A post for Newbies - Company issued options

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    I have been a member here for over ten years now and it struck me recently that I haven’t made too many ‘pay it forward’ posts to the posting and reading community here at HotCopper.  In the past, I have made many ‘educational’ posts at length on another site so I feel it’s time that I make a decent contribution here.

    Many posters here have provided me with information that has helped me on my investing journey over the years so this post pays forward my debt to them.  Thank you to those members who have helped me.

    This post is based on my own learning and should not be construed as financial advice.

    Apologies in advance for the five A4 pages you’re going to have to read through.

    So here it goes.

    This post is intended for ‘newbies’ so if you don’t fit into that category, save your time and move on to the next post or thread.

    I thought I’d write a post about options after reading a few threads lately.

    There are two types of options that can be traded on the ASX:
    • Exchange Traded Options (ETO’s) &
    • Company Issued Options

    ETO’s are beyond the scope of this post. In my opinion, these types of options are for experienced investors who can use them to:
    • Protect their shareholdings from falls in price
    • Earn extra income against shares they hold or are looking to buy
    • Increase their returns through leverage
    • Diversify their portfolios

    The ASX website has a heap of information for those interested in learning more about these types of options. http://www.asx.com.au/products/equity-options.htm

    Company issued options
    The second type of options are those issued by ASX listed companies and are the purpose of this post.  From here on in, the term option refers to company issued options.

    An option entitles1 a holder to purchase a share in the said company on or before a certain date2, for a pre-determined price3.

    I’ll break that down:

    1 Entitles the holder but does not oblige them;
    2 Expiry Date;
    3 Exercise Price.

    Company issued options are tradable in the same way that Fully Paid Ordinary [FPO] shares are and are denoted by the letter O after the company ASX ticker.  Subsequent issues of a new series of options then carry an additional letter starting with A and moving one letter forward for each additional issue.  I.e. OA, OB, OC etc.  The expiry and strike price of each series will usually be different.

    It is therefore possible for a company to have more than one issue of options (with varying strike prices and expiry dates) trading at any one time.  ‘Example Company’ ASX:EXM - options:  EXMO, EXMOA, EXMOB. (Not a real company so don’t bother looking them up).

    (I should probably clarify these tickers and state here that EXMOA is only used if there is an existing EXMO series currently still alive at the time OA’s are issued.  EXMOB would indicate that there were up to two series still alive when the OB’s were issued.  If there were no series of options alive at the time of issue, the issue would revert back to EXMO.  I hope that makes sense).

    Why do companies issue options?
    Your company may have issued options for a number of reasons:
    1. For free or at a nominal price to existing holders, in order to raise capital some time in the future;
    2. For free as part of a sweetener during a capital raising (CR) on a stated ratio to the fully paid shares purchased as outlined in the company’s prospectus; or
    3. As part of a bonus issue. This practice was common not so long ago with listing IPO’s as a reward for holding.  Bonus issues can be done by companies for other reasons and at any time.

    Company issued options differ from ETO’s in that the terms and conditions of the options are determined solely by the issuing company and released in a prospectus document.  This enables the issuing company to tailor specific terms according to their own needs and circumstances.

    Company options are effectively ‘call’ options which may be issued to shareholders of the company.  Option holders have the right, but not an obligation, to take up (exercise) the option to obtain shares or additional shares in the company at a fixed price before an expiry date.  Shareholders who are allocated company options but who do not wish to exercise them may sell them on the ASX once there is an established market.  Because these options are issued to shareholders, the market for company issued options is likely to be made up of shareholders wishing to sell their options, existing holders wanting to top up their holdings of options or new investors wishing to buy the options.

    What is an option worth?

    It depends.

    All things being equal, the option should trade at the overlaying FPO share price less the exercise price.  However, options may trade at a premium to this price for a long expiry date, if the overlaying share price is rising or if news is expected.  Conversely, it may trade at a discount if the expiry date is approaching, if the overlaying share price is falling or there is no news on the horizon.

