Derivative strategies using

Transcription

1 FP CLASSROOM Derivative strategies using options Derivatives are becoming increasingly important in the world of finance. A Financial Planner can use the strategies to increase profitability, hedge portfolio risks and manage cash flows of his/her clients. 44 FINANCIAL PLANNING JOURNAL JANUARY - MARCH 2008

2 Dr. K. K. Goel, CFP CM Orthopaedic Surgeon & Financial Planner profit is limited to the premium received and loss can be limited. (Fig. 2) Derivative is a financial instrument whose value is derived from the value of one or more basic variables called bases (underlying asset, index, or reference rate), in a contractual manner. Derivative instruments include forwards, futures, options, warrants, Leaps, baskets, swaps, etc. In this article I will highlight the use of options in various market situations. Options are derivatives that give the buyer, a legal right, acquired for a consideration, to buy or sell an asset at a predetermined price by a certain time in future. Options help to lock in price and buy the time. The buyer of an option has a limited risk and unlimited reward. There are two types of options: call options and put options. The buyer of a call option buys the right to buy an asset at the predetermined price in future for a consideration called premium. The buyer of a put option buys a right to sell the asset at a predetermined price in future for a consideration called premium. The buyer of an option is also called the holder of the option and seller of an option is called the writer of the option. Buyers of options are referred to as having long positions and sellers of options are referred to as having short positions. The holder of an option pays the premium whereas the writer of an option gets the premium. But he has to pay the margin money to the broker, which is decided daily by the exchange. A call option is called in the money if the stock price is above the strike price and it is out of the money if stock price is below the strike price. A put option is called out of the money if the strike price is lower than the stock price and in the money if the strike price is above the stock price. An option is called at the money when strike price and stock price are same. In India, the last Thursday of a month is the settlement day for the options and futures. Only current month options are liquid in India and on the day of settlement there is lot of volatility in the market. It is important to remember these points while dealing in options. Markets could go up, markets could go down, or they may remain sideways. We have four scenarios in market. 1. Bull Markets, when markets are consistently going up. 2. Bear Markets, when markets are consistently going down. 3. Sideways Markets. 4. Volatile markets. To protect assets and increase the cash flow one must use different strategies in different market scenarios. Strategies for Bull Markers 1. Buying call option When one is bullish on a stock, he could either buy the stock or buy the option and have a control over a large number of shares of the stock by paying a small amount of premium. The maximum loss the individual can have is the loss of his premium whereas the gain can be unlimited depending on the amount of rise in the stock price. The breakeven point is the strike price + premium paid. The figure graphically depicts the loss or gain of the buyer of the call option. (Fig. 1) 2. Sell put option By selling a put option, one gets a premium, which is the maximum profit one will be getting as long as the price of the stock remains above or at the strike price. If the price of the stock falls below the strike price, loss starts; theoretically this can be unlimited. Thus in this strategy 3. Bull call spread This involves buying a Call at lower strike price and selling another Call at higher strike price. This strategy would reduce the maximum loss. However, it would also reduce the maximum profit possible. The maximum loss would be the premium paid for purchasing the Call minus the premium received for selling the higher Call. The breakeven point is the strike price of the long Call plus the total premium paid. The maximum profit would be the difference between the strike price of the long and short Calls, minus the premium paid. Details are shown in graphical presentation in the figure. (Fig 3) 4. Bull put spread This involves selling a PUT at higher strike price and buying a put at lower strike price. Net premium received is the THERE ARE TWO TYPES OF OPTIONS: call options and put options. The buyer of a call option buys the right to buy an asset at the predetermined price in future for a consideration called premium. maximum possible gain. Breakeven point is the strike price of the PUT sold minus the total premium received. The maximum possible loss is the difference between the strike price of long and short puts minus the premium received. The details are represented graphically in the figure. (Fig. 4) Stratagies in Bear Market 1. Buy Put Option This is also called a protective put. One pays a premium for buying Put, and his profit is unlimited, depending on the amount of fall in the price of the stock. Loss is limited to the premium paid. A person holding stocks could insure the value of assets by buying a put. (Fig. 5) JANUARY - MARCH 2008 FINANCIAL PLANNING JOURNAL 45

