The MONEY WHAT'S HAPPENING Desk

Welcome to the February edition of MONEY WHAT's HAPPENING. Thank you for subscribing to our newsletter.

With volatility in the markets, inflation pressures ever more visible and interest rates rising these are interesting times. Whatever the state of play of our economy, we trust that the articles provided by our clients will prove interesting, informative and educational.

We hope you enjoy reading the articles and invite you to pass this newsletter on to your friends and colleagues. We welcome your feedback and any suggestions that you may have for future articles or topics.

Finally, a warm welcome to our many new subscribers, in the coming months we will present articles on finance, investment and managing your wealth.

In this issue:

Exchange Traded Options - Optionetics
Global Factors affecting Crude Oil Pricing - Commodity Warrants Australia
Banks vs Brokers - Australian Property Investor magazine
Self-Managed Superannuation Funds - WLM Financial Services Pty Ltd

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Spreading your options for less risk and better returns

Most investors that discover exchange traded options are attracted by the concept of high leverage with limited risk. Indeed options do offer this attractive combination. For example an investor looking to speculate on a bullish (or bearish) view in any of the 79 option stocks currently listed on the ASX can do so for a fraction of the cost of buying the actual shares in the underlying stock.

Typically, an at-the-money option (meaning the option exercise price is close to the current share price) with around three months to expiry will cost less than five percent of the underlying stock price, depending on volatility. This will give the option buyer unlimited profit potential with the maximum loss limited to their original purchase cost of the option – not bad!

In reality, whilst unlimited profit sounds attractive, the likelihood of a big move in an option stock over a short period is usually low, especially to the upside. Therefore buying simple call or put options on a stock to take advantage of a relative small or slow move may not yield much of a profit since the long call and put strategies tend to perform best with strong moves over a relative short period of time. In addition, you need to consider volatility levels as changes in volatility on a long call or put trade can have a dramatic affect on your potential profits.

One popular options strategy for milder trending stocks is the vertical debit spread. This directional options strategy involves a combination of buying (going long) one option and selling (going short) another further out-of-the-money option of the same type and in the same expiry month. The vertical debit spread, also known as a bull call spread (bullish strategy using calls), and a bear put spread (bearish strategy using puts), are best employed to profit from a slower more sustained directional move in the underlying stock.

Below is a summary of both vertical debit spread strategies:

On the risk graphs above, the profit axis is the vertical axis, and the price level is on the horizontal axis, with the price going higher to the right, and lower to the left.

The jagged line is the risk graph of the trade at expiration. A risk graph is a visual representation of profit and loss potential of the trade, as well as breakevens. Given the shape, and the fact that the lines are both flat higher than point B and lower than point A (in the bull call spread chart), this trade has a limited profit and loss potential.

While vertical debit spreads offer limited profit potential compared to the unlimited profit potential of their long call and long put counterparts, they offer a number of other advantages that make them attractive.

Below are some of the advantages of vertical spreads over a straight long call or put:

Lower Cost/Risk

Vertical spreads offer a lower cost alternative to straight calls and puts. Because we are selling one option against another we are in effect offsetting part of the entry cost - and since the entry cost is the most we can lose on this strategy, we are therefore offsetting part of the risk. This is of particular benefit to new traders given they can typically enter a vertical debit spread for only a few hundred dollars per contract.

Less sensitive to time decay

The design of the vertical debit spread (one long option + one short option) means that the effect of time decay is mixed. Time passing will hurt our long option and it will help our short option resulting in a minimal effect on our trade compared to a straight call or put.

Less sensitive to volatility changes

Similar to time decay, the effect of a change in volatility is also mixed. A decrease in volatility will hurt the long option and benefit the short option. An increase in volatility will have the reverse effect, helping the long position and hurting the short position. Again the resulting effect will be minimal compared to a straight call or put.

Some other points to consider when trading vertical debit spreads are:

Make sure you are satisfied that the cost of purchasing the spread is worth the potential reward. The vertical debit spread will attract higher brokerage costs on entering and exiting than purchasing a call option outright since we are dealing with two different strike options instead of one.

Consider exiting the strategy once 80% of the maximum profit of the trade is reached. The last 20% of maximum profit requires a lot of extra time and price movement to achieve. If you expect extra move in the stock once 80% maximum profit is achieved, evaluate closing out the trade and placing another.

Depending on the time frame of your expected move in the stock, consider placing the strategy with at least 60 to 90 days until expiry and exiting with no less than 30 days until expiry.

In summary the vertical debit spread can be a handy addition to the trader's toolbox. It can help reduce the cost of a trade compared to straight calls & puts and therefore the amount of money at risk, and at the same time it is a great way to remove most of the time and volatility risk that new option traders sometimes find difficult to manage.

