How To Use Index Options Strategies to Manage Portfolio

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Standardized call contracts, which are some of the tools we will review, were introduced to the markets in 1973, along with the Options Clearing Corporation and, of course, the Black Sholes Option Pricing Model. As we’ve already discussed, buying a call gives the purchaser the right to buy the underlying security for a specific price either at (for a European style contract) or up to (for an American style contract) a specified future expiration date. Sellers of calls become obligated to deliver the underlying securities at these same terms.

Standardized put contracts were introduced into the market four years after the introduction of calls. Buying a put gives the purchaser the right to sell the underlying security for a specific price either at (for a European style contract) or up to (for an American style contract) a specified future expiration date. Sellers of puts become obligated to receive the underlying securities at these same terms.

Puts were quickly adopted as a way to protect or insure portfolios against losses. This differs greatly from the practice of “portfolio insurance,” which was a strategy of selling index futures in declining markets and using those proceeds to help offset portfolio losses. “Portfolio Insurance” has often been labeled as a significant catalyst in the 1987 stock market crash while buying puts to protect against losses has never been implicated in anything except teaching novice investors the potentially expensive lesson to pay attention to volatility.

While there are many entities, such as trading desks and hedge funds, that trade options exclusively and are focused on complex, multi-legged trades, there are still traditional investment managers that take a more basic approach to options. Generally speaking, when it comes to options, equity portfolio managers use them to accomplish two things: i) enhance returns and ii) protect returns. Various option strategies can provide both.

Return Enhancement

A popular strategy employed by managers is to sell “covered” calls. 

Say you have an account that is technology focused and you are looking to augment the overall portfolio yield. You can do this by selling index calls against that position. Any potential delivery obligation would be in cash. 

For this example, assume the Nasdaq-100^® Index is currently trading around 12,700. You want to sell calls but you don’t want to be forced to fulfill your obligation to deliver. In order to protect your position, you want to set the strike price high enough so that the odds of your having to liquidate the position are very low but not so high that you end up earning only a modest premium.

This is where knowing the volatility (23% for this example), of the price level of NDX comes in handy. Say you want to sell one contract that expires in 25 days. An expected, one standard deviation move in the index level of NDX over the next 25 days can be found using the current index level of NDX (12,7000), the annualized volatility NDX (23% meaning that on an annualized basis, you would expect the NDX to fluctuate up to 23% of its current level 68% of the time), and the square root of 25/365, (which is converting annualized volatility of 365 days to a term of 25 days).

Given an annualized volatility of 23%, a one standard deviation move in NDX over the next 25 days would be 764 index points meaning 68% of the time, the NDX would be expected to end up between 12700 plus or minus 764, from 11935 to 13464.

Looking at the options montage for NDX, you see that there is a 13500 strike call that last sold for 68 and a 13450-strike call that last sold for 80, which would net you 6850 or 8070 respectively. If you think that all relevant news has already been priced into the markets and you can’t foresee any other surprises on the horizon that would cause markets to trade outside a one standard deviation range, you go ahead and sell that 13500 strike call and collect the 6850 premium. So what happens if the markets decide to completely ignore your thoughtful analysis and decide to run up beyond your projection, threatening to blow up your trade? At a high level, one of two things could happen:

You do nothing. The call your sold/wrote is now In-The-Money (ITM). Because your NDX option is what known as a European Style option contract you don’t have to worry about it being exercised or assigned prior to expiration. In essence, while your obligation to deliver is now eating into the premium you collected from selling the option, you don’t have to deliver until the contract expires in 25 days. If you think that NDX will trade down before then you might risk letting it ride, but as you are a disciplined investor.

You do something. This is a particularly vague statement because the reality is that there are any number of things you could do. The easiest thing to do would be to close out your short position. This can be done by putting in an order with your broker to buy that same 13,500 strike NDX option. The difference here though is that you mark the order as “Buy to Close”. This informs the broker that you want to buy this contract and then immediately use it to cover the obligation you created when you sold that contract earlier. Assuming you can execute this trade before it becomes more expensive to buy than the premium you collected you can still come out ahead.

