Basic concepts

Hedging strategies with options

Options

A call option is a right but no obligation to
buy an asset at predetermined price within
the specified time
Holder of call option exercises the option
when price of underlying asset is more than
the strike price.
If spot price is less than the strike price the
holder lets the option expire as it is worthless.


A put option is a right but no obligation to sell
an asset at predetermined price within the
specified time
Holder of put option exercises the option
when price of underlying asset is less than the
strike price.
If spot price is more than the strike price the
holder lets the option expire as it is worthless.


BUYER or HOLDER:
The person who obtains the right to buy or
sell but has no obligation to perform is called
the owner/ holder of the option.
WRITER or SELLER:
One who confers the right and undertakes
the obligation to the holder is called
seller/writer of an option


While conferring a right to the holder, who is
under no obligation to perform, the writer is
entitled to charge a fee upfront.
This upfront amount is called the premium.
This is paid by holder to the writer to induce
him to grant the right.
The amount belongs to writer irrespective of
whether the option is exercised or not.
It is not adjustable against the future
payment that arise upon exercise of option.


Define S as the price of the underlying asset, and K
as the strike price. Then, for a call:

In-the-money, if S > K option would be exercised
Out-of-the-money, if S < K
At-the-money, if S ~ K

For a put option:
In-the-money, if K > S option would be exercised
Out-of-the-money, if K < S
At-the-money, if K ~ S


Hedging strategies:
Concentrates on how to use options to hedge against the adverse
price movement for a long or a short position in the underlying asset.
Income generation strategies:
Concentrates on how to use options to enhance yields on the
portfolios.
Trading strategies:
Highlights on different options to achieve desired risk and return
profiles depending upon the perception of the market by the trader.
Synthesizing strategies:
Demonstrates the power of options to create synthetic positions of
other financial instruments. The replication of the payoff effectively
means lesser investment without compromising returns enhancing
the return on investment.
Examples of options: Insurance (put option), Real Estate
agreements (call option) , Warrants (call option), etc.
Hedging with stock options
A long position in stock means the investor will sell the stock in future in
case prices rise.
If the prices rise, there is a gain, but if the prices fall, there is a loss.
If the purchase price of the asset was S0 and the current price is S the
loss or profit is given by S S0.
If S > S0 the investor is happy.
If S < S0 the investor suffers a loss and is in a situation that investor
needs to safeguard against.
So he needs protection against fall in prices.
The expected loss is protected by buying a put option which gives him
the right to sell as the exercise price.
If the prices fall below the exercise price, the investor exercises his right
to sell, thereby providing protection against fall in price.
In case of price rise, the put is worthless. However profit from the
long position would stand reduced by the amount of premium paid on
buying the put.
When S > S0 , profit with put option will be S-S0-p where p is the
premium



Strategy:
Long position on stock of HUL
To hedge against fall in price:
Buy a put on the same asset for the period of hedge.
Example:


Protective Put:
Long position in HUL Stock.
Bought 1 put at X = 220
Initial cost of protection = put premium paid = 8

You intend to own the asset in future. You short sell the asset (expecting the
prices to fall) and buy back later when there is a fall in price. This is called
short position on the asset.
When price falls, you gain because you buy the asset at lower price.
When price rises, you lose because you pay more.
If the spot price of the asset was S0 and the current price is S the loss or
profit is given by S S0.
If S < S0 the investor is happy.
If S > S0 the investor suffers a loss and is in a situation that investor needs to
safeguard against.
So he needs protection against rise in prices.
The expected loss is protected by buying a call option which gives him the
right to buy at the exercise price.
If the prices rise above the exercise price, the investor exercises his right to
buy, thereby providing protection against rise in price.
In case of price fall, the call is worthless. However profit from the long
position would stand reduced by the amount of premium paid on buying
the call.
When S < S0 , profit with call option will be S-S0-c where c is the premium

Strategy:
Short position on stock.
To hedge against rise in price,
Buy a call on the same asset for the period of hedge.
Example



Hedging with call:
Short position in stock
Bought one call at X = 880
Premium paid = 34
Initial cost of hedging = 34

Hedging with index options

Index options are mostly used by mutual funds to hedge against the
systematic risk.
Index options are used by investors to cover the systematic risk or
market risk.
In case of portfolios the unsystematic risk is diversified away while
market risk remains.
Options on index are best suited for large funds that already have
minimized the unsystematic risk by diversification.
To protect against the market risk one can take a position in index
options.


Long portfolio position can be protected against systematic risk by
buying a put on index.
Consider a portfolio with current market value of Rs 10 lacs with Beta of
1.0.
With a beta of 1, the portfolio moves in the same direction with the
same % change as the change in the market index.
Index is currently at 4,000. Hence 1 unit = 10,00,000/4000 = Rs 250
Fall in equity prices is expected.
Investor needs to protect the value to at least to Rs 9.0 lakhs.
To protect against likely fall of the market: buy a put with strike 10%
below the current level of index i.e. 3,600.
The investor needs to buy 5 put contracts (assuming contract size = 50
indices, hence 50*4000 = Rs. 2 lakhs) to cover the exposure.


Hedging Strategy
To protect against likely fall of the market: buy a put with strike 10%
below the current level of index i.e. 3,600.
The investor needs to buy 5 put contracts to cover the exposure.
The position of the investor at the expiry of option period for two
contrasting situations of 20% fall and 10% rise in the index is


Short position in portfolio can be protected against systematic risk by
buying a call on index.
Consider an investor needs to acquire portfolio worth Rs 10 lacs with beta
of 1.00.
The index is currently at 4,000.
The investor needs to cap the cost of acquiring the portfolio to 110% at
Rs 11 lacs.
To do so the investor needs to buy a call with strike 10% above the
current level of index i.e. at 4,400 worth Rs 10 lacs.
If the index rises by more than 10% the shortfall in the portfolio would be
compensated by the payoff of the call. The cost would not exceed Rs 11
lacs.


Hedging Strategy
To cap cost investor needs to buy a call with strike 10% above the
current level of index i.e. at 4,400 worth Rs 10 lacs.
If the index rises by more than 10% the shortfall would be compensated
by the payoff of the call. The cost would not exceed Rs 11 lacs.
The position of the investor at the expiry of option period for two
scenarios of 10% fall and 20% rise in the index is presented below


Hedging portfolio value against fall in price with index options involves
following 3 decisions:
The value of the exposure in options
The protection level desired.
The strike price of the put option
In case of portfolio with beta as 1.00, all the three decisions were simple.
When the portfolios are aggressive or defensive, the strike price and the
value of the exposure in options need to be modified.
Example
Value of the portfolio = 10 lakhs
Beta = 1.6
Desired protection level = 10% over a period of 1 year
Current index value = 4000
Each contract = 50 indices
Dividend yield = 2%; risk free rate = 8%
What is the strike price of the put option which needs to be used?
Excess returns on a portfolio = beta* excess market returns.

Acceptable level of decline in portfolio value, capital loss -10%
dividend yield on portfolio 2%
returns net of dividend yield -8%
excess returns on portfolio -8%-8%= -16%
Excess returns on index -16%/1.60= -10%
Actual returns on index -10%+8%= -2%
Dividend yield on index 2%
capital loss on index -2%-2%= -4%
Hence strike price of put 96% of index value
No. of puts to be bought = beta (P/F)
= 1.6 (10,00,000/ (50*4000)) = 8 contracts
No. of indices under 8 contracts = 50*8=400
Strike price of the put option to be bought = 0.96*4000 = 3840

This implies that hedging portfolios with beta>1 is costlier since more
number of puts need to be bought with higher exercise price.
In general,
When beta of the portfolio is other than 1 the value of the put option and
its strike needs to be adjusted for the value of beta.
To hedge a portfolio with beta > 1 higher number of puts with higher
strike price need to be bought.
To hedge short position in portfolio with beta > 1 higher number of
calls with lower strike price is needed.
Put with higher strike and call with lower strike are more expensive,
increasing hedging costs when portfolio beta exceeds one.