ShareDigest blog

Call Options

Call options give an investor he right (but not the obligation) to buy a quantity of shares at a fixed price for the duration of the option up to date of expiration. The call option cosists of three variables:

1. The underlying stock;
2. The Expiration Date; and
3. The Strike Price.

What Are Options?

Options are one of several forms of derivative investment vehicles. That is, they are derived from an underlying investment such as property, stocks, futures etc. Here, and in all following articles, when we refer to options we will be discussing options related to shares on the stockmarket, known as Exchange Traded Options.

Put simply, an option is the right, but not the obligation, to
purchase or sell a fixed number of shares in a stock at a fixed price per share,
at any time up to a fixed date of expiration of the option. In order to obtain this
right, the option purchaser will pay what is known as the option “premium”.

We begin the explanation of options on stocks with a little story:

Lets define an option once again: An option (call) is a contract that gives the
owner the right,

but not the obligation, to purchase a security at a specified price
(strike price),

on or before a specified date (expiration date).

When trading options, the idea is to take advantage of the incredible leveraging
power of options. By making a relatively small investment in options,we can control
a much more valuable block of associated stock. In this way we receive the benefit
of the potential appreciation of that asset without owning it outright.

The expectation is that the market price of each lot will grow to $61,000 or

more, on or before a date one year in the future. $61,000 would be the break

even point,allowing enough appreciation to pay for the option. Any
increase

in price above $61,000 would be pure profit.

Each option contract controls a fixed number of shares in the underlying stock.
This number will vary depending upon which stock exhchange or country you are dealing
with. For example in Australia options listed on the ASX control parcels of 1000
shares, whereas in the US options contracts control 100 shares of the underlying.
This is something to be mindful of.

The two types of options
available: calls and puts

Margin Trading

Margin Requirements Buying shares on margin is similar to borrowing money through a margin loan to buy shares, or buying a house using a mortgage. To own a house, you are not required to have the full purchase price, only the deposit. This deposit is required by the bank to ensure that if they have to sell your house they do not lose money. CFDs offer a similar opportunity to a trader.

Most people buy shares for cash; but if you use CFDs, you can place down a deposit,
known as a margin. This margin requirement is used to protect the CFD provider if
it has to sell a trader out of a position.
The margin requirement varies from share
to share (and provider to provider) between 3% (low risk, generally the top 100
shares) and 80% (more risky shares) of the face value of the share. This is the
margin rate. For indices or currencies, margin rates can be as low as 1% of the
value of the underlying security. Margin requirements are broken into two components
known as the initial margin and the variation margin. Margin requirements
are calculated each day.

Initial Margin

Initial Margin Calculation

The initial margin is calculated on the face value of the contracts held.

Let’s say you’d like to buy AUD$10,000 worth of the Australian stock, Commonwealth
Bank, (CBA):

If the margin rate is 5%, the initial margin requirement is $10,000 x 5% = $500.

This is the amount you have to put up to enter the position (not including commission
and limited risk premium).

For short positions, the calculation is exactly the same:

If you went short $10,000 worth of share value for CBA:

Initial margin requirement is $10,000 x 5% = $500.

See the CFD QuickCalculator for easy calculations of the IM.

Notes on Initial Margin

Some CFD providers will allow you to reduce your initial margin (IM) requirement
by setting stop orders or guaranteed stop orders closer to the share price than
the margin requirement. For example, if the stop is set 2% below the current share
price, then the IM requirement becomes 2%.

Check with your provider what your margin requirements are. Although a CFD provider
will charge a higher margin rate for a more risky share, it’s important to understand
that
it is not the IM that will have the most impact on your account, but rather
the variation margin. Variation margin is explained in the next section.

Limited Risk Premium

Many CFD providers will only allow new CFD traders access to a limited risk account.
The limited risk account allows you to place a guaranteed stop with your entries.
Typically the closest this stop can be placed to the share price is 5% (in order
for the trader to take some risk himself). This is a great loss-prevention measure!
However, for this privilege you have to pay what is known as a limited risk premium
(LRP), which is calculated as a percentage of the share value of the position.

The LRP rate varies from share to share, and is based upon the share’s risk-level
(similar to the margin rate). For example, the LRP rate of CBA might be 0.3%, in
which case a position of $15,000 share value worth, will have an associated LRP
cost of $45.

Variation Margin

Variation Margin Calculation

The variation margin (VM) is your daily profit or loss on a position. It is
directly proportional to the number of shares in the CFD contract.
Let’s go back to our CBA example again. If the share price of CBA is $50, and we
have entered a $10,000 share value position, on 5% margin, then we have:

Number of shares is $10,000 / $50 = 200 shares.

Our VM will thus increase by $200 for every $1 increase in the price of the share
(for a long position), and, similarly, decrease by $200 for every $1 drop in the
price of CBA. The opposite is true for a short position.

From the above calculation, it can clearly be seen that for cheaper shares, the
VM will be higher : thus resulting in higher leverage. Care must be taken since
very high leverages can be obtained. Consider a position where the share value is
$5000 (which at 5% margin only requires $250 up-front) and the stock price $0.20.
This will result in 25,000 shares being bought. Very small changes in the share
price will have a huge effect on your account: A positive move will be highly desired
since even a slight negative move could wipe out your entire account (and more)!

The variation margin is calculated daily by a process known as marking to market.
At the end of each trading day, any gain is credited and any loss deducted from
your account. This is called free equity (a unique feature of CFDs) and allows the
trader to enjoy improved cash flow in his/her account.

Try the CFD QuickCalculator for yourself a few times to get a feel for the effect of share price and share value on variation margin (number of shares).

