Hedging with Index Options

(Note this article was first written in 2003, so the data is a little old but the concepts remain the same.)

The concept of hedging has always been a controversial one. There are some investors that would not enter the market without it. Then there are others that just do not see the point of hedging and that the whole exercise is just too expensive.

Before being able to develop an opinion however, one must know the options. That is, one must understand what hedging actually is. There are a greater range of hedging strategies out there than just selling futures or buying a put. Some strategies will have an outright cost, like buying a put. Other strategies may cost less but instead somehow limit your overall return.

You can see this in some capital guaranteed products in the market. Some capital guaranteed products will put a cap on your potential returns. That in essence can be considered the cost. Now as long as you are happy with this cap, then this type of product may suit you.

So too with options. That is, you can use options to place a stock or portfolio hedging strategy at the cost of capping your upside.

Most people are familiar with buying puts as a hedging strategy. The put works much like an insurance contract. Sometimes however (maybe even a lot of the time) this cost of insurance is too high. A hedging strategy that simply involves buying put options may turn out to cost more than it’s worth.

Buying puts however is not the only strategy around to protect your stock or total portfolio. This article will show you a very simple options strategy that can be used not only for a cheap speculative play, but as a low cost and effective hedge.

Let’s say you have a portfolio of German shares. Up until about late December, we have seen some pretty good gains as measured over the course of the year or even just the previous few months (see Figure 1).

After gains like these, it would be quite reasonable to build some protection against a fall in the market. One thing to consider is a hedging strategy using options.

Figure 1: shows the DAX Index. Some great gains over 2003 could leave the average investors thinking it may be time for a correction.

Source: eSignal (www.esignal.com)

Current volatility, while not at its lowest level, is still quite low and therefore the first option would be to look at buying puts. It is a simple strategy that when combined with a long position in shares give a payoff that looks like a long call.

How? What? Think about it. Long shares plus long put… Here you will make money if the market gains and your backside is protected if the market falls. That payoff is just like a long call option.

That strategy is a pretty simple one to get your head around. The put option works just like an insurance contract. For a cost of the premium, you have a certain amount of coverage.

To add a little complexity and fun to it we could look at selling a call with a strike above the current market level. Why? Well the put will cost money. It is the cost of insurance. If we sell a call as well, we will receive some premium which will pay for (or at least partly pay for) the cost of the put insurance.

However selling the call does not come for free. Selling the call has the effect of putting a cap on your share profits given a gain in the market. You see the short call will lose money if the market rises and the shares will make money if the market rises. The two offset each other at or above the call strike price. This is called a “cap”.

Now back to the put (don’t worry, we will explain all this with an example in a moment. For now think about the concept not numbers). The put will make money as the market falls. The shares will lose money as the market falls. Here, these two offset each other. Buying the put has created what is called a “floor”.

Together, the long put and the short call creates what is called a “collar” on the long share position. It simply means downside is fixed and upside is fixed. The point at which the floor or the cap cuts in are the respective strike prices chosen.

As a side point, if you have ever looked at the various warrants or structured products on the market with profit caps and/or stop loss guarantees, then maybe now you can see how the issuer creates them… Most of those complicated structured products can be broken down into optional components like a short call or a long put. That’s just a side point though. Back to the trade.

So let’s look at an example. Let’s say we have $100.000 in diversified shares. By “diversified”, it is meant these shares mimic the overall market index (the DAX Index) tick for tick. Given this, it is very easy to use index options to create the collar rather than the individual share options.

The first thing to do is consider the put option. How much protection do you want? Buying a put close to the current market value gives greater protection but will cost more. Further out-of-the-money options will be cheaper but this is because they offer less protection. So you must ask yourself how much protection you want.

To keep things simple, we will look at a timeframe (and options) with approximately three months to run. In this example, we will protect against a fall of more than 10% over this time.