Wayne North - General Manager Asia Pacific - Optionetics

Optionetics is a leading trading education company specialising in low-risk, high-return option strategies. For more information on Optionetics or to attend one of there free options workshops visit www.optionetics.com.au 

a discussion by Peter McGuire - Commodity Warrants Australia

Crude Oil

Over the last decade global crude oil prices have been steadily rising with more than a 780% gain. Over the last six months alone, crude has risen over 50% and although the crude market experiences high levels of volatility, we find ourselves in a 'supercycle' in terms of a relatively sustainable upwards trend for prices.

The global market for crude oil is subject to a range of price drivers of varying impact and complexity that contribute to frequent price fluctuation. It is difficult to cover all factors affecting price; however there are generally three key drivers at play that positively or negatively influence supply and demand:

Geopolitical issues

The Organisation of Petroleum Exporting Countries (OPEC) and other international bodies in the energy sector can influence the supply of crude oil and therefore affect price. One of the primary OPEC functions is to stabilise crude prices through increasing or decreasing the level of supply through bilateral negotiations. Dually, tension and conflict in regions of high oil concentration can significantly effect on the supply of crude. For example, the combination of the Iranian revolution and the Iran-Iraq war led to the loss of 2 to 2.5 million barrels per day of oil production between November, 1978 and June, 1979.  This caused crude prices to more than double from $14 in 1978 to $35 per barrel in 1981.

Strengthening demand

As emerging economies such as Brazil, Russia, India and China (the BRIC economies) shift their energy requirements to keep up with rapidly increasing populations and industrial development, the level of demand for crude is increasing to the point where supply levels are diminishing at accelerating rates. For example, as population centres emerge in China there is increasing demand for energy to support their development. Similarly, as the emerging Indian middle class accumulate higher levels of disposable income there is greater demand for goods such as automobiles and consumer goods that use crude in their production.

Natural elements

Adverse natural events in production and refining areas affect supply levels, in turn affecting price. For example, the annual hurricane season in the United States affects one of the world's key refining regions. Not only is there physical damage done to rigs and refineries which affect production, but as international investors speculate on future price movements there is a flow through of positive or negative trader sentiment to the wider market. For example, in the aftermath of hurricane Katrina in 2005 crude spiked as the market accounted for damage done to physical assets.

Crude Oil - Price History Graph (Source, Bloomberg)

These statistics outline the performance of CWA Warrants
from inception in July 2005 - Dec 31 2007.

Average length of Warrant (Days)

Average length of warrant 84.81

% of Warrants that have had a Positive return at sometime during their life

% of warrants with positive return 69.03%

Average maximum return %

Average Max Earn % 34.69%

Average time to Max profit (Days)

Average time to Max profit 15.24

Peter McGuire - Managing Director - Commodity Warrants Australia    www.cwa.net.au
Peter is a regular commodities commentator on Bloomberg Television and CNBC and appears widely in the Australian financial press.

There are generally two ways to get a loan - dealing directly with a bank or using a mortgage broker. So which one is best? - Michael Moran

With more than 1500 investment loans available in Australia, finding the right loan can be challenging, even for a savvy property investor. Traditionally over the past 25 years, there have been two avenues for a property investor to search for an investment loan - dealing directly with a bank or using a mortgage broker.

What's the difference?

Working in conjunction with you, a broker should seek to determine your borrowing needs and ability, and shop around for you, selecting a loan suited to your circumstances. A broker should manage the entire loan process for you, all the way through to settlement. Banks, on the other hand, will also work in conjunction with you to determine suitable loan options, however they won't shop around for you.

Brokers are accredited to offer loans from certain lenders, which they call their panel of lenders. Lenders will normally range from the major banks through to mortgage managers and non-bank lenders. The size of a panel of lenders will vary from broker to broker and you can ask to view your broker's panel. Banks will only offer their specific products, so your options, when compared to dealing with a broker, are limited.

Banks can provide representative specialists for numerous finance areas. Likewise, brokers can also specialise in a variety of finance areas ranging from investment loans to business loans. In both cases, you'll benefit from dealing specifically with a bank representative or broker who specialises in the particular financial area of need.

Conflict of interest?

Is the loan that's best for you best for the broker or bank?

Typically, brokers are remunerated by the lender and receive an upfront commission and a trailing commission on the loans that they settle. It's important to realise that it's not standard industry practice for a residential broker to charge you for their service due to this remuneration arrangement; it's 'free' until you've signed the dotted line.

On the other side, bank representatives may receive a bonus if they meet required performance levels, however again there's no service or consultation fee.

You may save time when shopping for the right investment loan.

They should do all the legwork for you.

If they're independent they should be able to negotiate on your behalf against loan conditions such as exit fees, at your request.

Sometimes, given the broker-lender relationship, a bank will accept a loan application that they would otherwise have rejected.

Access to a wider range of loans, when compared to shopping for a home loan with a single bank.

Potential greater expertise as they focus on loans only.

Mortgage brokers make their money from commissions; so they may be inclined to sell you a loan specifically based on their commission.

