Wednesday, September 30, 2009

Sold - all actively managed funds

I made the decision to sell all the actively managed funds to contribute to the purchase of the new property purchase.

The funds sold were:

1. Thailand
2. Taiwan
3. Vietnam
4. Asian small cap
5. European small cap

As a group, I lost money on these investments (largely due to buying too close to the top of the last bull market).

Given that I now have a modest range of index tracking ETFs which have much lower expense ratios (although still high by US standards), it was a relatively easy to decide to liquidate these funds rather than the ETFs, the HK listed stocks or to use the money currently allocated to ELDs.

As an aside, I found it difficult to figure out whether the funds had out performed or under performed their respective benchmarks during the periods I held them.

Monday, September 28, 2009

How not to sell financial services

OK, so I know that it is a complete waste of time meeting with so-called independent financial advisers but I make a point of meeting with one every year or two as a means of seeing if anything new and/or worthwhile is on offer.

Recently, I met with what has to rank as the worst sales pitch I have ever come across:

1. the adviser reeked of cigarette smoke

2. the adviser had a lot of visible dandruff on his suit

3. the adviser droned on and on and on about how happy his very wealthy clients were with the products he had sold them

4. he mentioned one client by position with sufficient detail that I could probably work out the client's identity. This raises serious concerns about confidentiality and professionalism (or the lack thereof)

5. when the adviser eventually got around to talking about me, he made a number of unwarranted assumptions -at least three of which were wrong

6. even after I said I had all the life insurance I needed (not quite true, but I was not going to do business with this person anyway), he spent a few minutes talking about the benefits of whole of life policies

7. apparently actively managed funds with an unspecified front end load were preferable to low cost no load ETFs "because people can trade the ETFs too easily"

Not even worth the entertainment value.

Estate planning

Most people should have a will and an enduring power of attorney.

A will is simply instructions for dealing with your assets after your death. If you do not have a valid will, your assets will be divided according to the laws of the relevant jurisdiction - which may not be the way in which you would like them to be divided. The basic requirements for a valid will under Hong Kong law are:

(i) your signature must be witnessed by two mentally sound adults who are not beneficiaries under the will;

(ii) you must be an adult of sound mind at the time you make the will.

It is not necessary for a will to be prepared or witnessed by a lawyer. However, having a lawyer prepare the will does reduce the risk of mistakes being made (e.g. not all of your assets being included in the will, excluding persons who are entitled to a share of your estate by law etc). We used the services of a lawyer to make sure that we did not make any of these mistakes.

Our estate planning is relatively simple:

(i) I have left my entire estate to be divided equally among my children (to be held in trust while they are young) - my wife does not benefit at all;

(ii) my wife will take my interest in two properties in which we are "tenants in common" - this takes place by operation of law and falls outside my estate;

(iii) a life insurance policy will pay a lump sum to my wife which is intended to be sufficient to discharge the mortgage on our home. Due to drawing down to fund an investment in my employer, the amount of the policy is no longer sufficient. I will increase this when the policy comes up for renewal in February next year. The same policy also provides for smaller payments to my siblings.

My wife's will is also simple with certain life interests to her parents and the rest to our children.

The lawyer we used confirmed that these arrangements are compliant with Hong Kong legal requirements for testamentary dispositions.

An enduring power of attorney is an authority and/or directions to be followed in the event that you are still alive but unable to direct your own affairs. This can happen to people who suffer from deteriorating mental capability as they age, in a coma etc. I do not have an enduring power of attorney but should get one.

Friday, September 25, 2009

Property purchase update #1

I have finalised the plans and quotes for the renovation of the new property purchase . I had to restrain my overly enthusiastic contractor/designer who had had urges for a much more ambitious project than I did. This is a rental project, not own use, and there is no point in spending money that is not going to be recovered through enhanced rental income.

When I signed the agreement, I negotiated multiple pre-completion visits. This will enable the building contractors to do all the measurements and start work immediately after completion (instead of taking 1-2 weeks to do the measurements etc.

I have also signed the formal sale and purchase agreement and had the lawyer check the title and the body corporate rules.

I have submitted a mortgage application to DBS for a loan equal to 60% of the purchase price. This level of gearing was selected because it will give me a small positive cash flow on a 20 year P+I mortgage with headroom for interest rates to rise to 3% and assuming that the property is rented at the mid-point of the agent's indicative rent. Of course, if interest rates remain where they are, I will have a positive cash flow even at the lowest rental level.

I also have to sell some of my equity investments to fund the rest of the purchase price, pay the stamp duty and other closing costs and fund the renovation - I do not have enough cash on hand. I'll make a decision over the weekend but am leaning towards selling all of the actively managed funds. With the increase in the number of relatively low cost ETFs, the justification for paying the higher MERs of actively managed funds is becoming very marginal.

Completion is due on 8 October.

Thursday, September 24, 2009

10 percent penalty

Well this just sucks. I own a couple of small properties overseas. Every year the local council sends me the annual demand for rates (property taxes) and every year I send them a cheque. This year things did not go according to schedule. I sent the cheque in good time but have just received a couple of letters telling me that I have not paid the rates and have been assessed for a 10% penalty. I checked the bank account online and the cheque has not been presented so I have to assume that it never arrived at its destination.

I've sent off a replacement cheque for the original amount together with a politely worded plea for leniency which, having previous experience in dealing with the self serving blood suckers on the local council, I expect to fall on deaf ears.

Wednesday, September 23, 2009

Life insurance - how much?

My post summarising in very simple terms the three main types of life insurance concluded that term life is useful if you have dependants but that whole of life and investment linked policies are wealth destroyers and should be avoided like the plague.

James pointed out that I had not addressed the important question of how much life insurance is needed.

So how much insurance is needed?

There is no universally correct number however the following may serve as a starting point:

If you have no dependants

If you have no dependants (or people you wish to benefit in the event of your death to an extent that exceeds the net assets of your estate): zero - you do not need any life insurance.

If you have a spouse/significant other but no children

If either (i) your spouse is financially independent through employment or other means or (ii) your estate (net of debt) will provide sufficient wealth to meet his/her financial needs, the theoretical answer is that you do not need life insurance. That said, a discussion with your spouse on the subject would be in order - you may conclude that a policy sufficiently large to pay off the home mortgage and any other debts is appropriate - especially if those debts could not otherwise be met out of the estate.

If your spouse is wholly or partly financially dependant on you, then things get a bit more complicated. The correct amount of life insurance is an amount which when aggregated with the net value of your estate (i.e. after paying off the mortgage and other debts) will be sufficient to sustain your surviving partner in the same life style as at present (or something acceptably close to it) for life. The ability and willingness of a non-working spouse to (re)enter the workforce, age and other factors will all affect the number that comes out of this exercise.

If you have children

If you have children, the bottom line is that you should provide through a combination of inheritance and life insurance, sufficient funding for them to become functional independent adults. Notwithstanding my father's opinion that this does not happen until the children reach at least 40, I would normally settle for ensuring that their cost of living, education costs etc are covered until they have completed an undergraduate degree. Anything beyond that is nice to have but not a necessity.

Once the children are grown and financially independent, life insurance to benefit them becomes optional.

Adding it up

The aggregate needs of a surviving spouse and children (net of estate assets) is the minimum amount of term life coverage I would consider necessary. Anything less may involve subjecting your surviving family members to undesirable financial constraints. Anything more, and you need to weigh the cost of the premium against the additional payments to your family.

What if the insurance premium is too great an expense?

Then you will need to accept that you cannot provide for both your spouse and your children in full and will need to make some compomises. If you have to make compromises, I would prioritise as follows:

first: discharge of any mortgage or other debts which cannot be met out of the estate

second: educational expenses for children (to be held on trust)

third: enough money to support your spouse for a year or two while he/she adjusts and/or finds a job

Annual review

An annual review is in order. As the children grow older, your spouse grows older and you accumulate assets, the amount of life insurance needed will usually decline (absent other factors). You may eventually reach the stage where it is no longer necessary and you can save yourself the expense of further premium payments.