Since we have a portfolio that is tied to the DAX, we can look directly at the index (it makes things much easier). The index is around 3900 and if we want to protect against a fall of more than 10% over the next month, it means we would have to buy 3500 puts (3500 is around 10.3% below 3900). At current put volatility levels, a three month 3500 puts costs around 59 index points (forget the euro cost for just a moment).

As for the call, here we really want to pay for all or part of the put purchase. We have the choice of the following prices:

Call Strike

Premium

4100

85

4200

56

4300

35

Source: Eurex 19th Dec 2003

Now we could look at selling the 4100. The premium received here would more than offset the cost of the put (no commissions considered). But remember this is where our profit would be capped, so 4100 might be a little close.

What about 4300? That gives us plenty of room for the market to gain and the shares to profit. The downside is the premium level. For 35pts, it does not quite cover the cost of the put.

So perhaps the 4200 call for 56pts would be the option the take. It would leave a net cost of 3pts for the total collar (59 less 56).

So what does our payoff look like? Well for a cost of 3pts, you have protected yourself for a fall below 3500 (10.2% or more). Note you are still subject to any smaller losses from the shares.

On the upside, you can still gain from the position but only so far as the market stays below 4200. If the market moves above this point, it does not really matter since the trade has capped your gains here (capped at around 300pts or 7.7%) for the month.

Figure 2: The DAX Index chart shows the cap and floor levels from the trading example.


Source: eSignal

It is true you do not own the index. We have just assumed the portfolio matches the index so all the talk above has been on the index.

To equate things back to our $100.000 portfolio, we just have to work out how many contracts to trade and that’s pretty simple. Just divide the portfolio value by the put strike multiplied by the put option point value. Eurex DAX options have a point value of 5 euro, so the number of contracts needed would be:

$100,000

5 * 3500

= 5.7 (round to 6 contracts)

So we would buy six 3500 puts and sell six 4200 calls. Now assuming we can get filled at the above prices (which may or may not be the case), we could place this strategy at a 3pt debit since calls are worth 3pts less than the puts. Over six contracts, this equates to 18pts or 90 euro plus commissions.

The way to think about this trade is to consider the cost of the six puts by itself 59pts or 1770 euro (6 contracts times 5 euro times 3pts). That is the cost of put insurance. Adding the short call cut this cost down to 90 euro but at the expense of capping profits at 7.7% for the three months. Is that worth it? Maybe, maybe not. The question of hedging or not hedging comes down to individual choice.

The strategy is good one once you understand what it costs. The true cost is in the profit cap. If you are happy with this cap over the life of the options, then the strategy will make sense.

This article shows just one possible hedging strategy. The great thing about options is you can create pretty much any risk profile you like with a combination of positions. The key to remember is you get what you pay for. Like any type of insurance, the greater the hedge the more it will cost.

Pros and cons of Index options

New to Index options? Well there are some definite advantages to trading these options including:

The Pros:

  • Cash Settlement. The advantage of using index options over equity options is in the form of cash settlement. If the call option goes in-the-money (market moves above 4200), then you cannot be forced to mess around with delivering of the actually stock if exercised.
  • Tick value. Eurex Index options on the DAX have a small tick value of 5 euro meaning smaller amounts can be hedged.
  • European style exercise means there will never be an issue with early exercise.

To be fair, there are two sides to every coin. Some of the disadvantages of using Index options for Hedging are:

  • Rounding error. Because you cannot trade in fractions of a contract, a simple strategy like this will not always be a perfect hedge. In the example, a perfect hedge would involve trading 5.7 contracts. The example traded six and was therefore slightly over hedged.
  • Basis drift. This refers to the risk of the shares not moving in line with the index. There will always be factors that impact an individual share and not the market and vice versa. The shares can move against you while the rest of the market (the index) does not.
  • Beta factors. There is also the issue of your portfolio not mirroring the performance of the DAX Index in the first place. In the example, we assume the portfolio moves tick for tick with the index. This problem can be solved with the use of a Beta Factor. Ask your broker for more details on this.