Free Equity

Free equity is used to refer to the free cash in your account after margin requirements have been taken into account. If you deposit $10,000 into your account and you enter
$50,000 worth of CFD positions at 10% margin, then your initial margin requirement
is $5,000, leaving free equity in your account of $5,000. If the position moves
in your favour by $500 during the trading day, then your free equity will increase
to $5,500.

Conversely, if the position moves against you by the same amount, your free equity
will decrease to $4,500. If your free equity moves to zero, you will receive what
is known as a margin call. This is a request to deposit more money into your account
or decrease the position that you are trading.

Finance Charges

Interest Charges

When trading in CFDs, you are in effect borrowing money, as you are when you place down a deposit to buy a house. There is no interest charge on positions that are
closed the same day you bought them.
However, if positions are held overnight, that
is considered longer than one day, then interest is charged, or credited if you
are in a short position.

Interest is charged or credited on the face value of the transaction, which is the
total amount of the position (share value) NOT the initial margin. In the CBA example,
interest will be charged if you are long $10,000 or credited if you are short the
position.

CFDs are like a margin loan on steroids! The leverage is much greater with CFDs
than with a margin loan. The financing structure is also different to that used
in a margin loan. For a margin loan, an investor would contribute $30,000 and borrow
up to $70,000. Interest is only charged on the money that is borrowed. If a facility
of $70,000 has been approved and the investor is using $50,000 of the margin loan
facility, then interest is charged on the $50,000 that was borrowed. If a trader
has $30,000, then this can be used as initial margin, allowing the trader to borrow
up to $1m (at 3% margin).

If $500,000 of CFDs are purchased, then interest is charged on the whole
$500,000. There is no credit given for the initial $30,000 margin that is used,
although the trader will receive interest on the free equity in his or her account.

Interest rates vary from provider to provider and are usually based on the country’s
nationally accepted rates (e.g. in Australia, the Reserve Bank of Australia, or
in the UK, LIBOR rates). They usually add/subtract a margin for long/short positions
respectively. This interest rate margin usually around 3%. So if the RBA’s rates
are 5% p.a., your CFD provider might charge you 8% for long positions held and credit
you 2% for short positions held.

Some CFD providers link their interest rates to overseas base rates.
Check with your CFD provider how interest rates are calculated. Interest will be paid on the
free equity in your account at varying rates, depending on the provider. These are
worthwhile checking with your provider.

CFDs

Contracts for difference (CFDs) open up a whole new range of opportunities to the active trader. The access to leverage, the ability to trade long or short and the flexibility to enter or exit a trade at market prices when you choose are now available to all traders. Having these tools at your fingertips provides a great opportunity and also requires the trader to implement rules to ensure survival in the market.

When sailing in the oceans, anything can happen: from massive storms to long calm periods. The oceans and weather are unpredictable and we have no control over them; however, sailors can safely navigate around the world.

Its exactly the same with the markets. No person can reliably predict the stock market, and certainly no individual or company can control it. Yet it is possible to safely navigate the market and profit from it using CFDs and many other instruments.

Long vs. Short

Most traders are familiar with trading long: Buying shares and selling them for higher prices
to make a profit. When trading CFDs, it is just as possible to make money trading short as it is
trading long. When trading short, you sell the share, then buy it back later, hopefully at a cheaper price.
This confuses many people because how do you sell something that you do not own?

The mechanics
behind it works like this: Imagine borrowing your neighbour’s lawnmower and selling it for $500.
You get the $500 now, but at some point in time, your neighbour is going to want his lawnmower back
(unless he’s very generous and lets you keep it – most neighbours aren’t like that!).
If you can buy the lawnmower back for $300, then you can return the lawnmower to your neighbour
and you get to keep the profit of $200. If however, you have to buy it back for $600,
you have just lost $100.

This same mechanism is used in the stock market to short sell shares. However, in the plain stock market, its not that easy to short-sell a stock, due to the uptick rule which stipulates that a short seller cannot sell a stock short unless on an uptick or a zero-plus tick; this means the stock can only be sold short if the last non-zero “tick” (i.e. trade price) was higher than the preceding one.

Go Either Way With CFDs

With CFDs (and all derivatives in fact), you don’t have this problem. If you buy
a CFD at $10 and sell it at $12, you settle for the difference, a profit of $2 (ignoring
commission and interest charges). If you sell a CFD at $12 and buy it at $10 you
again keep the profit of $2. Short selling with CFDs is easy: the CFD provider takes
care of the mechanics behind the short-selling process; all you need to do is click
“sell” instead of “buy” to enter a position.

Benefits of CFDs

Leverage

CFDs are NOT a fix for poor performance when trading outright stocks. They offer an opportunity to
move you well beyond the returns offered by trading shares, but they will also amplify the downside
when things go wrong. This is the effect of the two-edged sword called leverage.

CFDs Are Simple

Unlike with options or warrants, understanding the mechanics of CFDs is relatively simple.
But the key to your success is not this understanding, but rather your risk management and how
you cope with the ups and downs as a trader. Coping with the psychological impact of large wins or large losses when trading CFDs will be a key component to your success.

CFDs Offer Variety

CFDs are a revolution in trading. No other instrument offers the variety of underlying securities
that CFDs do. The world’s markets offer an unlimited opportunity and using CFDs, traders can now
choose exactly what they would like to trade, when they would like to trade and how much they would like
to trade: A trader could buy shares locally in Australia, short-sell a share in the United States, buy
another share in Japan, trade on an index in Europe or trade a currency anywhere in the world!