore investors • Market making system • enhancing market liquidity and efficiency • Same electronic trading system (HKATS)

  11. Advantages of Trading SFO(3) • Clearing house guarantee Risk management tool -counterparty toall open contracts -the performance guarantee on registered contracts -the quality of clearing participants -mark to market -position limits -Reserve Fund

  12. Advantages of Trading SFO(4) • Low transaction costs Comparison of transaction costs (per side): HWL@$80, a HWL futures contract is valued @$80K, and a HWL option @$5 Stock futuresStock Options Minimum commission: $20 0.25%* Exchange fee: $3.5 $5.0 SFC levy: $1.0 Nil Compensation Fund levy: $0.5 Nil Stamp Duty: Nil Nil** Total: $25 0.25%+$5 Transaction costs ($) $25 $55 * not less than 0.25% of the transaction value with a min of $50 **Stamp Duty applies to exercising options (amount equivalent to trading stocks)

  13. +55% +11% -11% Advantages of Trading SFO(5) Leverage effect HSBC Stock Futures- Long a Futures PNL($) -55% Assume 20% of the traded value as the client margin

  14. +6.45% Leverage effect (continued) PNL($) HSBC Stock Options- Long a Call +200% Assume the call premium@$3

  15. How to Apply SFO to Attain Investment Objectives? • Trading strategies • Hedging strategies • Income enhancement strategies (options) • Leverage effect • Arbitraging strategies

  16. Feasible SFO Strategies Bullish • Directional trades • Hedging strategies • Income enhancement strategies (options) • Stop loss strategies Stagnant Bearish

  17. Directional Trades--Bullish Strategies(1) Anticipated a bullish market: • A targeted stock is expected to rise within this month or next • Going to have sufficient capital to purchase the stocks later • Now with enough money to deposit margins/pay an option premium Possible strategies: 1.Long stock futures 2.Purchase a call on the stock 3.Sell a put on the stock

  18. Directional Trades--Bullish Strategies(2) Possible strategy(1): Long stock futures * Example:in early July, HSBC @$91 Buy Jul HSBC futures @$91.25 * Advantages: deposit the margin low initial investment costs leverage effect

  19. Analysis: • If the stock futures price rises above the purchase price, investor can sell the stock futures to profit from the accumulated price appreciation, or wait until the expiry to determine the PNL • If the stock futures price falls below the purchase price, investor incurs a loss. • If the accumulated loss makes the account balance drop below the maintenance margin level, he must deposit an additional margin • or investor can sell the stock futures to close out his position before the expiry so as to stop further losses

  20. Directional Trades--Bullish Strategies(3) Possible strategy(2): Purchase a call on the stock * Example:in early July, HSB @$82.25 Buy Jul HSB 85 call @$1.46 * Advantages: low initial investment costs leverage effect limited risk

  21. Analysis: • If stock price rises above exercise price, investor can sell the call option to profit from the price appreciation, or exercise to purchase the stock at $85 (the actual purchase price is $86.46=$85 +$1.46) and earn the price difference between the market price and $86.46 • If stock price falls below exercise price, the investor’s maximum loss is limited to the premium paid; on the other hand, investor can then purchase the stock at a price lower than the exercise price.

  22. Directional Trades--Bullish Strategies(4) Possible strategy(3): Sell a put on the stock * Example:in early July, HWL @$75.5 Sell Aug HWL75 put and receive @$2.02 * Advantages: enhanced income from the received premium if the sold put is exercised, investor can lock in the purchase stock price

  23. Analysis: • If stock price rises above exercise price, the sold put expires worthless and the seller can receive the premium • If stock price falls below exercise price and the put is exercised, investor will need to purchase the stock at strike (the actual purchase price is $72.98=$75-$2.02)

  24. Directional Trades--Bearish Strategies(1) Anticipated a bearish market: • A targeted stock is expected to fall within this month or next • Stock short-selling requires borrowing stocks plus borrowing cost • Now with sufficient capital to deposit margins/pay an option premium Possible strategies: 1.Short stock futures 2.Buy a put on the stock 3.Sell a call on the stock

  25. Directional Trades--Bearish Strategies(2) Possible strategy(1): Short stock futures * Example:in early July, HSBC @$89.25 Short Jul HSBC futures @$89.34 * Advantages: low initial investment costs leverage effect ease of short-selling