As an aside, if you felt that overall volatility was on track to decline over the next month or you felt confident that NDX was rangebound well within current volatility expectations, then you might have sold the 13450 strike, which would have netted you 8070.

Portfolio Hedging (Delta Hedging)

Managing risk and protecting your portfolio have a couple of extra moving parts. An important one is referred to as “Delta,” which is one of the “Greeks.” If you’re a student of algebra and remember some of its basic concepts, the concept of delta won’t be completely foreign to you. In the options world, delta represents the relationship between the change in the price of an option contract as compared to the change in the price of the underlying security. Delta also incorporates aspects of both intrinsic value and extrinsic value (often referred to as “time value”).

As such, an option with a strike price that is At-The-Money (ATM) has a Delta of 0.50 (“Fifty Delta”) as there is a 50/50 chance of it expiring with the underlying at that price. Again, Delta measures the change in the price of an option relative to the change in the price of the underlying security, so for a 50 Delta contract, a 1 change in the price of the underlying security will translate to a 0.50 change in the price of the contract.

Let’s work through an example, for which we’ll assume that you anticipate some upcoming volatility and want to protect your 1 million portfolio. 

Like most investors, you likely have a benchmark you are looking to outperform, say for argument’s sake, your benchmark is NDX (Nasdaq 100 Index). Because you are trying to outperform NDX, your portfolio is going to be different from NDX, meaning its correlation coefficient (r) compared to NDX is something other than 1. You run the numbers and find that your r is 0.9, meaning 90% of the movements in your portfolio can be attributed to movements in NDX. This is useful because it lets you know that using NDX options (NASDAQ 100 Reduced Value Index [NQX] options in this example) to hedge your portfolio will not result in a perfect hedge. For now, let’s assume that you are comfortable with this coverage gap.

Let us assume the “50 Delta” NQX contract you are contemplating is a 2,650 strike put expiring in 39 days. Because this is a put, Delta is displayed as negative, meaning a decrease in underlying price will result in an increase in the option price. The price of the put in our example is 70, and therefore each contract (70.00 * 100 contracts) is worth 7000.  As stated earlier, you have a 1 million portfolio you want to hedge, and given a current NQX index level of 2,500, you will need 1,000,000/2,500/100 = 4 contracts.

Using the put we have selected, a 1 drop in NQX value will result in a 0.50 increase in the price of the put. To fully delta hedge your portfolio, you would need to buy twice as many contracts to cover the anticipated price moves for (70 x 100 x 4 x2) 56,000, which is rather expensive.

Are there any other contracts we can look at?

Let’s look at the 25-delta contract, meaning a 1 change in the price of the underlying would result in a 0.25 change in the price of the options contract. The 25-delta contract is a 2,510 strike and is quoted at 32.90/34.40. Let’s take the midpoint and assume we buy it at 33.65 or 3,365. Because this is the 25 delta, we will need 16 contracts (4x4) for a total cost of 53,840.00 (4 x 4 x 3,365). It’s not a huge cost savings, but it does provide the same coverage at an initial lower cost.

If you wanted to reduce to cost of this hedge further, you could sell some Out-Of-The money (OTM) calls. Assuming you feel the market is looking to correct this would fit into your overall view. 

Once your hedge is set up, you can decide to either actively manage the delta exposure so that your hedge sits as close to fully covered as possible or not if you feel comfortable doing that. If your assumption was correct and the markets do start to decline, you can take advantage of what will become an over-hedged position as the total delta exposure increases as underlying prices approach your position strike price. As an aside, the rate at which delta changes in response to the underlying price moving closer to the contract strike is measured by another “Greek” known as Gamma.

In any event, inasmuch as there are many different ways to establish positions to either protect or enhance an exposure, we hope that these examples serve as a basic template for you to better understand how these strategies can be implemented.