Your hedging options

PORTFOLIO POINT: Index options are a low-cost way of way of protecting and enhancing your portfolio. Here’s how.

A sharemarket index is a number that measures the relative value of a group of shares; as the shares in this group change value, the index also changes value. There are many sharemarket indices, the All Ordinaries and the Dow Jones being well-known examples.

In the following exercise we are going to concentrate on the option on the S&P/ASX 200 Index listed on the Australian Securities Exchange (ASX). The S&P/ASX 200 index is commonly used by fund managers to benchmark performance and reflects the prices of the largest 200 shares, and around 80% of the value, currently listed on the ASX.

Options on the S&P/ASX 200 Index

The option on the S&P/ASX 200 index gives an investor exposure to the shares that make up the S&P/ASX 200 index listed on the ASX.

This option contract offers similar flexibility to that provided by options over individual shares and also allows an investor to trade the S&P/ASX 200 Index. First a few key option concepts and terminology for the option on the S&P/ASX 200 index:

Options on the S&P/ASX 200 Index are European style, which means that they can only be exercised at the expiry date. They only settle for cash and there is no requirement to deliver stock at settlement
The buyer of a call option participates in the gain of the underlying S&P/ASX 200 Index above the strike price, and the buyer of a put option participates in the decline of the underlying S&P/ASX 200 index below the strike price. The strike price is the price the option trades at and, for the option on the S&P/ASX 200 Index, it is expressed in points.
A call option with a strike price below the market price of the underlying asset or a put option with a strike price above the market price of the underlying asset is considered to be “in the money”. If a call option on the S&P/ASX 200 Index had been bought and it expired in profit, a cash payment would be made to the buyer of this option.
A call option with a strike price above the market price of the underlying asset or a put option with a strike price below the market price of the underlying asset is considered to be “out of the money”. If this option expired today it would be worthless.
If the strike price of a call option or a put option equals the market price of the underlying security it is “at the money”. If this option expired today it would be worthless.
The premium cost, contract value, and settlement amounts of the option on the S&P/ASX 200 Index are quoted and calculated in points. In order to calculate a dollar value for these points an “index multiplier” is used. The “index multiplier” for the option on the S&P/ASX 200 index is $10 per point per option contract.
The option premium is expressed in points and its dollar value is calculated by multiplying the premium points by the index multiplier. For example, an option on the S&P/ASX 200 Index premium of 120 points would cost $1200 (being 120 points x $10)
The contract value of the option on the S&P/ASX 200 Index is calculated by multiplying the strike price of the option by the index multiplier. For example, an option on the S&P/ASX 200 Index with a strike price of 4200 would have a contract value of $42,000 (being 4200 points x $10)

The settlement amount for an option on the S&P/ ASX 200 Index is calculated by comparing its strike price to the current level of the S&P/ASX 200 Index. A call option will be in profit (in the money) if the current level of the S&P/ASX 200 Index is higher than the option on the S&P/ASX 200 Index strike price. Conversely, a put option will be in profit (in the money) if the current level of the S&P/ASX 200 Index is lower than the option on the S&P/ ASX 200 index strike price.
The “intrinsic value” of an option is the in the money portion of the option’s premium. For example, if we purchase a put option on the S&P/ASX 200 Index with a strike price of 4200 and the underlying S&P/ASX 200 Index declines from 4200 to 3700, we will have intrinsic value of 500 points. If we decide at a later time to sell the put option on the S&P/ASX 200 Index the premium we will receive will generally include the intrinsic value. An option that is at, or out of the money, has zero intrinsic value.
Option premium will often have “time value”, which is calculated as the premium – intrinsic value. As the expiry date of an option approaches, the time value within an options premium typically declines, particularly in the last weeks of the option.
The seller of an option earns the premium while the buyer of the option incurs a premium cost.
An option may be bought or sold in the money, at the money, or out of the money. Generally speaking, the greater the option is in the money, the closer its price movement will be to that of the underlying index.
The purchaser of an option has unlimited profit potential but the maximum loss is limited to the premium paid for the option.
After the option on the S&P/ASX 200 Index expiration date the contract will cease to exist.

Bought put option strategy

We have a portfolio of managed funds valued at $420,000 that invests only within the Australian sharemarket and all use the S&P/ASX 200 Index to benchmark performance. We are concerned that there is going to be a decline in the share market and want to protect the current level of our portfolio.