My own situation

Until recently, our life insurance needs were relatively modest. My spouse was working and able to support herself and our children if the mortgage had been paid off. So I took out a term life policy which (i) would discharge the home mortgage and (ii) would leave small legacies to my siblings (based on love and affection rather than financial need). Under my estate my wife would take our current home and the previous home while the remainder of my estate would be held on trust for our children. Given my wife's earnings and the value of the estate, it was not necessary to provide life cover for our children.

That position has now changed. Mrs traineeinvestor has resigned from her job so that one parent can stay at home to deal with school work etc (she is still negotiating a finish date). Also, I drew down against the home mortgage to fund an investment in my employer which means that the life policy would not cover the home mortgage any more. Accordingly, I need to increase the amount of cover. My wife and I are working through the numbers but the likely outcome is that I will need to double the size of the cover when the policy comes up for renewal.

Monday, September 21, 2009

Equity put options written

The equity put option I wrote against China Construction Bank (939) expired unexercised.

This morning I entered into two new contracts against China Construction Bank (939) and Hutchison Whampoa (13). Details are as follows:

Underlying: China Construction Bank (939)
Market price: $6.46
Strike price: $6.21
Valuation date: 19 October, 2009
Maturity date: 21 October, 2009
Implied yield: 9.43%
Net purchase price if exercised: $6.16

Underlying: Hutchison Whampoa (13)
Market price: $56.45
Strike price: $54.80
Valuation date: 19 October, 2009
Maturity date: 21 October, 2009
Implied yield: 12.15%
Net purchase price if exercised: $54.23

If I get hit I will have effectively purchased the shares at about a 4.6% (CCB) or 4.0% (HWL) discount to the prevailing market price. These are both shares which I am happy to hold long term if I get hit.

Amvig - loss taken

I spent some time over the weekend running the numbers on Amvig after the shocking asset sale and share repurchase announcement.

Concluding that the proposed share buy back was an incredibly bad deal for shareholders was a no brainer - paying a massive 29% premium to the market price before the deal was signed was, in my view, indefensible. The explanation (that it was linked to the price paid by the vendor when it originally subscribed for the shares in 2007) was not a reason for the pricing but, in my view, an admission that they did not have a basis for pricing the repurchase so high.

Such a stupid explanation also sends a pretty clear message to shareholders and I really have to wonder what on earth the directors were thinking when they put this deal together?

Given that the deal is subject to shareholder approval, and that neither of the two largest shareholders can vote, there must be a reasonable possibility of the deal being voted down by shareholders. Given the fall out from the announcement, it would not suprise me to see the directors move into damage control mode and issue further announcements.

The whole issue of the repurchase price overshadows the issue of the whether the asset sale was in the best interests of the shareholders and the interim results which came in below market expectations.

The next question was whether I should bail out now, take the loss and move on or whether the share price had dropped to a level where it represents a good investment.

At present price levels I would probably conclude that the stock may represent good value (it is trading at the post announcement price target set by Credit Suisse). However, this transaction has pretty much destroyed my confidence in Amvig's board of directors and management and I have decided to sell on that basis. At an average sale price of HK$3.83 I have taken a 19% loss on this investment.

I was tempted to keep one board lot of shares for the sole purpose of being able to attend the EGM and put some rather blunt questions to the directors but decided I had better things to do with my time.

As a side note, ASX listed Amcor is the controlling shareholder of Amvig. After this affair, I would not invest in Amcor either.

Friday, September 18, 2009

Amvig Holdings - an investment that went wrong

I purchased Amvig at $4.71 back in early June. In the weeks that followed the shares increased by about 35%, peaking near the end of July. They then started dropping until 10 September when trading was suspended for a few days. Trading was resumed after the company released its results - results that were materially below market expectations - and announced a conditional sale of one of its operating subsidiaries. Since then, the share price has fallen significantly and brokers have been tripping over themselves to come out with downgrades on the stock (too late to be useful as usual).

Leaving aside the fact that the stock fell significantly ahead of the suspension and results announcement - at a time when the market was rising, I need to consider whether I should take the loss and move on or keep my investment.

