Trading Software and Books Reviews

Contract Sizes and Strike Prices

When writing both put and call options over shares it’s important to check the underlying contract size before placing your order with your broker. Too often an option writer will automatically assume that one option contract in Australia is equal to 1,000 underlying shares.

It can be a very frustrating exercise to buy shares in multiples of 1,000 in order to write covered call options, only to find that you can’t write the required call option contracts due to the fact that you don’t own enough shares to perform the exercise.

One reminder to check the underlying contract size will usually be the fact the option contract exercise or strike prices are at odd numbers. This will usually mean that the company has undergone a capital return or bonus or entitlement issue to shareholders and the current option contracts are adjusted to protect the exercise value of the options that are in existence before and after the entitlement has expired.

So how does the option contracts become odd contract sizes with odd strike prices then?

Well let’s look at the current options for Telstra Limited. Telstra’s option exercise prices are at odd price numbers. For example Telstra is trading at $4.70 and the two nearest strike prices for both the near dated put and call options are $4.72 and $4.47. In other words the strike prices are now all 3c lower per share.

If we now check the contract size we can see that the underlying contract size for Telstra has been adjusted to 1007 shares per option contract. So we need to own 1007 shares in Telstra in order to write one covered call option contract.

It’s the same if we wanted to write put options over Telstra in order to purchase the shares at a discount to the current market price. We now need to lodge the collateral or margin to purchase 1,007 shares instead of 1,000 shares.

The reason for this adjustment is that Telstra paid out a special 3c bonus dividend to shareholders on the 17th of March 2003. Therefore when the announcement was made and the ex-dividend date was declared, the call options that were in existence after that date would normally fall by 3c per share and the put option premiums would normally rise by 3c a share, as it was taken into consideration that the underlying stock would naturally fall by the dividend amount on the ex-date.

So to keep the options market orderly, the ASX applies the following formula for such incidents.

The contract size is adjusted by taking the current contract size and adding it to the special dividend per share divided by the volume weighted average price of the stock on the last day of cum-dividend trading, minus the special dividend amount.

Now that the option contract size has been adjusted, the option exercise prices must also be adjusted too.

So the formula here is to multiply the current strike or exercise price by the old contract size divided by the new contract size.

Once the stock goes ex-special dividend, the new contract size and strike prices take effect. Once those options expire, the contract size and strike prices revert back to normal on the new options.

Glen Van Ooran

Become A Wise Trader

It is a wise person who recognizes his limitations, a courageous person who overcomes them, and a fool who does not recognize they exist.

Children arrive into this world with two instinctive fears, fear of loud noises and fear of falling. All other fears are a learned and conditioned response. B.F. Skinner pioneered operant conditioning in the 1930’s based on Pavlov’s experiments. Operant conditioning rewards positive responses and punishes negative responses.

If you possess fear of losing money, how and where did you learn it? Was it in the markets??

Futures traders are not characters in children’s stories, so few children grow up wanting to be futures traders. I know of know super heroes who trade futures. Certainly, Spiderman, Superman, Batman, and others like them are not presented as futures traders.

Ah! But you read Market Wizards! Is that where you came into the hero worshipping of futures traders? Tell me something: Did any of those wizards tell you how they became market wizards? Did they show you what they do? What did you learn from the market wizard books? Was there any proof that what these wizards told the author is true?

A person’s life is short and should be spent on doing what he truly wants to do without any financial incentives. If the fear of financial loss is greater than the potential rewards of trading, do not trade the markets. It is a wise person who recognizes his limitations, a courageous person who overcomes them, and a fool who does not recognize they exist.

Courage is not lack of fear, it is overcoming fear. The best traders are armed with the knowledge of what actions should be taken for any given market condition to provide the highest probability of a profitable expectation.

Being a stalwart hero is not a good idea for trading. Gritting one’s teeth and trying to ride out an adverse move, gains you nothing. I’ve seen countless traders go to their financial ruin trying to tough-it-out when prices were moving against them. Nevertheless, stubbornly hanging onto a losing trade is what is required of most system traders.

Anyone is allowed to make one mistake. When the same mistake is repeated a second time, caution should be noted. The third repetition of the same mistake constitutes self-destructive habitual behavior that must be reversed. All trading must stop immediately until the trader’s self-discipline is thoroughly examined. Once the reason for the repetitive mistakes is understood, usually fear, anger or guilt, it must be corrected before trading may begin again. Some traders lose money because they are atoning for guilt feelings or gifts they feel are undeserved. Such traders should donate funds to their favorite charities, not to other traders.

Any flaw in a trader’s character, like greed, hatred, dishonesty, revenge, arrogance, etc., will soon result in a loss of money. Traders must know the market as well as they know themselves. Negative feelings towards any person, or one’s self, must be replaced with the understanding that these feelings are choices the trader has made that will eventually cause personal and financial destruction. Negative feelings prevent the trader from realizing his maximum growth potential, because his choices for growth have been limited by his self-defeating thoughts. The mind’s electrochemical network sends energy impulses throughout each atom of the body as it thinks. Thoughts create feelings experienced by the trader. Traders should take trades based on scientific price action analysis, not feelings. Deschapelles, the French chess champion, would give his opponent a pawn before the game began. This action always provided the necessary excuse for losing. Give nothing away when trading markets; enough will be taken from you.

All the best in your trading.

Joe Ross, Trading Educators Inc.