Using options to hedge

This paper was written to assist in the management of risk for those not qualifying for a government pension who manage their own investments as self-funded retirees.  Because of the appalling low interest rates one must invest in a variety of equities and interest bearing securities to secure even a very modest self-funded pension.

This paper is an introduction to options which facilitate hedging strategies that protect investors from sharp falls. It can be regarded as purely educational and general in nature. Readers should not rely on the contents which may not suit individual investors. When contemplating hedging or using options interested parties should always consult a licenced professional. The paper will support one tutorial at the University of the 3^rd Age devoted to the management of risk.       

Introduction      

Options are used for a wide group of securities classified under the heading of derivatives. A derivative is anything that derives its value from something else, in this instance for options, from the underlying shares or share indexes. They are only risky when used improperly for purely speculative purposes or in naked trading. In the 2008 Global Financial Crisis mortgage backed securities and credit default swaps caused most of the problems. Options were largely blameless.  

Used properly, options can be useful tools to facilitate modest hedging and gain a small additional income. You can hedge against individual shares or your entire portfolio by buying an index put.

Similarly rises can also be covered without the need to buy any more shares by buying an indexed call. Professional fund managers routinely use indexed options, aimed at enhancing overall returns.  The options market can also influence the share market.  

At the end of the paper is a glossary of terms as a reference point although my aim is to explain comprehensively along the way. 

Options Market

Buyers and sellers take market positions in the underlying shares according to their assessment of likely trends. Contracts are for 100 shares. In Australia daily turnover fluctuates from around 500,000 up to a million. Additionally there is about 40,000 daily trades in indexed options which are traded at much higher values. Contract size is 1000 points plus an investor multiplier of 10, meaning it’s effectively $10 a point.   Option trading can exasperate trends in share prices and their indexes.

This happens when share prices are very close to the exercise prices at close proximity to maturity. Traders then will engage in buying and selling the underlying shares to improve their option outcomes. These activities can sometimes move prices by 1% or more. You can also gauge market sentiment by examining the put-call ratio. This is an indicator ratio that provides feedback about the trading volume of put (sell) options to call (purchase) options. The put-call ratio has long been viewed as an indicator of investor sentiment in the markets. At the moment it is bullish. 

Options Terminology -Options Contract

An agreement between buyers and sellers defining such terms as the underlying security and the exercise (strike) prices. There are 2 contract types, namely European, whose underlying shares or index can only be exercised on maturity and those called American where exercisment can occur at any time up until maturity.  

Description: 79.01 CALL OPTION EXPIRING 28-MAR-2018
Underlying asset: COMMONWEALTH BANK.
Expiry: 28 Mar 2018
Exercise Price: 79.010
Exercise style: European
Open Interest: 2,624
Contract size: 100 securities
Commenced Trading: 26 Apr 2017 

·      Call Option explanation

The above Call option gives the holder the right to buy, but not the obligation, the designated number of shares at the exercise (strike) price of $79.01 which will mature shortly. The exercise (strike) price is the price a share must go to or move above it before a position can be exercised for a profit. However, in all cases, because of the unexpired tine value it makes more senses to sell the share before maturity. Typically this current option would have been bought many months before when the share price was closer to $79.01 than when a buyer expecting its price to increase. The option is very likely to expire worthless but presently would have just a modest unexpired time value. .   

·      In or out of money

A call options is in-the-money if the share price is on or above the exercise (strike) price. A put option is in-the-money if the share price is at or below the strike price. The option can be sold at any time prior to expiration. In both cases options can always be sold prior to expiration when they will have a small unexpired time value.     
·            Putt Option a Put option confers a right, but not the obligation, to have bought, at expiration, at the exercise price, the shares which are the subject of the put option. That is, where shares are at or below the exercise (strike) price.

Description: 79.01 PUT OPTION EXPIRING 28-MAR-2018
Underlying asset: COMMONWEALTH BANK.
Expiry: 28 Mar 2018
Exercise Price: 79.010
Exercise style: European
Open Interest: 1,661
Contract size: 100 securities
Commenced Trading: 26 Apr 2017

·                Putt  Option explanation

This option also began trading on the ASX options market on the the 26th April 2017 but as a put option. A buyer, say in late January may have bought this Put option as insurance against a fall in the CBA share price. Rather than expire worthless, as is the case with the buyer of the call, the put option holder has partially hedged falls in the CBA share price after allowance for the initial premium paid.

For this option we can calculate the intrinsic value and the unexpired time value for a total of the option price as follows:

Intrinsic value: Exercise Price of $79.01 less current share price of $76.39 =$2.62.

One then adds the intrinsic value for time value unexpired, which is   18 cents. The option is currently trading at $2.80, so the time value differences continue to decay but will apply up until expiration.

Hence the time value is ex intrinsic value, a determinant of two variables (1) time remaining until expiration and (2) the closeness of the option exercise (strike) price to being in the money.
In summary options are in the money or out when they are at or compare favourably or not with their exercise (strike) price.

When specifying a particular option it is customary to refer to the strike price in lieu of the exercise price. 

Selling covered calls. 

The difference between a seller of calls and a covered seller is the latter holds already holds the shares in the options being sold. The seller also receives the premium paid by the buyer. To the extent the covered call seller receives premiums this could be regarded as a mild form of hedging against possible falls in the share price. The alternative is called naked trading and is not recommended. 