    Options are referred to as either being in-the-money or out-of-the-money.  An in-the-money option is one whose exercise price is less than that of the current overlaying FPO share price.  For example, the current FPO share price of ASX:EXM is 10c and the cost of exercising the option is 5c.  This does not include what you may have paid for the option.  An out-of-the-money option is one whose exercise price exceeds the current FPO share price plus whatever you may have paid for the option.

    Newly issued options may trade at higher than expected prices.  If an option was issued to you as an incentive through a credit raising (CR), via a bonus issue, a loyalty issue or just as an issue to current shareholders, there may be an opportunity to profit quickly from your holding whilst there is interest and a market for the options.  You could even recoup some of what you may have paid for the FPO shares in a CR by selling the options issued to you.  Depending on what is on the horizon for the company, you could make many times the price you paid by selling the option early.  You can always buy back at lower price later if you really like the company.

    Whilst the Black-Scholes valuation method is used more for valuing ETO’s, some companies do use this method to affix a valuation or exercise price to options that they issue.  This is done more for options issued under an employee incentive scheme or for director issued options as performance incentives.  If you would like to read more about this, this link currently works. http://www.investopedia.com/terms/b/blackscholes.asp  If, by the time you read this post the link no longer works, just do a search for Black-Scholes.  I should say here that performance options are generally unlisted.  Which bring me to this.

    How do I find out if a company has options on issue?
    Some time ago there was a great site for establishing this called tradingroom.  The site no longer exists.  You could try here: http://www.ozstockstats.com/company-option/  or perhaps another member could post a link to another site in this thread.  However, the best way to establish if a company has options on issue and their expiry and exercise price is to locate the latest appendix 3B that the company has issued by searching the company’s announcements.  A 3B will list the number and class of all company issued securities quoted on the ASX in section 8.  It will also list unquoted securities (generally unlisted options issued under employee or director incentive schemes) in section 9.  The benefit of 3B’s is, if you wanted to do some research regarding previously issued options which may have since expired, you can just go back through the company’s 3B announcements.

    Advantages of holding options
    I spent some time looking for data related to the percentage of company issued options that were in-the-money come expiry date but I came up empty.  There was plenty of information related to ETO’s on this subject but not for company issued options.  If anyone can link that information to this post, feel free.  So in the end, I’m going to have a stab at this figure based on my experience and say that only about 30 percent of options will ever be in-the-money and or exercised come expiry date.  However, I wouldn’t be surprised if the figure was less … much less.  I should also probably say here that very few options are exercised prior to expiry (obviously there are exceptions).

    So if my guess is close to the mark and most people won’t think about exercising until expiry date, you’re probably asking yourself what’s the point of owning or buying options?

    In the market, leverage has several meanings and there are various mediums which can effect it. In this context, leverage refers to the potential upside (or downside) that can be achieved with a set amount of money and how trading in company issued options can increase your exposure to price increases to your benefit. Trading company issued options may be the simplest form of leverage for newer investors to dabble with. Take this example:

    Let’s say you have $2,000 to invest in ‘Example Company’ – ASX:EXM.  EXM has a current trading price of 10c for the FPO shares.  Using this scenario, you could purchase 20,000 shares ex of brokerage and fees.  This means for every 1c movement in price, the value of your holding will increase (or decrease) by $200.

    Now let’s say that EXM also has a series of company issued options on issue.  The strike price is 20c (so they are currently out-of-the-money) and the expiry date is two years from now.  The company issued options are trading at 3c.  With exactly the same amount of money, $2000, you can purchase 66,667 options ex of brokerage and fees. This means that for every 1c movement in price, the value of your holding will increase (or decrease) by $666.67.  That is a difference of $466.67c for every 1c movement in price for exactly the same outlay!

    But remember the piper will need to be paid eventually, that is the exercise price should you hold the options on expiry date.

