Volatile markets that come after a long period of rising share prices are known for producing a lot of angst-ridden private investors. Is the market decline a permanent one? If you sell now, might you risk missing out on a subsequent rise? And what about capital gains tax liabilities if you sell?
The options market offers a way of answering some of the questions, by providing insurance for your portfolio, or for some of the individual stocks within it. And options markets have the seal of approval of respected professionals. Fidelity’s fund management guru Anthony Bolton bought a large put option on the index several months ago as a way of insulating his fund’s performance from an expected decline in the market.
Before getting into the detail of how you can use options to help preserve your portfolio’s value, it’s worth taking a few minutes to note some key points when trading options. First and most basically, a call option’s price (the option to buy at a future date at a pre-agreed price) moves in the same way as the underlying security it derives from. A put option’s price (the option to sell at a future date at a preagreed price) rises when the underlying security falls in price, and vice versa. So buying a put option in a stock you hold, or in the index, can insulate a shareholding or portfolio of index stocks from a sharp fall in the market.
So far so good. But option prices to some degree have a life of their own, and there are other factors beyond the underlying security price that complicate the issue. The first is that, other things being equal, option prices of whatever type decline progressively quickly the nearer the option gets to its expiry date. Second, volatility in the price of an underlying security or index will raise prices of options of whatever type, other things being equal.
But buying an option as a way of protecting your portfolio, has some advantages. One is that it gives you choice. If holding the option works in your favour, it can be sold in the market or exercised at a profit. If it doesn’t, you can walk away and forfeit only the initial price of buying it. It works rather like insurance, and this is why an option’s price is sometimes called its ‘premium’.
How index options work
Say you have a portfolio of blue chip stocks, representative of the market as a whole, worth £125,000. The FTSE is at 6250 at the time of writing, but looks vulnerable to a large setback. You have a major profit on your stocks, like the market long term, and don’t want sell and incur CGT.
The solution is a FTSE 100 index put option. Say you buy two contracts of a FTSE index put expiring in six months time. The price of an index option with an exercise price of 6250 (in the jargon, an ‘at-the-money’ put) is 275. FTSE options work on the basis of £10 per index point, so the cost of one option contract, which will protect a portfolio worth £62,500 (10 x the index value) is £2,750. Full protection of the portfolio, by buying two contracts, would cost £5,500.
Now suppose that the index has a sharp correction and drops 15% over the course of a month. In so doing the underlying volatility measure for the market increases from the previous level of about 20% to around 30%. Plugging these numbers into an option pricing software model suggests that the option’s price would rise to 935, making the two put option contracts worth £18,700.
Let’s look at the Profit & Loss of this underlying movement. There is a profit on the option contracts of £13,200. The portfolio’s value has fallen from £125,000 to £106,250, a drop of £18,750. But the net loss after the hedging exercise using the put option is only £5,550.
This neatly illustrates the ‘options as insurance’ principle. You pay a premium, and you get protection, which avoids a much bigger loss.
Why ‘out of the money’ options are cheaper
You can extend the insurance analogy further. Buy a put option where the exercise price is below the current level of the index (i.e. the option is termed ‘out of the money’ in this case) and it will be cheaper. But you will bear the full amount of the initial loss in value of the index down to the point where the exercise price of the option equates to the value of the index, after which point the insurance protection offered by the option kicks in.
The principle is the same as an excess on an insurance policy, where a policyholder trades a lower premium for bearing an initial amount of the loss himself. Also similar to insurance is the concept that if the expected loss you are insuring against (i.e. in this case, the market falling) doesn’t occur, then the premium paid for the insurance is simply written off.
One of the drawbacks of using index options, however, is that index option contracts are ‘lumpy’. If your portfolio is worth less than £10 times the index value, then even buying one contract will mean that you are overhedged. In other words, you are paying for an element of protection that you don’t need. Matching your ‘hedge’ precisely to your portfolio is therefore a bit of a challenge, although there is a spread betting market in index options which can be used rather more flexibly to hedge smaller amounts than the standard £10 times index value.