3 2. Sell Call Opttion A person who is bearish on market would sell Call. He receives a premium, which is his maximum gain, as long as the price of stock remains at or below the strike price. Loss can be unlimited if the price of stock starts moving above the strike price. The breakeven point is the strike price plus the premium received. His profit and loss is depicted in Fig. 6. Fig Bear Put Spread In a bearish market strategy, buying a PUT at higher strike price and selling another put at lower price would limit the loss by reducing the total premium paid. However, it would also limit the maximum gain possible, to the difference between the long and short put prices minus the premium paid. Position of a bear put spread is shown below in a graphical manner. (Fig. 7) Fig Bear Call Spread In this strategy, one sells a Call option at a lower price and buys another Call option at a higher price with same expiration date, receiving a net premium. This premium received is the maximum gain possible in this strategy. The breakeven point is the lower strike price plus the premium received. The maximum loss is the difference between the two strike prices minus the premium received. (Fig. 8) Vertical Bull Call Spread High Fig. 3 Strategies for Sideways Markets 1. Short Straddle In this strategy, one sells a Put and a Call at the same strike price and same expiry date. The individual is expecting the market to remain sideways, and his maximum gain is the total premium received from selling the call and the put. His breakeven point is the strike price plus or minus the amount of premium received, depending in which direction market moves. Losses start if market moves beyond the strike price plus/minus the premium received. (Fig. 9) Low Low Vertical Bull Put Spread High Combined Positiion Combined Positiion Fig FINANCIAL PLANNING JOURNAL JANUARY - MARCH 2008

4 2. Short Strangle When it is expected the market is going to be range bound, one could sell a Call at high of the range and sell a Put at the low of the range, thus receiving premium for selling both call and put options. The maximum profit would be achieved if the market remains between the ranges of our strike price of call and put options sold. The loss would start only if the stock price falls below the strike price of put option minus the premium received or stock price rises above the call option sold plus the premium received. Details are depicted in the graphical presentation in the figure. (Fig. 10) Fig. 5 Fig Long Butterfly Call Spread This strategy is used in sideways market. This involves shorting two at the money calls and buying one call in the money and another at the higher level out of the money. The maximum loss would arise (the premium paid for two long calls minus the premium received for the short calls), if the stock price moves either above the higher Call bought or below the lower call bought. Reverse would be the situation for person shorting the butterfly Call spread. (Fig. 11) Strategies for Volatile Markets 1. Long Straddle This strategy can be very useful in a volatile market when one buys a Call and a Put at the same strike price and same expiration date. The maximum loss is the total premium paid. Gain starts when price of stock goes beyond the strike price plus/minus the premium paid. Breakeven point is the strike price plus/minus the premium paid. (Fig. 12) Low Lont Put Low Vertical Bear Put Spread Vertical Bear Call Spread High Fig. 7 Fig. 8 Insurance of Stocks Held Many a time clients would ask their Financial Planners, how they can ensure the protection of value of shares held. Following are the strategies which could be very useful in protecting /insuring the value of share held. High 48 FINANCIAL PLANNING JOURNAL JANUARY - MARCH 2008

5 1. Buying a Protective Put A put option is bought at or around the value of shares held, thus ensuring protection from fall of the price of shares whereas the upward move in share price would increase the value of the assets. 2. Covered call In case an individual s shares have made a significant gain and a correction is expected, this strategy proves useful in protecting the shares held. A call option is sold just at or above the price of the shares in cash market, and a premium is received. Say, if premium, from selling a call, received is Rs 20 per share of company XYZ, you are covered for a downfall in share price up to Rs 20 per share and you have made a profit of Rs 20 from the current price. This strategy is very useful in the Indian scenario, and can give a cash flow of 3-5% per month. 3. Collar strategy The strategy involves holding the stock, buying at the money put, and selling a call just one level above out of the money call. The premium paid for the put is almost equal to the premium received on the call sold. Thus, just by paying the margin money on the call sold - this margin money is received back on expiry date - one is able to protect assets with minimal or no payment of premium. Short Straddle Short Strangle At The Money Long Butterfly Call Spread 1 Month to Expiry 3 Months to Expiry Fig. 9 Fig. 10 Fig. 11 Conclusion In today s financial market knowledge about the working of derivatives, their uses and pricing is very important for a Financial Planner. Knowledge about various ways of using option strategies would help a Certified Financial Planner have an edge over others. It would also ensure protection of equity assets - his own and those of his clients. Leveraging, protection of assets and increasing cash flow is possible with the use of various combination of these strategies. Long Straddle s 2 s Fig. 12 kkg_55@yahoo.co.in 50 FINANCIAL PLANNING JOURNAL JANUARY - MARCH 2008