Low Exercise Price Options Explanation
Low Exercise Price Options or LEPOs were first introduced onto the Australian Stock Exchange in 1995. The instrument allows for the underlying stock to be traded on margin due to its unique characteristics. The low exercise price, ability to utilize margins and leverage mean that LEPOs offer distinct advantages compared to standard stock trading. Currently, there are 100 different LEPOs available for trade on the ASX.
LEPOs have an exercise price of AUD 0.01 and have the standard contract size of 100 units. This low exercise price means that the premium of the LEPO tracks very closely to the actual underlying asset, as the option is always deep in-the-money. LEPOs are European type options, meaning they can only be exercised on a set date, which may be beneficial for sellers of LEPO contracts. LEPO expiration dates follow the standard option calendar. LEPOs are also only available as Call contracts.
Traders can also utilize margin to trade LEPOs. The buyer and seller of a LEPO needs to post a margin for the life of the LEPO and only needs to pay the balance of the premium if and when a trader exercises the contract. Being able to use margins means that trading LEPOs is cash efficient as only margin is posted and allows for leverage.
Traders can post non-cash collateral against margins such as stocks or bank guarantees. Compare this to the purchase of stock, a trader of a LEPO can efficiently trade a stock due to the LEPOs characteristics and have resources left over for other investments.
Risks for LEPOs traders include margin calls and leverage exposure. LEPOs are subject to daily Mark to Market calculations which revalues the position daily and settles any differences to the margin in cash. This means that traders need to have enough resources available in the case of sudden movements against a position. Over leveraging can leave a trader exposed to larger than anticipated losses.
Overall, LEPOs are a unique instrument that allows traders to trade the underlying asset on margin. The ability to use margins is resource efficient and allows for leverage. This means that LEPOs offers an alternative to borrowing cash to purchase shares. However, traders of LEPOs should be aware of the margin requirements and risks associated.
Michael West is a business analyst with a keen interest in stock markets and deriatives. Michael holds a Masters of Business and writes for a number of financial publications.