    Freeing up cash
    Another advantage of buying company issued options is that they can allow you to free up money to take advantage of other buying opportunities that may exist.

    Going back to the previous example of EXM, you could sell your 20,000 FPO shares at 10c and buy 20,000 EXMO’s at 3c and free up $1400 (ex of brokerage and fees) to use elsewhere, whilst still (technically) maintaining exactly the same exposure to EXM share price movements.  It could be worth thinking about this play if you are short on cash and see another buying opportunity.

    How do you exercise your options?
    In the event that you wish to exercise your options it is simply a matter of filling out a form and sending off your cheque.  If your options were issued as part of a placement, CR, IPO or bonus or loyalty issue, you may have received an option exercise form with notification of your allocation. If you purchased your options on the market, a phone call to the company secretary or a visit to the company’s website will allow you to obtain the necessary form to effect the conversion. Your last resort is to contact the share registry that your company uses and obtain conversion information from them.  In any event, stand by for a company 3B announcement where the market will be able to see the issue of your shares.

    Expiry Date
    Come expiry date, unless you exercise your options, they will expire worthless. Whether you decide to exercise your options or not will depend on whether they are in-the-money or not, and or based on how you perceive the company’s future prospects.

    Disadvantages of holding or buying options
    I’ve mentioned some advantages of holding or trading company issued options so let’s acknowledge some of the bad stuff.

    • Holders of company issued options are not entitled to vote or participate in capital raisings (unless they exercise one or more of their options by the entitlement date).

    • Company issued options can be very illiquid, particularly if the company’s overlying share price is not moving. Therefore holders may find it difficult to sell their options should they need their money.

    • Should a company be the subject of a takeover, your options could drop sharply in value. That is because your option is to purchase a share in the said company, it doesn't entitle you to purchase shares in the takeover company. If your options are in-the-money you may wish to exercise them early or look to see if the company trying to take over your company is placing any worth on the existing options.

    • Finally, the option price may also fall quickly as the expiry date approaches. As an aside, I have noticed on more than one occasion that around the six-month-to-expiry date you can sometimes see ‘unusual action’ to the upside with either the overlaying share price and or the option price.  I now see this as a sign option holders may be trying to unload before expiry.

    Obviously, expiry date is very important to consider when looking at buying options.

    Something to consider with company issued options (and this is important so get your highlighter out) is that companies have a vested interest in having their options exercised as it means more money coming into the coffers. For this reason, some companies may 'ramp-up' activity or make a series of positive announcements close to option expiry date in order to ensure that the options are in-the-money.  On other occasions, a company may be happy to see listed options expire without exercise.

    Some other important information
    • Option trading ceases five business days prior to expiry. Don’t get caught out holding them if you can’t afford to convert some or all of your options.
    • Unless your options are in-the-money 25 trading days before expiry or convert automatically, the company has no obligation to inform you in writing of their upcoming expiry. Instead, the company will generally issue an announcement through the ASX that will list the three month trading high and low and inform the market of upcoming expiry.
    • Companies are not permitted to have more options on issue than overlaying securities. See listing rule 7.16 here: http://www.asx.com.au/documents/rules/Chapter07.pdf
    • On rare occasions, changes can be made to the exercise price of options. Full details can be found under listing rule 6.22 here: http://www.asx.com.au/documents/rules/Chapter06.pdf  The link worked at the time of posting but if you’re reading this now and it doesn’t work, do a search at ASX for listing rules.  Having a waiver granted by the ASX may also allow for option prices to be changed (mostly to a reduced price) if the company wishes but justification would need to be provided.
    • On other rare occasions, companies may ‘re-issue’ expired options for free or for a nominal price. This happened with many companies after the GFC when many company’s options were rendered worthless after the crash.

    Anyway, that’s it.  I hope some newer investors found this post useful and that it will help them on their way as I have been helped by other member’s post here.
    All the best,
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