I am particularly concerned at the proposal to repurchase a substantial block of shares at $7.00 each which represents a huge premium to the share price at the time the shares were suspended and a ludicrous 67% premium to the prevailing price of $4.19. Given these numbers, my initial reaction is that the deal is highly damaging to the interests of shareholders and there is a good chance that the shareholders will vote down the proposal.

I need to spend some time getting my head around the terms of the sale and the impact on future profitability per share before making a decision.

Thursday, September 17, 2009

Life insurance

At its most basic, life insurance is a very simple contract that represents a wager on when a person will die. From the perspective of the person taking out the contract, the purpose of the contract is usually to provide financial protection to dependent family members in the event of death of the insured. From the insurance company's perspective, it is a business that relies on a combination of life expectancies of a number of policy holders and investment returns on the premiums to generate a profit.

Where life insurance gets complicated is the variations (and the ridiculous and archaic legal documents which I will ignore).

Life insurance comes in three basic forms which can be summarised as follows:

1. term life: you pay a premium and if you die during the term of the contract (usually annually), the designated beneficiary will be paid the face amount of the contract;

2. whole life: you pay a recurring premium and are insured for life with the added benefit that if you are still alive when you reach a specified age, the policy will mature and you will be paid a guaranteed minimum cash value. There are several variations to these types of policies and the other forms of permanent life cover such as universal life cover and limited pay;

3. investment linked insurance plans: these are essentially a whole life insurance contract bundled with an investment savings scheme and sold as a single product.

As a general proposition, if you need to provide for dependants in the event of your death, a term life policy is a good idea. It's cheap and you are not locked in for more than the term of the contract. The downside is that your premiums are not fixed (they may go up each year) and the insurance company is not obliged to offer you a renewal each year (although some will commit to doing so).

Whole life is is generally a bad idea because the premiums are higher, the rates of return are awful and there is a lack of flexibility - you will lose a lot of your money if you cancel the policy before maturity. As a general proposition, you can achieve a much better result by taking out a term policy every year for as long as needed and investing the difference elsewhere.

An investment linked insurance scheme is almost always a bad idea. Term life renewed annually with the difference in premiums being reinvested should produce a much better result.

The key message is that insurance should never be viewed as a form of investment. Put differently, if whole life and investment linked polices where such great investments, why would insurance companies engage an army of people to sell them? The agents who sell policies earn massive commissions from the sale of whole life and investment linked polices - commissions which come out of the policy holder's pocket.

If you ever have the misfortune to be cornered by someone peddling whole life or investment linked policies, just asking two simple questions will demonstrate why these things are the modern equivalent to the medieval practice of buying indulgences:

1. how many years before I can surrender the policy and get back at least the total amount which I have paid in? You will either be given a number which will horrify you or be fobbed off with some nonsense about it being a long term plan;

2. how much commission will you get out of it? You will either be told a number which is close to a year's premiums (there is some variation here) - and remember that this is your money. Alternatively, they will shamelessly dodge the question.

The thing to remember about life insurance is that it is a tool to protect dependants in the event of your death - it is not a form of investment.

Wednesday, September 16, 2009

Resources for personal finance and investing

I reader asked me about what resources I use to help with my finances. The short answer is a lot. In fact I spend far too much time surfing the internet and doing finance related reading when I could be doing more productive things. In any case, here is a list of my most frequent reads (or, if not read frequently, the ones I consider to be the most useful):

General personal finance - forums and aggregators

PFblogs. This site aggregates a very large number of personal finance and investment blogs. I tend to visit almost daily.

Bogleheads. This is for those who follow the John Bogle philosophy of keeping costs to a minimum and investing in a mix of low cost index funds with periodic rebalancing. I'd subscribe to this approach if I could access such funds from Hong Kong. Even with limited access to such products, this is still worth an almost daily visit.

Early Retirement. A forum for people who have or wish to retire early. Excellent reading for both motivational and more practical purposes. The retirement calculator is an excellent tool.

The only issues I have with these are (i) there is a lot of stuff which is of limited interest to me and (ii) they are (understandably) very US centric. All three sites are worth visiting often, but I frequently find myself spending too much time there.

A word of caution - while there are a lot of great blogs and other websites out there, there is also a lot of material which is either wrong or dangerous.

