NZX pins hopes on electronics to fire local options market

Geoff Brown

Goldman Sachs JBWere and sharemarket operator NZX have high hopes that a new electronic market-making facility will be the catalyst for a viable market in New Zealand stock options.

Share options based on the New Zealand market's biggest and most heavily traded stocks relisted on the Sydney Futures Exchange last year but did not trade for want of firms accredited to deal in them and for the lack of an effective and transparent pricing mechanism.

Previous attempts to establish viable options markets on New Zealand stocks have all fizzled.

But Goldman Sachs JBWere has now been accredited to trade and settle options, and Australian market-making firm Optiver has linked live to the Sydney Futures Exchange and has been quoting Telecom option prices for several days, although they have yet to trade. Prices for Fletcher Building, The Warehouse and Contact Energy are expected to follow shortly.

Goldman Sachs derivatives manager Greg Boland said previous attempts to develop a viable options market for New Zealand stocks had been dogged by pricing difficulties.

"In the past there was no dedicated market-maker. You'd ask a broker to try and get a price and it may have taken all day," he said. "Now the market-maker with an electronic system can continually quote prices throughout the trading day."

A market-maker is essentially a trading firm that continuously offers buy and sell prices.

Pricing and processing orders for options can be extremely difficult according to Boland, a veteran of derivatives markets.

At any one time the market-maker will quote buy and sell prices for options on bundles of 1000 shares, with nine strike points at 25c intervals for each call and put option and four different quarterly expiry dates. That means up to 144 prices have to be recalculated each time the underlying security's price moves.

"Electronic market making should be catalyst for the market," said Boland. Since the ASX adopted an electronic market making system about four years ago, trading volumes in options had doubled to about 20 million contracts annually.

NZX head of markets Geoff Brown viewed Goldman Sachs' capability to execute trades and the prices created by the market-maker "live and on the screen" as "huge headway" for viable New Zealand stock options trading.

Brown was hopeful the prices offered for options would become more competitive and therefore more attractive to investors and that other share broking firms would follow Goldman Sachs' lead and become accredited to deal in them, giving the fledgling market some momentum.

Although options may have traditionally been viewed as a speculative tool for investors who want to bet on movements by buying puts or calls, Brown said the NZX was keen to promote them as a protective or income-enhancing tool.

That was a view echoed by Goldman Sachs' chief executive, Lance Jenkins, who said there were two key drivers for his firm offering options to its increasingly sophisticated retail clients.

"To enhance income for those who already own shares if we've got a flat view on the market, or to protect the value of the shares if the client is concerned about short-term downside."

Goldman Sachs was in the process of talking to its clients about the benefits of options.

The firm's head of private client wealth management, John Cobb, was convinced of the viability of the options market. "We wouldn't have gone about investing significant capital and resource in this business if we didn't think there was some good volumes to be had."

However, Jenkins was expecting the business to grow relatively slowly.


Options, the basics

A share option is the right, with no obligation, to buy or sell a specified quantity of a share at a fixed price (the strike) on or before a specified future date (the expiry).

The right to buy shares is a "call option", and the right to sell them is a "put option".

A call option is "in the money" when it would be profitable to exercise, ie, when its exercise or strike price is below the market price of the underlying security. A call option is "out of the money" when its exercise price is above the market price of the underlying stock.

For instance, the June 2006 $5.00 Telecom call option gives the owner of the option the right to buy Telecom shares for $5.00 each in June. Because Telecom shares closed on Friday at $5.31, these options are "in the money".

A put option is in the money when the exercise price is above the market price of the underlying security.

Buy and write: The owner of a stock writes or sells call options on their holding, giving someone else the right to buy their shares at a specified price on a specified date. The stock owner receives income in the form of the premium paid for the option. However if their stock rises above the strike point they are obliged to sell it to the call option buyer who then benefits from the difference between the strike price and the higher market price minus the premium.

Downside protection: By buying put options, the owner of a stock can lock in the value of their holding at the strike price minus the premium.