Hence a covered call is an options strategy to holds shares (what is called in the industry long positions) but sell options over those shares aimed at generating increased income. It can call also be known as a "buy-write".

In summary the position for covered call sellers is as follows:

Out of money options are likely to see their option expire worthless. 

In the money options can be bought back before expiry by sellers. For sellers there is always the possibility of selling another contact at a different exercise price, to recoup or even exceed the buyback cost.  

In and out of money is a common industry term to describe positions. In this case we are talking about an option where the exercise price has been reached or breached. In other words where the underlying shares or indexes exceeds exercise prices. 

When using European style options one is protected from being exercised just prior to dividends becoming due, as the style can only be excised on maturity on the exercisment date.   

Indexed options 
The exact same principles and contracts apply except except we substitute share indexes in lieu of individual share prices. The exercise price then becomes various index levels. A buyers of an index put can cover an entire portfolio as c insurance against a catastrophic market crash. 

However to ensure premiums are not prohibitive discounts can be deducted from the current index levels. 

Illustrative example Index put over S&P/ASX200
XJOZO7
Description: 5350.0 PUT OPTION EXPIRING 17-MAY-2018
Underlying asset: S&P/ASX200
Expiry: 17 May 2018
Exercise Price: 5,350
Exercise style: European
Contract size: $1000 / point
Commenced Trading: 17 Nov 2017

Explanation

The Buyer is desirous of cover for $400,000 over the portfolio. 
Note that by choosing an index exercise price of 5350 the buyer is prepared to wear as an excess a discount of 10% (545 points) since the index is presently trading at 5895, at the time of writing.  
The next step is to calculate how many contracts we have to enter into. This is calculated by dividing the cover required of $400,000 by the current index 5895 and applying the investment multiplier of 10. So we calculate a need to buy 7 contracts.  Under such contracts a specified number of dollars per point of $10 is to be applied. 
The cost at the time of writing is 32 cents per point, so the total cost for a 1000 point contract is $320 to which we must apply the investment  multiplier of 10 =$3200. Each contract then costs $3,200 for a total premium payable of $22,400.

However is there was to be very sharp correction of say 30% prior ton expiry the option purchase would afford hedging as follows:   

The intrinsic value of one contract would be 5350- 4127=1223 points @ multiplier of 10=$12, 230 per contract times 7 contracts =$85610

Less original cost  =                                 $22400
Hedging achieved                                     $63210
Fall in prices                                          $120.000
Loss absorbed in excess 10%                    $40,000
Less cost of cover                                    $22,400
Intrinsic value                                         $57, 600
Time value, the time value unexpired        $5,610
Index  now trading at 4127. 

Note that if the index rose instead of falling the put option does not inhibit any upside. Large scale catastrophic losses (GFC) render the insurance much more worthwhile. 

Final expiration of open positions.

To recap options cover varying time periods and buyers and sellers can elect to take positions any time prior to maturity. In the previous illustrative examples we assumed positions in late January and examined their likely result.

In other words to examine if these positions were likely to be in or out of the money on expiration on the 26th March 2018.

Those options that remain in the money will be automatically exercised on the 26th March and positions finalised by execution by brokers on behalf of their clients. If you elect to use options you will be required to sign a derivatives agreement with your on line or full service broker. Clients get BUY and Sell notifications at brokerage according to broker agreements. 

The market in options.

Just to recap there are 4 participants in the options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts.
·      Buying and selling options is very similar to shares in that you receive or pay a premium based on what is called a strike price under a particular share option contract, The premium is determined by factors inclusive of the share price, strike price and the time remaining until expiration of the contract.
·      An option contract typically represents 100 shares of the underlying shares. There are 2 types-American and European. Holders of the latter don’t have any rights until expiration.
·      The European Indexes are for 1000 points and an investor multiplier of 10 is applied.
·      Options materially affect share prices.

Glossary of terms

A "buy-write" is selling a covered call.  
Call Option: gives the Buyer the right, but not the obligation, to buy a share or option index contract at an excise price within a specific time period.

Collateral – to be lodged by sellers as security.  
Contracts that sets out the agreement for Buyers and sellers covering option parameters.
Contract sizes – 100 shares or 1000 points by 10 for indexed options.
A covered call is an options strategy to holds a share (long position) and sell options on that same share aimed at generating increased income from the share held. A covered call is also called a "buy-write".
Exercise price is usually called the strike price.    
In and out of money will be determinants of whether or not the underlying share or index level reaches or exceeds exercise prices.  Outside of money is indicative current prices will render the option worthless on expiration.     
Option Style: An American option is an option that can be exercised any time prior to expiration or in other words anytime during its life. European options are exercisable only at maturity.
Putt Option
A Put option confers a right, but not the obligation, to have bought, at expiration, at the exercise price, the shares which are the subject of the put option. Subject to share prices below or at the exercise (strike)  price.
Time Value of options
The time value is ex intrinsic value, a determinant of two variables (1) time remaining until expiration and (2) the closeness of the option exercise (strike) price to being in the money.
Investment Multiplier
Under a contract a specified number of dollars per point when using European Index Options. Usually $10

Lindsay Byrnes -Value Investing 2018