How to use a volatility Call Spread as a Downside Hedge?

on Mar 22, 2015 in Derivative, Equity, Home | 2,098 comments

One way to hedge the downside risk in your portfolio over the following three months is to purchase some put options. The exchange-traded fund SPY tracks the S&P 500 index, is highly liquid and makes a nice proxy for your US equity holdings. If you purchase the adequate out-of-the-money puts on SPY to hedge against a 10% market decline for your entire portfolio, you’ll pay about 3% of portfolio value. It is only under the condition that the market slumps more than 13% (10% decline plus 3% cost for the put premiums), that you have put a floor under which the portfolio is covered. Is that actually the best strategy to play? The call spread option trading strategy on the CBOE Options Volatility Index (VIX) might be the solution. In my view, this could be an interesting indirect theme to play. Remember, if the market goes down the VIX will go up. And if the market really pukes, the VIX will roar higher. Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying and the same expiration month. By shorting the out-of-the-money call, you reduce the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the volatility skyrockets. As the market continues to shoot to all-time highs, this strategy would act as a complementary trade to your portfolio since volatility typically expands when the market sells off. Higher volatility means higher options prices as larger swings are expected. Low volatility means little is expected in the way of market movement which is why I often think of the VIX as an indicator of relative market stress. Some people call the VIX the Fear Index as volatility tends to explode in falling markets and drop in rising markets. Currently the VIX is trading at 14.07. Its 52 week range is 10.28 – 31.06 and this indicates to me that there is still a relatively high level of complacency in the market despite the global economic uncertainty and equity markets shooting to all times highs. Keep in mind that at the height of the financial panic in 2009 it touched 80. Let’s look at the VIX April contract 16-20 call spread. This spread is trading at 0.85, which seems cheap to me. A VIX at 20 or higher will more than triple your investment. That means that if the VIX is over 20 in the following month (not at all unlikely, and under the 52-week high) the spread will expire at four. So, you are risking less than one to make more than three, I consider it to be a highly favorable risk/reward ratio in this market environment. This strategy could be a way to hedge your equity portfolio against a major move lower, albeit perhaps...

Liquid Alternatives, the new Eldorado for active managers?

on Jun 14, 2014 in Derivative, Fixed Income, Home, Portfolio ad hoc | 2,133 comments

Thanks to the unconventional measures of central banks and the march of index investing strategies, we are in fact seeing the rise of a new, more aggressive version of active management. Investment managers are launching investment products that give them more flexibility to roam around financial markets in search of alpha. The question is whether end investors will ultimately benefit from this phenomenon. So, what are exactly Liquid Alternatives? Liquid Alternatives are complex and opaque investment wrappers that require a bit of caution. They are packaged into a fund, covering a wide-ranging category of assets, while using a hedge fund strategy. Unlike most traditional funds, they can go short, use leverage and derivatives. The rise of Liquid Alternatives opens up a vast new market and come at a convenient time for asset managers. Now with bonds looking fairly expensive and equities unstably climbing higher, asset managers are looking for an alternative that could hold its value in dangerous waters. This is where Liquid Alternatives come into play. The risk is that unconstrained funds are not being pitched correctly. They are marketed as uncorrelated assets that increase diversification or act as insurance protection. Faced with a universe of styles and possible strategies, investors ought to be doing their due diligence in a similar fashion as a hedge fund. Consider for instance, fixed income where, after three decades of declining interest rates, the normalization of monetary policy may be a headwind for returns for the coming years. In this respect, PIMCO is pursuing a push for so-called unconstrained bond funds. In practice, the funds are sold as a conservative choice, a prudent alternative to a core bond fund that might no longer be able to preserve capital. It consists of placing bets across a wider spectrum of the fixed income market, such as emerging markets, junk debt, credit derivatives, and taking bets on the direction of interest rates. Retail investors are only catching up with what is happening among institutional investors. This process will lead to more volatility in markets, and be consequently ready to tighten the seat belt. Their record is not long enough to know whether they could get credit for diversification benefits. Don’t forget to do your homework before...

What is a LEAP option?

on Sep 27, 2012 in Derivative, Home | 1,611 comments

Long-Term Equity Anticipation Securities or LEAPs are very similar to standard options except for the fact that expiration occurs 36 months after purchase. They can be safer than traditional options because it is somewhat easier to predict share movements over longer periods. Therefore, they can be effective for both leverage and hedging purposes. For leverage: Investors can purchase a LEAP call option contracts instead of shares of a company in order to get similar long-term investment benefits with less capital outlay. Substituting a financial derivative for a share is known as a share replacement strategy, and is used to improve overall capital efficiency. LEAP call options may be purchased and then rolled over for many years, which allows the underlying security to continue to compound as the investor simply pays the roll forward costs. For hedging: Investors could purchase LEAPS put options as long term insurance against a catastrophic fall. In terms of price, LEAPS put options cost much lesser than all the short term monthly put options added together. This is why investors seeking to hedge for the long term should not hedge using short term put options. Hedging using short term options also result in more trades as short term options expire, resulting in higher commissions...