General personal finance - blogs

Millionaire Mommy Next Door. Written by Jen Smith, a self made millionaire who retired very early in spite of starting on a low income. Ms Smith's story and her postings cover many important personal finance issues in a clear no-nonsense style.

7Million7Years. Written by entrepreneur Adrian Cartwood, who went from having a negative net worth to more than seven million in the bank in the space of seven years. Very different from a lot of other writers, the author provides a very refreshing and welcome approach to achieving financial independence.

The Simple Dollar. If I had to pick one blog to recommend to people who were just beginning to manage their finances, this would be the one. Although I have outgrown a lot of the postings, it is worth visiting for the book reviews alone.

These are my three favourites. There are some other regular reads listed in my sidebar.

Hong Kong real estate

Centanet. I primarily use this for looking at transaction records when buying or negotiating lease terms

HSBC property valuation tool. A number of banks have these on-line valuation services. They tend to be conservative, but will generally give a good benchmark for calculating the maximum amount which a bank will lend against the property. I also use this for keeping track of the value of the portfolio

SCMP Property Post. A bit limited but it gives me an idea about what is going on in the market

Walking around and visiting show flats for new buildings. Having purchased from a Hong Kong property developer once, I have no intention of ever repeating the experience. The main point of these visits is to remind myself that the secondary market represents better value (and to get decorating ideas).

Taking the time to look at properties every few months. There is no better way to know the market than to get out there and look around.

Talking to investors (professional and private). Usually a worthwhile exercise (and generally more interesting than most of the other conversations that come up).

There are much better Chinese language sources - unfortunately, I do not read Chinese

Hong Kong stocks

Bloomberg. Although I do not have access to a Bloomberg terminal, I can get some of the feeds on a delayed basis through my bank. This is a good source of leads for stock research.

Reports provided by contacts at brokers and private banks. I view broker reports with a high degree of suspicion. Again, they are a useful source of leads for further research.

HKEX. This enables me to read recent announcements, annual and interim reports etc for all HK listed companies. Other stock exchanges provide similar services.

Finet. A HK financial portal. There is a reasonable amount of useful information on this site.

I tend to avoid talking to people about stocks or frequenting stock chat forums - it's too easy to get caught up in the herd and too much time is wasted reading rubbish.


Ten favourites are listed here .

Books on economic history. The more I read about this subject the more comfortable I am with my handling of my finances - probably a bad sign.

Newspapers and magazines

The Economist. The best magazine for global financial and economic commentary. We subscribe to this.

The Financial Times. It's a UK paper and I am neither from the UK nor do I have any substantive investments there. However, it rivals the economist as one of the best sources of commentary on global financial and economic issues. We recently decided to subscribe when access to a free copy got cut.

SCMP. Hong Kong's leading newspaper. SCMP contains good coverage of financial issues with (as you would expect), a focus on Hong Kong and greater China.


Fuller Money. Although predominantly chart focused, there is a huge amount of very useful material - enough to justify a subscription. Even if you do not want to subscribe, the free abbreviated comment of the day makes interesting reading.

Merrill Lynch Cap Gemini World Wealth Report. This report comes out once a year. Leaving aside the voyeuristic statistical data, the high level insights into how the wealthy manage their money makes this mandatory annual reading for me.

Barclays Wealth. The Insight reports make very good reading.

People - the most important category

My parents - who taught me that money does not grow on trees and exposed me to the financial world at an early age.

My long suffering wife - who shares many of my values and puts the breaks on some of my more reckless ideas.

A wide group of friends, colleagues and mentors who provide both ideas and informal brain storming sessions.

The people component has been the most incredibly valuable resource in my financial journey. I seriously doubt if I would be as close to achieving financial independence without them.

Other suggestions welcome.

Tuesday, September 08, 2009

Ten favourite finance and investing books

Over the last 20+ years I have read a lot of books on personal finance, investing and related topics. The following is a list of the the ten books which I have found most useful and/or interesting. I could easily list a lot of other books which I regard as excellent, but have arbitrarily limited myself to ten.