They may only offer a limited number of investment loan products, hence it may not be the best available product in the market.

A number of lenders don't deal with brokers, meaning you could really be missing out on a great deal.

It has been reported that you can shave up to 70 basis points off your interest rate by negotiating directly with banks.

Convenience and benefits in banking with one institution.

You can shop around by yourself to find the best deal on the market, especially considering that a number of lenders don't deal with brokers.

Extra work and time for you to shop around for a home loan by yourself.

The number of loans offered by a single institution is more limited than brokers.

Helpful tips

Do your homework and research the market first so you're able to better assess the value of recommended loans and the quality of advice. Check out and use repayment calculators to work out repayment amounts.

Prepare a list of questions before your appointment with the bank or broker. When talking to a broker, you should ask what lenders are on his list and why these lenders are preferred.

Remember, don't pay upfront fees to brokers before credit has been arranged. This is illegal in the ACT, NSW and Victoria. Ask the broker about commissions paid to him by the financial institution. This includes trailing commissions.

Focus on your needs and explore all options when looking at finance products. Get your quote, plus commission details in writing.

For your own peace of mind, ask if the broker has professional indemnity insurance and check that the broker has a complaints process and is part of an external dispute resolution scheme, such as the Banking and Financial Services Ombudsman or Credit Ombudsman, which are ASIC-approved. This may sound unnecessarily pessimistic but it's always sensible to look after your own interests.

Remember, there's no rush. Don't sign anything you don't fully understand, and if you're in doubt, get independent legal advice.

Michael Moran - Michael Moran is a financial analyst with financial services research group CANNEX

© Australian Property Investor magazine - www.apimagazine.com.au. Reproduced with permission.

Setting up a SMSF - what to do

In the last newsletter we addressed some of the advantages and disadvantages of establishing and running a self-managed super fund (SMSF). If the decision is to set one up, one should be aware of what will be required.

There are a number of trust laws as well as legislative requirements in regards to setting up a SMSF.

The steps involved, as advised by the ATO and others, include:

Obtaining a trust deed

The first thing you need to do is to have a trust deed prepared, which evidences the existence of the trust and establishes the rules of operation for the fund. You should ensure that the deed is correctly drafted to achieve the fund's objectives.

The trust deed needs to set out many aspects, including: details of who the trustees are, how trustees may be appointed or removed, the powers of trustees, eligibility for membership, conditions relating to acceptance of contributions, conditions for payment of benefits to members, procedures for winding up the fund and provisions relating to valuation of assets. The deed must be dated and properly executed.

Appointing trustees

All superannuation funds are required to appoint trustees. Trustees are responsible for ensuring the fund is properly managed and that it complies with Superannuation Industry Supervision Act 1993 (SISA) rules and broader legal obligations. To be an SMSF all fund members must be appointed as trustees of the fund.

Essentially anyone over the age of 18 can be a trustee of a superannuation fund unless they are a 'disqualified person' under SISA.

All new trustees (and directors of corporate trustees) of a SMSF are required to sign a declaration, in the approved form, within 21 days of becoming a trustee or a director of the corporate trustee. The declaration aims to ensure that new trustees (or directors of corporate trustees) are aware of their duties and responsibilities under the super laws.

Electing to become a regulated fund

A trustee must elect to be 'regulated' under SISA if the fund wishes to receive concessional taxation treatment. The trustees of a new SMSF must within 60 days after establishment of the fund give the Regulator a notice of election to be a regulated superannuation fund.

Elections must be lodged with the Tax Office and once a trustee has elected to become regulated, the decision cannot be reversed (that is, the fund would have to be wound up to cease to be regulated under SISA).

Obtaining a tax file number (TFN)

A TFN is a unique number issued by the Tax Office for each taxpayer. The trustees of a superannuation fund must obtain a TFN for the fund from the Tax Office.

Obtain an Australian Business Number (ABN)

The ABN is the new public identification system introduced to support business to government interactions across all agencies. An ABN will be allocated to new superannuation funds that complete an Application to Register for the New Tax System Superannuation Entity form.

The next step would be to open a bank account in the name of the trustee as trustee for the SMSF. This will allow the fund to receive any new contributions and/or rollovers from other super funds.

Most SMSF's are regulated through the ATO. The ATO points out that people who wish to set up their own fund would find it useful to consult with a professional adviser before committing to this option. There are many advisers, accountants, solicitors and superannuation specialists who have packages and 'kits' available, which simplify the process.

In the next issue we will look at the financial implications of running a SMSF, including; what would be an appropriate sum to start with, what are the initial costs as well as ongoing costs and commitments.

As with any area of your financial affairs, consider all aspects and seek advice from professional advisers.

Laura Menschik - CERTIFIED FINANCIAL PLANNER TM - SMSF SPECIALIST ADVISER TM
WLM Financial Services Pty Ltd.
Visit the WLM Financial Group online wlm.com.au

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