  26. Analysis: • If stock futures price rises above selling price, investor incurs a loss. • If the accumulated loss makes the account balance drop below the maintenance margin level, he must deposit an additional margin • or investor can buy the stock futures back to close out his position before the expiry so as to stop further losses • If stock futures price falls below selling price, investor can buy stock futures to profit from the accumulated price depreciation, or wait until the expiry to determine the PNL

  27. Directional Trades--Bearish Strategies(3) Possible strategy(2): Buy a put on the stock * Example:in early July, HSB @$82.25 Buy Jul HSB 80 put @$4.5 * Advantages: low initial investment costs leverage effect limited risk

  28. Analysis: • If stock price rises above exercise price, let the put expire worthless. The investor’s maximum loss is limited to the premium paid • If stock price falls below exercise price, investor can • sell the in the money put to profit from the option trades • or exercise the option to sell the stocks at $80 (the actual selling price is $75.5=$80 -$4.5)

  29. Directional Trades--Bearish Strategies(4) Possible strategy(3): Sell a call on the stock * Example:in early July, HWL @$75.5 Sell Aug HWL 80 call , receive @$1.08, and deposit an initial margin * Advantages: enhanced income from the received premium if the sold call is exercised, the investor can lock in the stock selling price

  30. Analysis: • If stock price rises above exercise price: • the call is exercised, investor will need to sell the stock at strike ( the actual selling price is $81.08=$80+$1.08) • or he can buy back the call to close his position to reduce further losses • If stock price falls below exercise price, the sold call expires worthless and investor can earn the full premium

  31. SFO Hedging Strategies • Hedge against downside risk • an investor with stocks can lock in a portfolio value by shorting futures or buying puts to protect against the value from being depreciated at times of falling prices • Hedge against upside risk • an investor planing to purchase stocks can lock in the purchase value by buying futures or calls in the market expected to be bullish

  32. Hedging Strategies(1) Scenario: • Plan to purchase the targeted stocks later • Worry about - an expected price rise before the purchase - a miss to catch the investment opportunity Possible strategies: 1.Long stock futures 2.Buy a call on the stock

  33. Hedging Strategies(2) • Hedge against upside risk: • * Example: in early July, CITIC@$23.2. Investor would like to buy the stock, but he does not have sufficient capital until one month later to make the purchase. • He can purchase Aug CITIC futures @23.35 • * Advantages and Analysis: • if stock price rises, investor with the long futures position can lock in the purchase price • if stock price falls, the lower market price can offset the loss from the futures bought. Thus, investor can still lock in the purchase cost at the predetermined price Possible strategy(1): Long stock futures

  34. Hedging Strategies(3) • Hedge against upside risk: • * Example: in early July, CLP@$32.6. Investor would like to buy the stock, but he does not have sufficient capital until one month later to make the purchase. • He can purchase Jul CLP 32 call @$0.88 • * Advantages and Analysis: • limited risk • if stock price rises, investor can lock in the purchase at strike • if stock price falls, investor can choose to buy the stock at a lower market price and let the call expire worthless Possible strategy(2): Buy a call on the stock

  35. Hedging Strategies(4) Scenario: • Plan to hold the stock as a long term investment while worry about an expected price fall in the short term • Going to receive some stocks later while worrying about a miss to leave the market at the current level Possible strategies: 1.Short stock futures 2.Buy a put on the stock

  36. Hedging Strategies(5) • Hedge against downside risk: • * Example: in early July, HKEL@$30.1. Investor would like to hold the stock as a long term investment to receive dividends, but worrying about a potential price drop. • He can short Jul HKEL futures @30.05 • * Advantages and Analysis: • if stock price falls, investor with the short futures can lock in the stock price • if stock price rises, the higher market price can offset the loss from the short futures position. Thus, investor can still lock in the portfolio value at his predetermined price Possible strategy(1): Short stock futures

  37. Hedging Strategies(6) • Hedge against downside risk: • * Example: in early July, SHK@$72. Investor will receive stocks later and would like to lock in the value at the current level. • He can purchase Jul SHK70 put @$1.46 • * Advantages and Analysis: • limited risk • if stock price falls, investor can lock in the stock value at the exercise price • if stock price rises, investor can choose to hold the stock or sell it at a higher market price and let the put expire worthless Possible strategy(2): Buy a put on the stock

  38. Income Enhancement Strategies(1) Scenario: • Market is expected to be stagnant • Desire to receive an additional income from the stock held or cash on hand Possible strategies: 1.Short a call (Risky to seller when the call becomes in the money and is exercised, then he is required to sell the stock at exercise price in the bullish market) 2. Short a put (Risky to seller when the put becomes in the money and is exercised, then he is required to buy the stock at the exercise price in the bearish market)