The ten books selected cover what I consider to be the four of the seven main areas relevant to people concerned about their finances. The fifth area (biographies) is not represented - as much as I enjoy reading about the successes of others, such books provide much less in terms of assistance with my financial management than books on the other topics listed below. The sixth (tax) and seventh (estate planning) topics are not represented either. A combination of Hong Kong's relatively simple tax regime and the lack of books on estate planning in Hong Kong make inclusion of books on these important subjects either immaterial or impossible.

The basic criteria for selection is personal preference. I'm sure others will have different views.

Personal finance

The biggest issue I have with a lot of the literature on personal finance is that it is heavily focused on issues which are relevant to US investors (particularly on the tax side).

The Millionaire Next Door (Thomas Stanley and William Danko): this is the best book on the live within your means principle that I have read.

The Automatic Millionaire (David Bach): a basic guide to the need to and benefits of paying yourself first, saving early and often and paying down unproductive debt.


One of the issues I have with a lot of the literature on investing is the assumption that a range of low cost index funds are readily available. Until 2000 when the Hong Kong Tracker ETF was listed such funds were generally not available to Hong Kong investors. Things have improved since then, but the range of low cost funds is still limited and the MERs of what funds are available are higher than US investors in the likes of Vanguard are used to paying.

Missing from the list are books about investing in real estate. I have not found such a book on Hong Kong real estate and other books on the subject tend to be country specific.

The Four Pillars of Investing (William Bernstein): writing on personal finance and investing does not get much clearer than this - for most people low cost index funds covering basic asset classes and periodic rebalancing will produce the best returns. The author also gives some history lessons and a short course in behavioural finance.

The Only Guide to Alternative Investments You Will Ever Need (Larry Swedroe): covers most of the alternative investments available to investors and explains in very clear language which ones are worth considering and which ones should be avoided.

Where are the Customers' Yachts? (Fred Schwed): one of the earliest lessons on the conflict between the interests of the brokers and the interests of their clients.


Notwithstanding the current popularity of criticism of classical economics, understanding economics is helpful when making investment decisions.

The Origin of Wealth (Eric Beinhocker): one of the best books I have read. Excellent. Among other issues, this book explains why so few companies out perform for long periods of time.

Your Money and Your Brain (Jason Zweig): a basic introduction to behavioural economics. A useful self help book in the sense that it gives you the knowledge to avoid doing a lot of dumb things with your money. I wish I had read this before I invested in a Vietnam equity fund near the top of the market.


It seems that every bull market/bubble throws up a new generation of investors who believe that "this time it is different". Even a basic reading of economic history should be enough to cure people of this delusion.

The Great Crash (J K Galbraith): A concise history of the stock market crash of 1929, the events which preceded it and the depression which followed.

Against the Gods: the Remarkable Story of Risk (Peter Bernstein): a history of risk in business and how it is perceived and managed.

Anatomy of the Bear: Lessons From Wall Street's Four Great Bottoms (Russell Napier): a look at bear markets and how they end. A little bit dry, but still an excellent and worthwhile read. This book was at least partly responsible for putting most of my cash into the market between October 2008 and May 2009.

Some books which I really should get around to reading:

A Random Walk Down Wall Street (Burton Malkiel)

When Genius Failed: the Rise and Fall of Long Term Capital Management (Roger Lowenstein)

I was tempted to write a post on the ten worst or most overrated books I have read but I'd prefer not to get sued.

Monday, September 07, 2009

Options - What I use them for (2)

My previous post looked at writing put options as a means of enhancing yields on cash and forcibly buying the dips. The other use of options is as a speculative investment - either buying call options to benefit from an anticipated rise in the price of the underlying asset or buying put options to benefit from an anticipated fall in the price of the underlying asset.

Why use options instead of buying the underlying?

Options provide a degree of leverage. Put differently, you only have to invest a smaller amount of money to give the equivalent exposure to a much larger amount of money invested directly in the underlying. When you buy an option, you only have to pay the premium - you do not have to pay for the underlying unless and until the option is exercised (which may be never).

Another way of looking at investing in options is that you have limited downside (the premium) but greater and theoretically unlimited (or much less limited) upside. Investing $100 in options has the potential to produce a much bigger return than investing that same $100 in the underlying asset while only risking, at most, that $100.