Put option details:

As the current level of the S&P/ASX 200 index is 4200, we decide to buy a put option on the S&P/ASX 200 Index with an October 2011 expiry date and a strike price of 4,200. The put option is at the money and this will allow us to benefit from declines in the S&P/ASX 200 Index.
As each option contract has a value of $4200 (strike price of 4,200 x Index multiplier of $10) we buy 10 option contracts for a total contract value of $420,000.
The premium per option contract is 139 points and this equals a premium cost of per option contract of $1390 (premium of 139 points x index multiplier of $10). As we are buying 10 contracts we will incur a total premium cost of $13,900 (premium cost per option $1,390 x 10 contracts).
The put option is at the money as the strike price of the option on the S&P/ASX 200 Index and the level of the S&P/ASX 200 Index are the same.

Example 1: The S&P/ASX 200 index declines to 3,700 and the Option expires

Our concerns regarding the sharemarket prove correct and the S&P/ASX 200 Index declines by 11.90% to 3700 and it remains at this level until after the expiry of the put option on the S&P/ASX 200. As our Australian share managed funds track the S&P/ASX 200 Index closely, our portfolio of $420,000 has declined by $49,980, or 11.90%.

If we allow our option to expire we will receive a cash payment of $50,000 for the intrinsic value (profit) generated by the option. This is calculated as (strike price of 4200 – expiry price of 3700) x 10 contracts x $10 index multiplier.
After deducting the put option premium cost of $13,900 from the option cash payment of $50,000 the option protection strategy produces a net benefit of $36,100.
As our managed fund portfolio has declined by $49,980, and our option protection strategy has generated $36,100, our net portfolio decline is $13,880 or 3.31% (being $49,980 – $36,100).
Our option protection strategy has reduced the loss on our managed fund portfolio by 8.59% (being 11.90% – 3.31%).

Example 2: The S&P/ASX 200 Index declines to 3700 and the Put Option is sold

In this example the assumptions used are the same as those in example 1 and both the S&P/ASX 200 Index and our managed funds decline by 11.90%. In this example we want to be more proactive with the option protection strategy and we decide to close out the put option on the S&P/ASX 200 Index if the premium we earn exceeds the intrinsic value (profit) of the put option we bought.

One month after purchasing the put option on the S&P/ASX 200 Index the S&P/ASX 200 Index drops to 3700. Within our option we now have intrinsic value (profit) of 500 points (4200 strike price – 3700 index level). We note that we can sell our put option for 550 points per contract and that this exceeds our intrinsic value by an additional 50 points (which is time value).
We sell a put option on the S&P/ASX 200 Index with an October 2011 expiry date and a strike price of 4200 and we receive premium of $55,000 (550 points premium per contract x 10 contracts x $10 index multiplier).
The benefit of our option protection strategy is $41,100 (being $55,000 premium earned – $13,900 premium paid).
As our managed fund portfolio declined by $49,980, and our option protection strategy generated $41,100, our net portfolio decline is $8,880 or 2.10% (being $49,980 – $41,100).
Our option protection strategy has reduced the loss on our managed fund portfolio by 9.80% (being 11.90% – 2.10%).
As we have bought and sold a put option at the same strike price we will not generate any further benefit or loss from our options. However, as the managed fund portfolio is now without protection future changes in its value will ultimately determine the effectiveness of our strategy. If, for example, the sharemarket recovered to 4200 before the options expire the managed fund portfolio would not incur a loss but we would receive the $41,100 benefit of the option strategy. Conversely, if the sharemarket fell below 3700 additional losses would be incurred.

Example 3: The S&P/ASX 200 Index appreciates

Unlike the previous two examples, here we have incorrectly assessed the sharemarket and it appreciates shortly after we purchase the put option on the S&P/ASX 200 Index. As the buyer of the option our maximum risk is the option premium paid of $13,900. Furthermore, we may be able to sell the put option on the S&P/ASX 200 Index before it expires and generate premium income that will partially contribute towards our premium cost.

Final thoughts

Index options are a low-cost tool that can be used to provide portfolio protection and also enhance the performance of a portfolio. While the examples within this article have focused on managed funds, index options could be used to protect and enhance other portfolios, such as direct shares, that have a strong correlation with an index.

Mark Bennetts is a senior adviser with Lachlan Partners Wealth Management. This extract from the Investing Times newsletter was first published on September 30.