Synthetic ETF: as an investor you should remain cautious

on Sep 20, 2012 in Derivative, Home | 1,262 comments

The old investors’ advice to “Never invest in something you don’t understand” strikes for synthetic exchange traded fund.  A synthetic exchange traded fund is an investment that mimics the behaviour of an exchange traded fund through the use of derivatives such as swaps. The most obvious way to track an index is to own all (or most) of its component securities in the same proportion as that index. However the synthetic ETF can imitate an index without owning a single one of the benchmark’s securities. In fact, well-known providers such as Lyxor and db x-trackers are both swap based. Why would an investor invest into a synthetic ETF when they could simply use a plain vanilla index fund? The answer is that the swap structure provides a low tracking error. While most managed index funds follow their benchmarks closely, it’s not unusual for tracking errors to be a drag on returns. With a swap structure, the counterparty must deliver the return of the index precisely. So why go to the trouble of actually owning the shares of an index when you can deliver its return using swaps? However the reduction in tracking error comes at the cost of heightened counterparty risk. In the worst case scenario – counterparty default – the ETF’s source of return is cut-off and it’s time to fall back on the collateral. Even though ETF must be backed by collateral worth at least 90% of its market value and in practice, ETF are often over collateralized – meaning backed up to 120% of its value in collateral – there is no requirement for collateral to be held in the same securities that the ETF tracks. It implies that the ETF’s collateral basket can include illiquid assets! I recommend investors greater scrutiny of collateral pools to avoid being soaked up in a downturn by applicable...

Delta neutral hedging strategy

on Aug 23, 2012 in Derivative, Home | 727 comments

The option price does not always move in conjunction with the price of the underlying asset. Consequently, it is important to understand the factors contributing to the price movement of an option, and the effects they generate. Delta for instance measures the sensitivity of an option’s value to a change in the price of the underlying asset. It indicates how much the value of an option should change when the price of the underlying share rises by 1 USD. For example, if you short one call, maturity December 12 with a delta of -0.45, you should lose USD 0.45 if the share price goes up by 1 USD. Now, if you want to create a market neutral position, you should sell enough calls so that the net position is delta neutral.  The term means that your position has no market directional bias, in other words the position is neutral to market movement.   In a covered short call strategy, you are buying the underlying shares and shorting call options against it. For instance, if you are long 100 shares SPY, you could sell 2 contracts with a delta of 0.5 at the money calls, or 4 contracts with a delta of 0.25 out of the money calls and so on. If the net position delta is at or close to zero, your position will not have directional risk as long as it remains delta neutral. The primary motivations for this strategy is that you are prepared to liquidate the share at a defined price above current market value and cost price, and sell the option to pocket a decent premium. Once you go short on the call, you are exposed to the risk of having to sell shares at the strike price when the share price is trading upwards. If the stock price moves downwards, the call options decrease in price. You can either buy back the call option to close your position, or, you could wait, hoping that the options expire worthless. Some investors believe this option strategy is worth your consideration as you will be able to sell the share for a fair price and generate a premium income from the...

Additional income through covered call option strategy

on Jun 14, 2012 in Derivative, Equity, Home | 1,775 comments

During times of economic uncertainty, having blue chip titles in your portfolio that pay  steady dividends is one way to ride out the storm. Dividends provide indeed regular  income to investors. But did you know you could earn an extra income on shares you already own? This strategy involves selling covered calls on shares that you own. By using a covered call option strategy, the investor gets a premium writing calls and at the same time enjoys all benefits of share ownership, such as dividends and voting rights, unless he is  exercised on the written call and is then obligated to sell his shares. It is also important to cover a caveat of this strategy. When you sell a covered call on a share, you are limiting your upside potential. If the share price goes skyward then the option will probably be exercised and you will be obligated to sell the share at the agreed on strike price. However, if the asset price is below the strike price at expiration, then the calls that you sold are not exercised and the premium that you collected provides additional income for you, increasing your rate of return on your portfolio. If you are writing out of the money calls, the share may continually increase in value, yet the options may never get exercised, allowing you to simply roll over the strategy. This generates continuous income for you. Obviously, you want to sell covered calls at a strike price above your cost basis, so you still profit if the market price is above the strike price and the shares are called. Ideally you would like to set the strike price above where you believe the price will rise by the expiration date, so that you can pocket both the premium and keep the shares within your portfolio. When your view is neutral on a share and you want to generate additional income from your investments, this option strategy is worth your...