Going through an option report can be overwhelming. The report is usually quite long. Options are complicated; selling options in particular can be rather counter-intuitive. In addition, different brokers have their own terminologies and formats to present option transactions and positions. For example, transfer price, traded price and opening price are all used to refer to cost price for accounting and tax purposes. Sometimes we can find detailed summaries on every single account, other times we have to rely heavily on cash transactions to calculate our own balances.
This article aims to find commonalities among option reports provided by various brokers, and discuss possible solutions in processing options.
In practice, option transactions may be mixed with equities and other derivatives in the same report. Some methods mentioned here could be useful for a more complex report as well.
Understanding cash accounts and their interactions
Potentially, there could be three cash accounts in a fund – one linked cash account for daily fund activities, e.g. Macquarie CMA, one option transaction cash account in the option report, and sometimes a cash margin account in the same report.
The option transaction cash account may settle trades frequently with the linked cash account, or get a large amount of cash injection initially and top-up amounts/withdrawals during the year.
It can be disorienting to see cash moving in and out from one account to another, especially when every trade is settled externally with the linked account. However, the only relevance of the linked cash account in deciphering an option report is its net cash flow to/from the option transaction cash account.
Creating a summary for an option report
We can summarise and process any large report into a few transactions by creating a set of mini financial statements for that report.
For balance sheet: Opening market value of portfolio + total movement in P/L = closing market value of portfolio
For P/L: Investment income – investment expense + realised capital gain/loss + unrealised capital gain/loss + cash contribution – cash withdrawal = total movement in P/L
“Cash contribution – cash withdrawal” is the net cash flow from the linked cash account mentioned above. When there is no summary on this net cash flow, it has to be calculated. Some reports provide a summary of accounts on the movement from the opening portfolio to the closing portfolio, which is tremendously helpful. When these account balances are not available, again, they have to be calculated.
In recording the total assets (opening/closing market value of portfolio), it would be easier to recognise cash and options as a whole. To recognise cash and options separately, effectively we need to create journal entries to bridge the opening cash balance and closing cash balance, which leads to another approach, constructing a mini cash flow statement. Under this approach, cash can be separated from other investments to achieve a better presentation.
Three potential outcomes of an open position
All option reports have a section on open positions. When an option contract is entered into, an open position is created. Options have a short life; an option may either expire, get exercised, or closed out. When there are open positions on 30 June, it means these are open contracts. Although there are uncertainties as to what would happen to these options, it is the cost to close out the options that is recognised as the market value on the fund financial report. To close out an open position is to enter into a contract with the exact terms but the opposite position. Both option buyers and sellers can close out their positions. The majority of the options are closed out rather than exercised.
Consider a call option buyer who bought 50 BHP option contracts. A standard contract size is 100, by entering into 50 contracts, he bought 5,000 options. The purchase price of each option is $1.2490, at 30 June, the market price of each option is $0.6150. The option buyer may sell the options at this lower price, close the position, and realise a loss on the assets. At 30 June, the market value of the options is $3,075 ($0.6150*50*100), unrealised loss is $3,170 (($1.2490-$0.6150)*50*100).
Most options traded on ASX are American style options; they can be exercised at any time prior to the expiry date. Index options are European style options; they cannot be exercised prior to the expiry date. However, they can still be closed out any time before exercised.
The primary tax code for options in a super fund is CGT.
At the time of entering into an opening position, option buyers will recognise an asset and realise a capital loss when the option expires. Option sellers derive a capital gain equal to the amount of premiums received (Section 104-40 ITAA 1997, CGT event D2 happens if you grant an option to an entity, or renew or extend an option you had granted).
When an option is closed out, a capital gain or loss arises at the time the equal and opposite option is entered into, equal to the difference between the premiums paid and received (Section 104-25 ITAA 1997 CGT event C2 – Cancellation, surrender and similar endings).
When an option is exercised, the exercise of the option and the acquisition or disposal of underlying shares are regarded as one transaction for CGT purposes. This means the premium received adds to the capital proceeds for call sellers, the premium paid forms part of the cost base for call buyers; the premium received reduces the cost base for put sellers and the premium paid reduces the capital proceeds for put buyers.
A complication is created for option sellers here, at the time of writing an option, the premium received is already taxed as capital gain. At the time of the option being exercised, the premium is taxed again. Section 104-40(5) removes this double taxation. It states that a capital gain or loss you make from the grant, renewal or extension of the option is disregarded if the option is exercised. So if we have previously recognised a capital gain from writing an option, we will need to reverse that transaction when the option is exercised.
When there is a cash margin account in an option report, it serves only one purpose, to provide collateral required to cover trades. The initial transfer-in of a cash margin will never go to the cost base or be reflected in the capital gain/loss, as the other side of the transaction is always just another cash account. All the actions are happening in the option transaction cash account.
When the money from the linked bank account goes through the trading account to the margin account:
Option transaction account $20,000
Macquarie CMA $20,000
Cash margin account $20,000
Option transaction account $20,000
When the money from linked bank account goes directly to the margin account:
Cash margin account $20,000
Macquarie CMA $20,000
When the money is transferred from cash margin account to the option transaction account:
Option transaction account $10,000
Cash margin account $10,000
The principal is the same as the way an external linked cash account interacts with the option transaction account, only the net cash flow is relevant. Any recognition of asset/liability or gain/loss is within the option transaction account.
Accounting for options written
When an option is written, the option seller receives a premium. In order to close out the open position, like an option buyer, the option seller will need to enter into an exactly equal and opposite position, which is to buy back an option contract of the same terms. When the market value of the option goes down, it is in favour of the seller, as it costs less to exit the contract. When the market value of the option goes up, the seller will make a loss. It can be confusing trying to understand the DR and the CR in this part of the report.
Using a BHP example again, the option seller sold 50 call contracts and received a premium of $1,172.50 ($0.2345*50*100). On 30 June, the market price for the options is lower than the cost. The option seller can buy back the same option at $300 ($0.0600*50*100), potentially realising a gain of $872.50 ($1,172.50 - $300).
When the premium is received:
At 30 June:
Unrealised gain $872.50
Derivatives that give charge over an asset of the fund must have a derivative risk strategy. Regulation 13.15A states that a trustee may give a charge over an asset of the fund only if all the four conditions below are met:
- the charge is given in relation to a derivative;
- the charge is given in order to comply with the rules of an approved body;
- the fund has in place a derivatives risk statement; and
- the investment to which the charge relates is made in accordance with the derivatives risk strategy.
A derivative risk statement is always required when there is a charge over an asset of the fund such as a margin account.
Vivian Bai, principal, Access Super Audit