What's the catch?

You can't get something for nothing. The sum of the premium on a call option and the strike price will always be greater than the market value of the underlying asset at the time the option is purchased. This means that even if the option ends up in the money (i.e. the underlying is worth more than the strike price), an investor can still lose money. Put differently, the price of the underlying not only has to move in the right direction, but it has to move by enough to make the investment profitable.

The other catch is time. Options have a finite life. As they get nearer to maturity, all other things being equal, the value of the option will decay. If you buy a call option and the price of the underlying remains unchanged, the value of the option will fall. Where the strike price remains above the underlying share price at expiry, the option will end up being worthless and an investor will sustain a total loss of the original investment.

An investment of $100 in options is much more likely to suffer a 100% loss than the same $100 invested in the underlying asset.

To use a recent example, the call warrants (options) I purchased over Hutchison Whampoa on 24 July are currently worth about 14% less than what I paid for them. The same investment in shares of Hutchison Whampoa would have shown a loss of about 6% over the same time period. Of course, these warrants do not expire until 19 July 2011 so I still have some time for the underlying to move sufficiently in my favour to make a profit. If this does not happen, then I risk losing the entire investment.

Needless to say, I only put very small sums of money into buying options.

Tuesday, September 01, 2009

Options - what I use them for (1)

I use options for two purposes:

1. yield enhancement: discussed below; and

2. speculative trading: discussed in the next post in this series.

What I do

I write put options against cash deposits. These are commonly called equity linked deposits (where the underlying is listed ETFs or shares) or currencies (where the underlying is a currency).

A recent example is here. I was paid a premium equivalent to HK$0.15 per unit. In return for receiving the premium I have agreed to buy the underlying units in the Hong Kong Tracker fund for HK$19.58 on the maturity date. If the price of units in the Hong Kong Tracker fund is below HK$19.58 on the determination date (two business days before the maturity date), I will have purchased the units at an effective price of HK$19.43 (HK$19.58 - HK$0.15). If the unit price is above HK$19.58 I will get back my deposit (as well as keeping the premium).

Why this is generally considered to be a bad idea

Fat tails is the technical term. I am receiving a very small amount of money in exchange for taking a big risk. If the market drops 20% I would end up losing (about) 15% of my investment. There have been months when indexes have dropped by that much or more. For individual stocks, the downside risk is even larger - the shares of a single company could go to zero. In contrast, the upside is limited to that small premium. In simple terms, I am taking a small certain gain in exchange for a potential large loss.

(You can also write calls - the risk/reward analysis depends on whether the calls are covered (you own the underlying) or naked (you do not own the underlying).)

Why I do it anyway

Asset allocation. Risk management. Buying the dips. Yield. Combating inflation.

Like most investors I have some of my assets allocated to cash rather than in equities or real estate (which are my main asset classes). In part this is by default (cash comes in each month from both my job and my investments). In part it is by choice - having some cash reserves is a good thing. Cash in the bank currently yields zero or as close to zero as makes no difference. By writing equity or currency linked options I and achieve annualised yields of anything from 2-3% up to more than 40% depending on how aggressive I want to be. I usually go somewhere in the middle.

So I am earning a lot more on my cash than I would just leaving it in the bank. But I am also taking risk. Given the volatility of the market it is inevitable that I will get hit (have an option exercised against me) at some stage. That is a risk which I (try to) manage as follows:

1. I only write options against assets I would be willing to hold as long term investments - index funds, blue chip stocks and currencies that have a role to play in my long term asset allocation. I am not going to end up owning something which I have no wish to own;

2. I only write at prices which (net of premium) represent a discount to the prevailing market price. If I get hit I am effectively committing to buying the dips;

3. I have cash coming in each month from my savings and investments and keep enough cash uncommitted to ensure that I will always be able to meet my obligations even if I get hit on all my open positions at once. Put differently, I am in a position to replenish the cash position if the need arises. Also, I am not going to end up in a position where I have to sell a loss making position in order to meet my obligations.

For me the incremental returns are worth the risks involved. I would rethink this strategy if (when) the market starts looking over materially valued - the higher the market the greater the risks.