Applications of Stock Futures and Options SFO HKEx Aug 2001

1
Applications of Stock Futures and Options (SFO)
HKExAug 2001
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 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

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
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SFO Concept(2)

• Stock Futures
• The buyer
• buys (long position) stock futures
• The seller
• sells (short position) stock futures

• 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

6
SFO Concept(3)

• 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)

• 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

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

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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)

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Advantages of Trading SFO(3)

• Clearing house guarantee
• Risk management tool
• -counterparty to all open contracts
• -the performance guarantee on registered
  contracts
• -the quality of clearing participants
• -mark to market
• -position limits
• -Reserve Fund

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Advantages of Trading SFO(4)

• Low transaction costs
• Comparison of transaction costs (per side)
• HWL_at_80, a HWL futures contract is valued _at_80K,
  and a HWL option _at_5

Stock futures Stock 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 To
tal 25 0.255 Transaction costs ()
25 55

Before 1 Apr 2003 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)
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Leverage effect
Advantages of Trading SFO(5)
HSBC Stock Futures- Long a Futures
PNL()
-55
Assume 20 of the traded value as the client
margin
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Leverage effect (continued)
PNL()
HSBC Stock Options- Long a Call
200
Assume the call premium_at_3
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How to Apply SFO to Attain Investment Objectives?

• Trading strategies
• Hedging strategies
• Income enhancement strategies (options)
• Leverage effect
• Arbitraging strategies

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Feasible SFO Strategies
Bullish

• Directional trades
• Hedging strategies
• Income enhancement strategies (options)
• Stop loss strategies

Stagnant
Bearish
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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

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Directional Trades--Bullish Strategies(2)

• Possible strategy(1) Long stock futures
• Examplein early July, HSBC _at_91
• Buy Jul HSBC futures _at_91.25
• Advantages deposit the margin
• low initial investment costs
• leverage effect

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• 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

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Directional Trades--Bullish Strategies(3)

• Possible strategy(2) Purchase a call on the
  stock
• Examplein early July, HSB _at_82.25
• Buy Jul HSB 85 call _at_1.46
• Advantages low initial investment costs
• leverage effect
• limited risk

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• 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
  86.4685 1.46) and earn the price difference
  between the market price and 86.46
• If stock price falls below exercise price, the
  investors 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.

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Directional Trades--Bullish Strategies(4)

• Possible strategy(3) Sell a put on the stock
• Examplein early July, HWL _at_75.5
• Sell Aug HWL75 put and receive _at_2.02
• Advantages enhanced income from the received
  premium
• if the sold put is exercised, investor can
• lock in the purchase stock price

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• 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
  72.9875-2.02)

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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

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Directional Trades--Bearish Strategies(2)

• Possible strategy(1) Short stock futures
• Examplein early July, HSBC _at_89.25
• Short Jul HSBC futures _at_89.34
• Advantages low initial investment costs
• leverage effect
• ease of short-selling

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• 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

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Directional Trades--Bearish Strategies(3)

• Possible strategy(2) Buy a put on the stock
• Examplein early July, HSB _at_82.25
• Buy Jul HSB 80 put _at_4.5
• Advantages low initial investment costs
• leverage effect
• limited risk

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• Analysis
• If stock price rises above exercise price, let
  the put expire worthless. The investors 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 75.580-4.5)

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Directional Trades--Bearish Strategies(4)

• Possible strategy(3) Sell a call on the stock
• Examplein early July, HWL _at_75.5
• Sell Aug HWL 80 call , receive _at_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

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• 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 81.08801.08)
• 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

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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

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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

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Hedging Strategies(2)

• Possible strategy(1) Long stock futures

• Hedge against upside risk
• Example in early July, CITIC_at_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 _at_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

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Hedging Strategies(3)

• Possible strategy(2) Buy a call on the stock

• Hedge against upside risk
• Example in early July, CLP_at_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 _at_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

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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

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Hedging Strategies(5)

• Possible strategy(1) Short stock futures

• Hedge against downside risk
• Example in early July, HKEL_at_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 _at_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

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Hedging Strategies(6)

• Possible strategy(2) Buy a put on the stock

• Hedge against downside risk
• Example in early July, SHK_at_72. Investor
  will receive stocks later and would like to lock
  in the value at the current level.
• He can purchase Jul SHK70 put _at_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

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)

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Income Enhancement Strategies(2)

• Possible strategy(1) Short a call

• Stagnant to bearish market
• Example in early July, CKH_at_82.5.
• Investor with the stock anticipates the market to
  be stagnant to bearish.
• He can short Jul CKH 85 call _at_1.16
• Advantages and Analysis
• investor can earn the received premium in sticky
  market
• if stock price falls below85, 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
  86.16851.16)

40
Income Enhancement Strategies(3)

• Possible strategy(2) Short a put

• Stagnant to bullish market
• Example in early July, HSB_at_82.25.
• Investor with cash on hand anticipates the market
  to be stagnant to bullish.
• He can short Jul HSB 80 put_at_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 below80, 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 79.2480-0.76)

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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

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Stop Loss Strategies(2)