We also have to bear in mind the fact that options used as a hedge have to be sold and the gain crystallised in order to derive the benefit from the hedge, and consequently this opens up the possibility of a capital gains tax liability — unless you hold the option in a SIPP. In the context of the numbers involved in index options, however, dealing costs are relatively insignificant.
Hedge individual stocks too...
What about taking out insurance on individual stocks? Similar principles apply to hedging individual stocks, but there are some important differences. One is that individual equity option contracts in London are based around lots of 1,000 shares. If you want to protect a holding of 5,000 shares in a company, you need to buy five put option contracts. If you hold 3,000, you buy three contracts and so on. If you hold 2,500, you have a problem.
The other point to bear in mind is that not all companies have individual equity options available. Euronext LIFFE, London’s futures and options market, lists options on about 90 shares, not all of which are FTSE 100 stocks. There are options available for a larger number of exercise prices and expiry dates than is typically listed on the prices page of the Financial Times.
The mathematics of hedging using individual equity options is essentially similar to using an index option to hedge a portfolio.
The difference is that with individual equity options the initial outlay can be smaller, but also that the bidoffer spread in the options, especially in low-priced ‘out of the money’ options, is much greater in percentage terms than for index options. This needs to be taken into account in working out the costs and benefits of a hedging strategy.
It also goes without saying that dealing costs, which are normally a flat rate per contract and will also include a central settlement levy charged by the exchange, assume greater importance when the value of an option contract is lower, or if you have to buy more than one contract to achieve the hedge you need. Hedging using put options, while not free — as the example above shows — is the most controlled way of eliminating risk from a portfolio or an individual share. This is because the most you can lose when buying a put option is the initial outlay, your insurance ‘premium’.
Selling options backed by your portfolio can earn you extra income
Selling, or ‘writing’, a call option — sometimes advocated by market players — does not achieve the same end at all when it comes to hedging. This is because an option writer has the opposite exposure to an option buyer. An option buyer has strictly limited possible loss (the amount of the initial option premium) and geared upside if the underlying price moves in the anticipated way, precisely the outcome you want in a hedge.
An option writer by contrast has a known maximum amount of income received (the initial option premium paid by the buyer of the option), but geared up downside risk if the underlying price moves the wrong way. If you act as an option writer you face theoretically unlimited losses, not the best way of seeking the objective of preserving capital.
Writing call options is best considered as a separate strategy in itself, to be used in conjunction with an existing portfolio of individual stocks when markets are relatively stable, or ‘calming down’ after a period of intense volatility. In essence it is a way of generating extra income from a long-term portfolio of blue chip shares. For the purposes of hedging, however, it is a no-no.
What you’ll need from an options broker
If you’ve decided that hedging using put options could be a strategy worth using, whether for individual shares or using index options, the next step is to find a broker. While some stockbrokers also have options dealing offshoots, for the most part you will need to open a separate account with an options specialist and have funds in your account to finance your trading.
Account opening procedure is much the same as for any other broker. The broker will want to satisfy themselves that you understand the risks involved and that you have sufficient liquid assets to cope with any eventualities you might encounter. You can generally choose between execution-only, advisory and managed accounts, with differing levels of charges. The complexity of option trading suggests that, if you are an options market ‘virgin’, you might consider an advisory account until you become used to trading the market or if your use of it is likely only to be occasional.
Even with an execution-only account, it is worth having an account that allows you to speak in person to a broker since, while you will not get advice on a deal itself, they can acquaint you with some of the nuts and bolts of dealing procedures.
Action to take: To learn more about options speak to your broker or check out Euronext.LIFFE which has a website specifically devoted to the needs of private investors (www.liffeinvestor.com) where there is a range of educational information, price data, and a list of brokers who offer services for private investors.
