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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:
