Cheap and flexible strategy to boost portfolio returns
OPTIONS are set to alter the way some people invest in Hongkong.
The instruments offer the investor a cheap and flexible way to boost returns or protect downside risk in a portfolio of equities.
In the last of the Business Post series on options, the various more common options strategies will be looked at to see how they match an investor's view of the market.
The chart shows a series of option strategies along with the market view associated with each strategy.
An option is an entitlement, but not an obligation, to buy or sell an underlying security or investment.
A call option is the entitlement to buy and a put option is an entitlement to sell.
Buying options offers the opportunity to obtain unlimited gains if things go right while the downside is limited to the cost of buying the option.
Selling options has a very different risk profile, as the only gain from the transaction is the premium received from the investor, but potential losses are unlimited if things do not go right.
Before trading in options, individual investors need to seek professional advice to become fully aware of the risks involved.
The aggressively bullish investor will buy calls. Peregrine Derivatives, in its options strategy book The Art of War, says: ''An option is a highly geared investment, since the premium that you pay for the option is a fraction of the price of the underlying stock.'' A bearish investor, who believes the market is over-valued or is due for a fall, should buy a put, which offers the investor the right to sell the index, valued in points at $50 a point, at a fixed level over a pre-determined time.
For the aggressive bull who wants to limit downside risk, and the cost of the transaction, a bull spread might be appropriate. A bull spread is where the investor buys a call and sells a call at a higher strike.
The premium from the sale of the call at a higher strike cuts the cost of the transaction and brings down the break-even point of the strategy. The potential to make profits is still substantial, but it is limited as the strategy involves capping your maximum gain in order to lower the cost of the initial investment.
The bull spread is ideal for the investor who believes the market is due to go up, but not enormously.
A bear investor can buy a bear spread which involves buying a put and selling a put at a lower strike.
The type of investor who thinks the market is going to go up, but not significantly, could try a ratio spread, which involves buying a call and selling more calls at higher strike prices.
Should the index remain flat then the whole investment is lost since the call options would expire. However, if the market moves ahead of the pre-determined range, and goes beyond the two short positions taken, then the investor loses twice as much as hegains for every extra index point.
Peregrine points out: ''Ratio spreads are very much an active strategy. As the underlying index price alters, or your market expectations change, the investor should be altering the structure of the portfolio.'' This means reducing short positions if the market is going up or selling more options if the investor believes the market will fall.
Ratio spreads can be used by bear investors, using puts instead of calls in their strategy. They are extremely flexible and can be fine-tuned by the use of strike prices to fulfil a number of market outlooks.
For the investor who is bullish on the market, but is also a little cautious, a covered write might be appropriate. This is used by institutions in equity or bond fund management, which hold securities for long periods of time and want to earn income from their positions in addition to stock appreciation and dividends.
This involves the investor buying the underlying security and selling a call option on the security. This gives the buyer the option to buy the underlying security at a given strike price over a pre-determined period.
''This is therefore a strategy which makes an assumption that the share price is more likely to remain neutral or rise, but not dramatically,'' says Peregrine Derivatives.
The premium taken on the sale of the call reduces the cost of buying the shares and can enhance the return of a share portfolio during flat markets, so it is also appropriate for the investor with a neutral outlook.
Investors who are bulls or bears but have no idea on their timing might consider a calendar spread, which will require the investor to sell an option with a short life and buy another option with a longer life.
''The net effect is that the investor makes the maximum profit if the index does not move,'' says Peregrine.
The key part of the strategy is linked to what happens to the short-life option as its only value is the premium received in writing the option.
The hope is that nothing happens to the underlying investment over its life, so that it expires worthless and the investor pockets the premium.
The marginal bull might consider buying a direction calendar spread which involves selling a near-term call and buying a longer-term put at a lower strike.
The marginal bear would sell a near-term put and buy a longer-term put at a higher strike.
The marginal bear is making money if the market edges up a little, but will lose money if it falls. Profitability occurs with an increase in the underlying investment above the lower strike and it is at its maximum when it hits or rises above the higher strike.
The investor who is neutral or undecided on his or her market outlook might consider buying or selling strangles and straddles.
In the table, their market sentiment is illustrated by a turkey, as opposed to a bull or a bear. But even turkeys can make money with the right options strategy.
Selling a straddle involves selling an at-the-money put and an at-the-money call. ''At the money'' means the strike is equal to the close that day.
The best that could happen for the investor is if nothing happens at all in the underlying investment and the investor pockets both premiums from writing the options. The downside is that the losses could outstrip the premium gain.
The individual who buys a straddle, buys a put at the money and a call at the money so that it does not matter which way the market moves as long as it moves in one direction substantially.
In this the plan is to be in a position where the profits from one option outweigh the losses from the other while the investor has managed to hedge bets.
Peregrine points out that the key to strangles, which involve buying out-of-the-money calls and puts, is that the underlying investment should move sufficiently in one direction that the cost of one side of the transaction is more than offset by the profits from the other, as in straddles, but the cost of undertaking the strategy is less because out-of-the-money options are involved.