The financial market is unpredictable and volatile; with the sudden ups and downs, any time the market can turn towards a new direction affecting the share prices and market demand. And if there is one thing that you can be sure about in the market, it is the price change. The price fluctuates in response to the economy, agricultural production, election results, and government policies, among other factors, which can lead to losses and profits for the investors.
To hedge market risks involved in the stock market, investors opt for financial securities such as derivatives contracts. Derivative contracts, like futures and options, derive their value from underlying assets, such as stocks, bonds, commodities, currencies, interest rates, and market indexes, etc. The contracts are signed by two parties as they transact a fixed amount of an underlying asset at a predetermined price on a later date.
However, since the price movements cannot be predicted, it can cause substantial profits or losses and only individuals who have a lot of knowledge about the operations of a stock market primarily participate in such trades.
What is a Low Exercise Price Option (LEPO)?
To avoid stamp duty on securities transactions, a call option was introduced in the Swiss Options and Financial Futures Exchange. By setting the exercise price near zero, it facilitated the equivalent of owning the share directly, except voting rights and dividends.
Following this European style call option introduced in Switzerland and Finland, in April 1995, the Australian Stock Exchange started listing a new traded option with a low exercise price, i.e., with an exercise price of 1%. This call option that is traded on margin is known as a Low Exercise Price Option (LEPO).
The Australian Stock Exchange (ASX) lists LEPO options on 100 ASX-listed companies.
Buying a LEPO
Similar to a standard exchange-traded call option, you get the right to buy an agreed number of shares at a specified future date, in return for the payment of the exercise price (1 cent per share or $10 per contract) and a premium. There are 1000 shares per contract.
Selling a LEPO
You sell the underlying securities at expiry in exchange for the exercise price and the premium amount at which the LEPO was traded in the beginning.
Difference between LEPOs and Standard Exchange Traded Option
LEPO is essentially closer to being a “deep in the money” tool, which means it has a strike or exercise price that is below the prevailing market rate of an underlying asset. LEPO has a normal strike or exercise price, while, at the point of its expiry date, the price of a share is usually higher than the exercise price.
The other notable difference between LEPO and Standard Exchange Traded Options are given below.
- You do not pay the full amount of the premium upfront for a LEPO. Instead, you only pay a margin and pay the balance of the premium if and when you exercise your LEPO.
- The buyer of a LEPO need not exercise the option. The LEPO trader can choose to close out at any time just before the expiry by selling the same series as initially purchased, or buying the same series as initially sold.
- LEPOs are only available as call options.
- Unlike the standard ETOs which are American style options that are exercisable at any time before expiry, LEPOs are European style options and are exercisable on the last trading day before they expire.
- LEPO have a low exercise price and a very high premium – close to the initial value of the underlying shares and the subject of the LEPO.
- Have only one exercise price per expiry month, unlike standard exchange traded options which offer a variety of exercise prices.
- Do not need a value equal to the full premium to be paid on purchase. Instead, the buyer pays a margin that represents a small percentage of the value of the underlying shares.
- Involve ongoing margin payments from both the seller and buyer of the option.
What are Index LEPOs?
As the name goes, an Index LEPO works on the principle of the underlying asset being the index itself. Here, the index value is derived from the market price of a selected list of major companies chosen on their performance and market capitalisation. Each Index LEPO is specified by the name of the index they represent.
Index LEPOs can be an attractive option for investors who are looking for a cost-effective solution. It combines the possibilities of both good returns and containing risk at an affordable price point.
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Benefits - Why should you consider LEPOs for trading?
LEPOs as a trading strategy has gained acceptance over the years. Here is a closer look at the features and benefits it offers.
✅ Easy to begin operations
A LEPO account may not be as common as other financial products but the account opening process is still easy enough. The minimum funds required to open it is also fairly low. There is unhindered access to the LEPO ecosystem too.
For anyone with an exchange traded option account, all it takes is to complete the standard documentation through a broker to start using it for LEPO transactions.
✅ A useful leveraging tool
Leverage is a widely used tool in the financial markets and it is relevant in the case of LEPOs too. In the stock market, the ability to leverage opens up opportunities to trade bigger and trade more.
For a trader who is looking to gain from the short term movements of a stock, leverage is a useful tool to have.
✅ Getting physical delivery of shares
Another useful advantage of LEPO is that, instead of cash settlement of a trade, the trader gets physical delivery of shares. This is particularly helpful for those investors who want the acquisition or disposal of physical shares that otherwise are not possible in all trades done.
✅ Exercisable only upon expiry
This is a useful edge that LEPOs have as they can be held on to till expiry. This means that the risk inherent in having to exercise before expiry is non-existent for those who prefer taking a position early on.
✅ An ideal substitute as a stock
LEPOs are somewhat like shares in that the price movements mirror that of the stocks in the market. The appreciation in the premium of LEPOs is similar to those of shares.
✅ Cost effective alternative
Due to the leverage feature available in LEPOs, these turn out to be cost-effective and this works out cheaper than borrowing to buy shares. Only the overhead charges like fees need to be incurred in cases where the securities have to be used pledged while borrowing. The exposure too is also much less as compared to actually investing in shares as they require a cash payout.
Risks
LEPOs come with their own share of risks.
❌ Market risks
LEPOs value is affected by a number of factors. Changes in the price of the underlying may lead to changes to the price of the LEPO.
❌ Effect of leverage
Even a small market movement can have a huge impact on the value of the contract and lead to huge losses.
❌ Market conditions and pricing relationships
The normal pricing relationships with market conditions like volatility or liquidity may not exist under certain circumstances and can increase the risk of loss by making it difficult to effect transactions or close out existing positions.
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What to Be Aware of While Trading LEPOs
So, if you have decided to trade LEPOs, what are some of the key considerations that you should be aware of? For instance, how should you track the value of the position you have taken? What are the tools and reports you need to monitor the performance of the LEPO you are trading in?
Besides this, there are a few other aspects you should be aware of.
Understanding the costs while trading LEPOs
Even though it takes 100 shares to make one LEPO contract, the cost in terms of brokerage is applicable not on the total shares but at a contract level. The charges could either be on the overall premium amount or levied at a flat rate.
Margins
The margin amount is applicable for the entire period of the contract. This is paid by both parties - the seller and the buyer.
Adjustments to underlying shares
As happens with standard exchange traded options, the adjustments with regard to any corporate event can alter or cause an adjustment to the underlying shares of the LEPO. This can be any bonus or rights issue or any other action that could trigger an adjustment in the holding.
Voting rights and dividend claims
But unlike in the case of any bonus or rights issue, a LEPO purchase does not give you a claim to any dividend payouts. Nor do you enjoy any rights to voting during that period. It is only after the shares are transferred in your name that privileges like voting rights and dividend claims can be valid.
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