Over the years, domestic stocks in Japan have been gaining popularity. However, as the nation establishes new diplomatic and business relationships with countries around the world, many Japanese investors are looking outwards into the foreign equity market to make a profit. Many have turned to trade options on foreign equities.
In this article, we will explore what equity options are, how they are traded, and how they are defined by the Tokyo Stock Exchange. We will also move on to discuss the pros and cons of trading foreign equity options in Japan.
- 1 What are equity options?
- 2 Where can Japanese investors trade equity options?
- 3 Defining ‘foreign equities’ on the TSE
- 4 Why are foreign equity options so popular?
- 5 The risks of trading foreign equity options
What are equity options?
Options are a type of financial derivative. It involves the use of an options contract, whereby the holder has the right to buy or sell a certain amount of the underlying stock at a predetermined price.
Depending on the option style, the contract should be exercised on its expiration date or within a specified period before its expiration date.
Where can Japanese investors trade equity options?
In Japan, the largest stock exchange that trades foreign equities is the Tokyo Stock Exchange (TSE). Transactions are carried out in the Japanese yen, minimizing currency exchange risks. Trading hours are split into two main sessions, the first one from 9 to 11:30 in the morning and the second from 12:30 to 3:00 in the afternoon.
Defining ‘foreign equities’ on the TSE
On the TSE, foreign equities are classified in two ways: there are ‘blue chip’ companies set up and listed in their home countries’ stock exchanges, and there are foreign companies that are listed only on the TSE.
Why are foreign equity options so popular?
Foreign equity options are popular in Japan for the reason that they carry several advantages.
1.) Portfolio diversification
Firstly, they offer Japanese investors a chance to diversify their portfolios by geographical area. This is because foreign equities are not directly related to the Japanese economy.
Therefore, if the Japanese economy does poorly for a period, investors that have both foreign and domestic stocks will not be at such a high risk of incurring huge losses.
2.) Ability to earn huge profits
Secondly, foreign equities offer investors in Japan the opportunity to invest in high-growth companies. Even though the Japanese economy is strong, there are in fact many up-and-coming companies with massive growth potential overseas.
These include tech start-ups in the US, as well as various commodity-linked companies in emerging economies in Asia and Africa.
3.) Equity options do not obligate traders to act
Thirdly, options contracts are not legally binding, unlike futures contracts. Options contract holders pay a premium to lock in a price, but they do not have to exercise the option if they change their minds.
This gives traders plenty of flexibility and room to find the best price on the open market while having a backup option.
On top of that, equity options contracts can allow traders to buy or sell shares. This means traders can bet on both bullish and bearish markets, doubling the opportunity to profit from their trades.
5.) Options are leveraged products
Additionally, options are a leveraged product. Leverage is a trading tool that allows investors to amplify their position sizes. Leverage is expressed in ratios, such as 1:10 and 1:20.
When investors trade foreign equity options, they can create positions 20 times as big for every share they buy or sell.
This can potentially maximize investors’ earnings greatly, as profits from options trades are calculated against the entire position size.
Finally, many of these foreign stocks offer higher dividends compared to Japanese stocks. This can be a draw for investors who would like to make a passive and steady income from their investments.
The risks of trading foreign equity options
All trading comes with risk and foreign equity options are no different.
1.) Equity options are a leveraged product
The first risk that comes with all options trading is the use of leverage. The ability to open much larger trades based on a small initial principal is appealing and can create great earnings.
However, if the markets move against an investor, their losses will also be calculated against the entire position. In extreme cases, losses may exceed the initial principal and the investor will owe their broker money.
2.) Lack of familiarity with factors that move foreign equities
Secondly, foreign equities are moved by factors that may be unfamiliar to Japanese investors. For example, the share price of a stock company in the US may be dependent on the health of the US economy and domestic policies.
Meanwhile, a Canadian mining company’s share price may be moved by the health of the Canadian economy and domestic policies.
This risk grows when traders are investing in equity options from multiple foreign countries. One can only keep a close eye on so many regional and national news outlets. Sooner or later, an investor may be overwhelmed and end up making hasty decisions on their trades.
3.) Options trading can be complex
Options function simply, theoretically. However, when it comes to using them, they may prove to be too complex for beginner traders. Along with the unfamiliarity with foreign equities, foreign equity options trading is not appropriate for novice traders at all.
4.) Risk of time decay
Finally, the biggest disadvantage to trading options is that it is essentially a race against time. Equity options contain a time value and expose the investor to time decay.
While a regular investor of equities has plenty of time to contemplate and gauge the market, an options trader is limited by when the contract expires.
They can certainly choose to abandon the contract and let it expire and become worthless. However, investors are often slightly reluctant to do this as they have paid a premium to obtain the contract.
Foreign equities trading is popular with Japanese investors, and it can be very lucrative when done right. Before trading, you should ensure that your broker provides options for trading and the stocks you would like to trade.
If you are unsure, you can always go with an international broker with a Japanese presence, such as Saxo Bank.
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