  39. Income Enhancement Strategies(2) • Stagnant to bearish market: • * Example: in early July, CKH@$82.5. • Investor with the stock anticipates the market to be stagnant to bearish. • He can short Jul CKH 85 call @1.16 • * Advantages and Analysis: • investor can earn the received premium in sticky market • if stock price falls below$85, the sold call expires worthless • if stock price rises above $85, the call becomes in the money. When the call is exercised, seller is required to sell the stock at strike. (The actual selling price is at $86.16=$85+$1.16) Possible strategy(1): Short a call

  40. Income Enhancement Strategies(3) • Stagnant to bullish market: • * Example: in early July, HSB@$82.25. • Investor with cash on hand anticipates the market to be stagnant to bullish. • He can short Jul HSB 80 put@$0.76 • * Advantages and Analysis: • investor can still earn the received premium in sticky market • if stock price rises above $80, the sold put expires worthless • if stock price falls below$80, the put becomes in the money. When the put is exercised, seller is required to buy the stock at strike. (The actual purchase price is at $79.24=$80-$0.76) Possible strategy(2): Short a put

  41. Stop Loss Strategies(1) Scenario: • With sold options going to become in the money • Plan to reduce or stop the potential loss which may arise from the short positions Possible strategies: 1.Long stock futures to cover the naked call sold 2.Short stock futures to protect against the put sold

  42. Stop Loss Strategies(2) Possible strategy(1): Long stock futures to cover the naked call sold * Example: Sold Jul HWL$75 call. In early July, HWL price rises to near the call strike . Investor is worried about the potential risk involved in his position when the call sold becomes in the money. He can purchase Jul HWL futures contract @$75

  43. *Advantages and Analysis: • the potential risk of writing a naked call is when the call becomes in the money and is exercised, then seller is required to purchase the underlying stock at the market and sell it at exercise price in a bullish market • if stock price rises, profit from the long futures position can cover losses in the call sold • if stock price falls below: • 1. exercise price , investor can receive the premium • 2. futures purchase, he can sell the futures to reduce further losses of it at a price fall

  44. Stop Loss Strategies(3) Possible strategy(2): Short stock futures to cover the put sold * Example: Sold Jul SHK$70 put. In early July, SHK price drops to near the put strike . Investor is worried about the potential risk involved in his position when the put sold becomes in the money. He can short Jul SHK futures contract @$70

  45. *Advantages and Analysis: • the potential risk of a put sold is when the put becomes in the money and is exercised, seller is required to purchase the underlying stocks at strike in a bearish market and the stock price continues to drop after the purchase • if stock price falls, profit from the short futures can repair the loss in the put sold • if stock price rises above: • 1. exercise price , investor can receive the premium • 2. futures selling price, he can buy the futures back to reduce further losses of it in a price rise.

  46. Stock futures Before April 1, 02 *: HK$20 (overnight) HK$12 (day-trade) on or after April 1, 02: Negotiable Stock options Before April 1, 02: Not less than 0.25% of the transaction value The minimum commission HK$50 on or after April 1, 02: Negotiable Features of Exchange Traded SFO contracts(1) Commission *applicable to 16 specified stock futures, and the commission for the rest is negotiable for each contract per side

  47. Stock futures Contract value: Contract price X Contract multiplier Trading fees*: HK$5.0 Stock options Contract value: Option premium X Contract size Trading fees: Tier1:HK$5.0 Tier2:HK$1.0 Features of Exchange Traded SFO contracts(2) *including the Exchange Fee, SFC Levy ,and Compensation Fund Levy (for each contract per side)

  48. Stock futures Final Settlement Price: The average of the cash stock midpoints of the best bid/ask prices taken at 5 min intervals during the last trading day Settlement method: Cash settled Stock options Final Settlement Price: (Not applicable) Settlement method: Physical delivery Features of Exchange Traded SFO contracts(3)

  49. Stock futures Settlement day: The first business day after the last trading day Stock options Settlement day: T+1(options premium payable in full) T+2(stock transfer following the exercise) Exercise style: any time up to 5:30p.m. on or before the last trading day Features of Exchange Traded SFO contracts(4)

  50. Contract months: Spot, the next two calendar, and the next two quarter months Trading hours(Hong Kong time): 10:00a.m.-12:30p.m. 2:30p.m.-4:00p.m. Last trading day (expiry day): The business day preceding the last business day of the contract month Features of Exchange Traded SFO contracts(5) Same contract months,trading hours, and last trading day