Kiran Kumar K V
The risk of a derivative product depends on what an investor does with it. It is not the fork’s fault if someone sticks it in an electric outlets and gets shocked. People should think of derivatives as neutral products that can be combined with other assets to create a more preferred risk-return trade-off. If used widely, they can help an investor or portfolio manager quickly adapt to changing market conditions or client needs. In this article, we discuss certain dimensions of building and managing the portfolio of derivative products.
Setting Investment Objective
Every trade should begin with an opinion of the underlying market. Only then can an informed trading decision be made. With stocks and most assets, one thinks about the direction of the market: Is it going up or down? With options, it is not enough to think about only the market direction: it is also necessary to think about the volatility. In other words, what matters to users of options is not just the direction the underlying is headed, but the volatility of the underlying. For example, in a simple call option purchase, just having the underlying go up is not sufficient to make money. The underlying must go up enough that the option reaches breakeven. The gain in the value of the stock must be sufficient that the call overcomes the loss of its time value. A long call must have some upside volatility, and a long put must have some downside volatility.
Suppose an investor is neutral on market direction. Again, he should consider the volatility. A straddle buy is neither bullish nor bearish, but expects a sharp increase in volatility. Someone who is neutral directionally, but does not anticipate a sudden price change may want to write the straddle. Spreads tend to be middle-of-the-road strategies that fit best in neutral, flat markets. A spread trade is often appropriate when the outlook for an underlying market is either neutral or non-trending, meaning that it does not have a strong bullish or bearish outlook. In table-1 below, one way of looking at the interplay of direction and volatility, is presented:
Direction | ||||
Bearish | Neutral / No Bias | Bullish | ||
Volatility | High | Buy Puts | Buy Straddle | Buy Calls |
Average | Write Calls and Buy Puts | Spreads | Buy Calls and Write Puts | |
Low | Write Calls | Write Straddle | Write Puts | |
Some option traders refer to the concept of volatility as speed, with high volatility market being a fast market and a low volatility market being a slow market. Market speed can, however, also refer to the rate at which a market moves, so investors should take care to be aware of the distinction in the uses of these characterisations.
Market Risk
Derivatives enable market participants to take position that is extremely bearish, extremely bullish, or somewhere in between and to quickly and efficiently shift along this continuum as desired. Suppose a pension fund owns one million shares of HSBC holdings. For some reason, the portfolio manager would like to temporarily reduce the position by 10%, meaning to reduce the market exposure and convert the equivalent funds to cash. There are a variety of ways in which this might be done. The portfolio manager could do any of the below:
1. Sell 100000 shares, which is 10% of the holding
2. Enter into a futures or forward contract to sell 100000 shares
3. Write call contracts sufficient to generate minus 100000 delta points
4. Buy put contracts sufficient to generate minus 100000 delta points
5. Enter into a collar sufficient to generate minus 100000 delta points
Each of these alternatives has its own strengths and weaknesses. The first alternative, i.e., selling shares, has the advantage of clearly accomplishing the goal of a 10% reduction. For some investors, though this solution could create tax problem or result in inadvertently putting downward pressure on the stock price. Forward contracts are simple and effective, but they involve counterparty risk and are not easily cancel of later there is a desire to unwind the trade (It is possible to enter into an offsetting trade with the same counterparty, to net the position to zero. This approach is essentially the same as covering a futures contract position in which the counterparty is the clearing house. Offsetting a forward with a new forward is relatively easy to do). Writing calls brings in a cash premium, but leaves the writer subject to exercise risk. Buying the puts requires a cash outlay but leaves the investor in control with respect to exercise risk. In short, all the outcomes have advantages and disadvantages, but with derivatives, the investor has multiple choices instead of just one.
Analytics of the Break Even Price
Investors often construct a profit and loss diagram for an option strategy that is under consideration. These diagrams are helpful in understanding the range of possible outcomes. It may also make sense to use option pricing theory to learn more about what the break even points on the profit and loss diagram really mean. The current option price is based on an outlook that takes into account an assumed future volatility of the prices of the underlying asset. Volatility is measured by standard deviation of percentage changes in the spot price of the underlying asset, and with an understanding of some basic statistical principles, this volatility can be used to estimate the likelihood of achieving a particular price target.
There are a variety of factors that come into play when determining the value of an option. The underlying market price, the exercise price of the option contract, the time left until option expiration, the current risk-free rate, and any dividends paid before expiration are all taken into account by the market when valuing an option. The exercise price is known, and the underlying market price and risk-free rate are easily accessible. The time remaining until expiration is consistently changing, but we always are aware of how much time is left until expiration. Dividends paid by companies are fairly stable as well.
30 days until March option expiration A and B underlying stock price = Rs. 50 A Mar 50 Call= Re. 1.00 A Mar 50 Put = Re. 0.95 B Mar 50 Call= Re. 2.50 B Mar 50 Put = Re. 2.45 |
A trader buying a A Mar 50 Call and B Mar 50 put would be purchasing a A Mar 50 straddle for 1.95. Buying a B Mar 50 straddle would involve purchasing the B Mar 50 call at 2.50 and B Mar 50 put at 2.45 for a net cost of 4.95. Breakeven at expiration for the A straddle occurs if the stock moves up or down 1.95 whereas breakeven for the B straddle would require a move of 4.95. In percentage terms, this means that breakeven for the A straddle is 3.90% (1.95/50) whereas B needs to rise or fall 9.90% (4.95/50) for the straddle to just breakeven.
We say that B options have a higher implied volatility than comparable A option contracts. Implied volatility is the standard deviation that causes an option pricing model to give the current option price. Option users, in fact, use implied volatility as a form of option currency, meaning that prices are quoted as implied volatilities. For instance, knowing that an option sells for 2.00 reveals nothing about its relative price because that depends on the moneyness (i.e., the extent to which the option is in or out of the money) and the remaining life of the option. If, instead, someone says an option sells for an annualised implied volatility of 45% that is a standalone statistic that can be directly compared with other options. B option premiums are higher than A option premiums because the market expects greater potential price moves out of B than from A.
There are a few different perspectives on how we should measure the time periods with option volatility. There are usually 365 calendar days in a year, but the markets are not open on Saturdays and Sundays or official holidays, which vary by country. Because the stock price does not have the opportunity to change when the market is closed, most experts believe that those days should not count. For this reason, some people use 252 day or some other appropriate number for the number of trading days in a year. Dispersion is a function of both the size of the “jumps” in the variable and the number of those jumps. We convert an annual variance (σ2) to a daily variance by dividing by 252, and we convert an annual standard deviation (σ) to a daily standard deviation by dividing by √252. With options, volatility is measured by the annual standard deviation.
