VANDERBILT CAPITAL ADVISORS
INVESTING WITH OPTIONS
INTRODUCTION
Options have been developed on a
variety of investment vehicles. The
effectiveness of options in hedging for risk management and in enhancing return
has led to their broad acceptance by investors.
They have proven successful in a wide range of investment environments
over the past decade. Option products
are available in many markets including those for fixed income, equities,
commodities and currencies. They are
traded on the exchange and over the counter.
In this paper, we will review basic options concepts and instruments,
and examine some specific strategies being used by Vanderbilt Capital Advisors,
LLC to reduce risk and enhance portfolio returns in Fixed Income portfolios.
Definition
An option establishes a right for
the owner to buy or sell an underlying security at a specific price at any time
during the life of the option. This
right is sold by the option writer to the option buyer for a premium.
OPTION ELEMENTS
Strike Price
The strike price is the price at
which the underlying security may be bought or sold when the option is
exercised. For example, an option with a
strike price of 92 would give the option buyer the right to buy or sell
(depending on the type of option held) an underlying security at 92. The strike price is established by the
exchanges at or around the current price of the underlying security. New strike prices are introduced when the
price of the underlying security changes significantly.
Expiration Date
The expiration date of an option
is the last day on which an option can be exercised. Listed options on futures are referred to by
the underlying futures contract month.
For example, a September bond option is an option on September bond
futures. This option expires on a
specific date during the preceding month.
Premium
The premium is the price the
buyer pays in return for the rights conveyed in the option. In return for the premium the option seller
agrees to fulfill the terms of the agreement.
The seller keeps the premium whether or not the option is
exercised. Option premiums are sensitive
to changes in the underlying security price, volatility and time to expiration.
The sensitivity of premium
measurements are known as delta, gamma, vega and theta.
Delta is
the change in the premium given a unit change in the price of the underlying
security.
Gamma is
the change in delta given the unit change in the underlying security price.
Vega is
the change in the premium given a one percent change in the implied
volatility. For example, if an option
has a current implied volatility of 10% and a Vega of 0.1, then if volatility
increases to 11% the premium will increase by 0.1 points.
Theta is
the decline in premium price given a one day passage of time.
These terms are expressed
mathematically in the Appendix.
OPTION TYPES
Call Option
A call option gives the buyer the
right (not the obligation) to purchase a particular underlying security
at a specific price any time prior to expiration. For example, a September 92 call on T-bond
futures conveys the right to buy the September T-bond futures at a strike price
of 92 any time before expiration.
Put Option
A put option gives the buyer the
right to sell a particular security at a specific price before expiration. For example, a September 92 put on T-bond
futures gives the holder the right to sell the September T-bond futures
contract at 92, any time prior to the expiration date. This is an inexpensive and efficient way to
establish a short position. The strike,
expiration and premium elements are common to both option types.
ADVANTAGES
Safety
The most important advantage of
options is their safety. Options are
regulated by both the Securities and Exchange Commission and the Commodities
Futures Trading Commission. Listed
options are exchange traded and guaranteed against failure by the exchange.
Liquidity
Another advantage is
liquidity. The daily volume of options
on Treasury Bonds traded on the exchange is two and one half times that of the
volume of bonds traded in the cash market.
Efficiency
A third advantage is
efficiency. Transaction costs especially
on listed options, are very low, amounting to about one quarter of the
transaction cost of bonds traded in the cash market.
STRATEGIES
Options are valuable to a
portfolio manager because they greatly increase his flexibility, and his
ability to respond to different market conditions. Prior to the introduction of options, a
manager could only trade securities at prevailing market prices. The cost of these transactions was high and,
therefore, negatively impacted performance.
Options, however, created the ability to purchase and sell securities at
prices different from today's, and at forward dates, with low transaction
costs. In the following paragraphs we
introduce some strategies employing options.
Buying Calls To Lengthen
Duration
Calls, which have the duration of
the underlying instrument, are bought to increase portfolio duration in a risk
averse manner. The portfolio profits
point-for-point in a rising market with the underlying security once the
security's price exceeds the strike price plus the premium paid. On the other hand, if the security declines,
losses stop at the premium paid. The
manager has controlled his risk by limiting it to the price paid while allowing
the portfolio to perform to virtually the full extent of its upside potential. The asymmetric risk reward pattern of a
purchased call is diagrammed below.
Covered Call Writing
A portfolio manager can elect to
sell his securities at a price higher than today's, through the sale of a call
option. The manager can select that
price through his choice of exercise price.
The premium he receives is his regardless of whether or not the
purchaser exercises the call. When added
to today's price, the premium guarantees a higher sale price than prevails
today. If the security were to decline
from today's price, the premium received would mitigate the loss acting as a
small hedge to the current position.
However, it should be remembered that in the case of a rising market
this strategy will cap the possible appreciation of the underlying security to
the price plus the premium. Hence, in
bull markets the program limits the upside potential of the portfolio. Nevertheless, this transaction is low cost
and easily accomplished in the very liquid options market. Since the premium is typically a fraction of
the underlying security's price, the cost associated with a call sale is much
less than would be the cost of a sale of the underlying security.
CONCLUSION
The strategies outlined in this
paper are only a few of the many ways we use options to limit risk and enhance
return. A great range of market outlooks
can be hedged with strategies employing options. These flexible, highly liquid, low investment
cost vehicles permit us to achieve the highest level of return on our portfolios
for any given level of risk. Today's
highly volatile interest rate environment challenges institutional money managers
to respond quickly to changing risks and opportunities.
The liquidity of the options market together with the unique asymmetric
risk characteristics of options provides us with the means to meet challenges
and capitalize on opportunities in the markets.