• Possible strategy(1) Long stock futures to
  cover the naked call sold

Example Sold Jul HWL75 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 _at_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 SHK70 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
_at_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
Features of Exchange Traded SFO contracts(1)
Commission

• Stock futures
• Before 1 April, 03
• HK20 (overnight)
• HK12 (day-trade)
• on or after 1 April, 03
• Negotiable

• Stock options
• Before 1 April, 03
• Not less than 0.25 of the transaction value
• The minimum commission HK50
• on or after 1 April, 03
• Negotiable

applicable to 16 specified stock futures, and
the commission for the rest is negotiable for
each contract per side
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Features of Exchange Traded SFO contracts(2)

• Stock futures
• Contract value
• Contract price X Contract multiplier
• Trading fees
• HK5.0

• Stock options
• Contract value
• Option premium X Contract size
• Trading fees
• Tier1HK5.0
• Tier2HK1.0

including the Exchange Fee, SFC Levy ,and
Compensation Fund Levy (for each contract per
side)
48
Features of Exchange Traded SFO contracts(3)

• 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

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Features of Exchange Traded SFO contracts(4)

• Stock futures
• Settlement day
• The first business day after the last trading
  day

• Stock options
• Settlement day
• T1(options premium payable in full)
• T2(stock transfer following the exercise)
• Exercise style
• any time up to 530p.m. on or before the last
  trading day

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Features of Exchange Traded SFO contracts(5)
Same contract months,trading hours, and last
trading day

• Contract months
• Spot, the next two calendar, and the next two
  quarter months
• Trading hours (Hong Kong time)
• 1000a.m.-1230p.m.
• 230p.m.-400p.m.
• Last trading day (expiry day)
• The business day preceding the last business day
  of the contract month

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Risks of SFO trades

• Stock futures
• Margin requirement
• if the account balance falls below the
  maintenance margin level, investor is required to
  deposit an additional fund to restore the account
  to the initial level

• Stock options
• Factors affecting the option premium
• investor should pay attention to changes of
  market and factors influencing the option value.
  Select the contract with a suitable expiry and
  strike at option trades

52
Risks of SFO trades
Margin Requirement
If the margin account balance falls below the
maintenance margin level, the investor is
required to deposit an additional fund to restore
the account to the initial margin level
If the investor cannot provide the required fund
for the margin call within the specified time
period, the broker has the right to close out the
investors position immediately in the market.
The investor is responsible for all the losses.
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Risks of SFO trades

• Stock futures
• Trading on margin basis
• trading futures provides investors flexibility in
  money management however,investors should also
  pay attention to the capital liquidity to ensure
  their fulfillment of potential margin calls

• Stock options
• At the time of option exercise
• buyer must provide
• sufficient capital ready to buy the stocks (a
  call)
• the required stocks ready to sell (a put)
• seller must prepare
• the required stocks ready to sell (a call)
• sufficient capital to buy the stocks (a put)

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Leverage Risk
HSBC Stock Futures-Long a Futures
PNL()
55
11
-11
-55
Assume 20 of the traded value as the client
margin
55
Leverage Risk
HSBC Stock Options- Short a Call
PNL()
6.45
-200
Seller deposits margin for selling the call
56
Points to Note in SFO Trades

• Contract month
• choose the right contract month to allow expected
  market direction to realise
• SFO (with expiry) vs stocks (no expiry)
• Leverage
• the actual investments of futures investors and
  options sellers are much larger than the margins
  initially deposited as a portion of the contract
  value
• Trading amount
• have sufficient capital to fulfill the contract
  settlement
• do not trade excessively

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Points to Note in SFO Trades

• Be familiar with contract specifications and
  settlement procedures
• Pay attention to the market changes in direction
  and volatility
• Construct feasible trading strategies
• Set stop loss or hedge strategies
• Prepare sufficient capital to fulfill contract
  requirements and margin calls
• Consult registered brokers or investment
  advisers for professional advice

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How to Obtain Market Information?

• List of real time quote vendors
• downloadable from HKEX website
• e.g. ABC, Jade Network, or Star Internet
• e.g. TeleText
• SF-on and after Page 785
• SO-on and after Page 3001
• Non real time information
• Local newspapers
• HKEx website

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How to Start Trading SFO?

• Obtain a list of qualified market participants
  from HKEx
• Inquire for opening account procedures and
  service charges from the qualified participants
• Select and open an account with the one best fit
  to your needs
• Ensure to read and understand the risk disclosure
  documents before signing
• Establish market view before constructing trading
  strategies
• Participate SFO trades by placing orders in the
  market

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Q A
61
For Detailed Information, Please Visit

• http//www.hkex.com.hk

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Appendix-Available SFO in HKEx (as of 27/08/01)
63
Appendix-Available SFO in HKEx (as of 27/08/01)
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Appendix-Available SFO in HKEx (as of 27/08/01)
No futures contracts on the Tracker Fund of
Hong Kong for trading Before 1 April, 03, the
minimum commission rate for each marked contract
per side is HKD20.0 (overnight) or HKD12.0
(day-trade) commission for others futures
contracts is negotiable. On or after 1 April, 03,
the minimum commission rate will be negotiable
for all stock futures contracts.