Fyshe Horton Finney Ltd

1
Fyshe Horton Finney Ltd Stockbrokers Investment
Managers Chris Pook Private Client
Stockbroker 44 (0)116 251 2845
Hedging Portfolios With Traded Options .
2
TRADED OPTIONS
Risk Warning Please read the risk warning
at the end of this presentation.
3
TRADED OPTIONS
Hedging with Traded Options Introduction The
equity markets are uncertain. But even if a fall
in the general market is anticipated, disposal of
equity holdings is often inappropriate. CGT
implications, transaction fees, emotional
attachment and not least the question of what
and when to sell can all lead to inaction and
preventable losses. There is an answer.
4
TRADED OPTIONS
Hedging with Traded Options Introduction Invest
ors may use traded options to hedge the value of
their portfolios. Often considered complex and
risky, in reality the process is simple, and for
a known cost can actually reduce risks. In fact
the premium paid for a protective option may be
likened to an insurance premium.
5
TRADED OPTIONS
Hedging with Traded Options Introduction This
presentation explains Static Hedging. A general
knowledge of Option terminology is presumed. The
examples are based on the ESX (FTSE 100) Index
Option Contract traded on Euronext.Liffe This
contract is cash settled at 10 per index
point. The portfolio in the examples is valued
at 800,000
6
TRADED OPTIONS
Hedging with Traded Options Two choices There
are two simple methods to gain protection from
market risk. This presentation covers static
hedging using either Long Puts or Synthetic
shorts Dynamic Hedging, which is more complex,
more costly, and more appropriate to the
Institutional or larger private client, will be
covered in future presentations.
7
TRADED OPTIONS
Hedging with Traded Options Market Risk - What
are we protecting against? Equity investors face
two main risks Unique (Company) Risk The
risk that internal factors (e.g. weak management
or failed projects) could cause the fortunes
(and the share price) of a company to
falter. Market Risk The risk that external
factors (economic issues) cause the market as a
whole to fall. internal factors cause the
prospects (and the share price) of a company to
fall
8
TRADED OPTIONS
Hedging with Traded Options There are two
simple methods to gain protection from market
risk. This presentation covers static hedging
using either Long Puts or Synthetic
shorts Dynamic Hedging, which is more complex,
more costly, and more appropriate to the
Institutional or larger private client, will be
covered in future presentations.
9
TRADED OPTIONS
Hedging with Traded Options Static v Dynamic
Hedging Dynamic hedging Close hedge of
position from the outset. - Calls for frequent
rebalancing of the hedge position. Given the
contract size of available instruments, and cost
of trading, for most investors a static hedge is
adequate.
10
TRADED OPTIONS
Hedging with Traded Options Static
Hedging A static Hedge involves the
purchase of a number of Put Options or
construction of a Synthetic Position To
hedge falls in the value of the investors
portfolio At expiry
11
TRADED OPTIONS
Hedging with Traded Options Dynamic
Hedging A dynamic Hedge involves the
purchase of a number of Put Options or
construction of a Synthetic Position To
hedge falls in the value of the investors
portfolio At the date the trades are
undertaken
12
TRADED OPTIONS
Long Put Hedge Type Static Hedge
Construction Buy a Put Motivation Belief
that the underlying will fall in value and /
or volatility will increase Cost Premium
paid Maximum Reward Equivalent to loss on
Underlying Portfolio
13
TRADED OPTIONS
Long Put Hedge Buy 36 x December 5500 Puts Net
debit of 100,808 P/L at Expiry
Cost of Insurance if Market Rises
PL of Underlying
PL of Overall Position
PL of Option Contract
Value of Insurance if Market Falls
14
TRADED OPTIONS
Synthetic Short Hedge Type Static
Hedge Construction Buy a Put, Sell a
Call Motivation Belief that the underlying
will fall in value Cost Premium Dr for
Long Put - Premium Cr for Short Call Maximum
Reward Equivalent to loss on Underlying
Portfolio
15
TRADED OPTIONS
Synthetic Short Hedge Construction of the
Synthetic Short Buy 36 December Sell 36 x
December 5500 Puts _at_ 280 5500 Calls _at_
310 Debit of 100,800 Credit of
115,200 Net Credit 14,000 P/L at
Expiry
P/L of Sold Call
PL of Bought Put
PL of Synthetic Short
16
TRADED OPTIONS
Synthetic Short Hedge Overall Position of
Synthetic Short Selling Calls and Buying
Puts P/L at Expiry
PL of Underlying
PL of Overall Position
Cost of Insurance if Market Rises
Benefit of Insurance if Market Falls
17
TRADED OPTIONS
Synthetic Short Hedge Overall Position of
Synthetic Short Selling Calls and Buying
Puts P/L at Expiry
18
TRADED OPTIONS
How many Contracts? How many contracts are
required to hedge a portfolio? FACTORS
Portfolio Value Value of Option contracts
LIFFE Traded FTSE 100 Options are settled for
cash at 10 per point. Portfolio Beta The
degree to which the movement in value of a
portfolio is correlated with the FTSE.
(Portfolio Value x Portfolio Beta / (Value of
Contracts x Index Valuee. Worked example
Portfolio Value 2m Option Contracts 10
per point of index movement Value of FTSE
5500 Portfolio Beta 1 No of Contracts
(2,000,000 1) / (10 5500) 36.3, Say 36
Contracts
19
TRADED OPTIONS
Questions?
20
TRADED OPTIONS

• Risk Warning
• This notice is provided to you, as a private
  customer, in compliance with the rules of the
  FSA. Private customers are afforded greater
  protection under these rules than other customers
  are and you should ensure that your firm tells
  you what this will mean to you. This notice
  cannot disclose all the risk and other
  significant aspects of warrants and/or derivative
  products such as futures and options. You should
  not deal in these products unless you understand
  their nature and the extent of your exposure to
  risk. You should also be satisfied that the
  product is suitable for you in the light of your
  circumstances and financial position. Certain
  strategies, such as spread position or a
  straddle, may be as risky as a simple long or
  short position.
• Securitised Derivatives
• These instruments may give you a time-limited
  right to acquire or sell one or more types of
  investment which is normally exercisable against
  someone other than the issuer of that investment.
  Or they may give you rights under a contract for
  differences which allow for speculation on
  fluctuations in the value of the property of any
  description or an index, such as the FTSE 100
  index. In both cases, the investment or property
  may be referred to as the underlying
  instrument.
• These instruments often involve a high degree of
  gearing or leverage, so that a relatively small
  movement in the price of the underlying
  investment results in a much larger movement,
  unfavourable or favourable, in the price of the
  instrument. The price of these instruments can
  therefore be volatile.
• These instruments have a limited life, and may
  (unless there is some form of guaranteed return
  to the amount you are investing in the product)
  expire worthless if the underlying instrument
  does not perform as expected.
• You should only buy this product if you are
  prepared to sustain a total loss of the money you
  have invested plus any commission or other
  transaction charges.
• You should consider carefully whether or not this
  product is suitable for you in the light of your
  circumstances and financial position, and if in
  any doubt please seek professional advice.

21
TRADED OPTIONS

• Risk Warning
• There are many different types of options with
  different characteristics subject to the
  following conditions
• Buying options
• Buying options involves less risk than selling
  options because, if the price of the underlying
  asset moves against you, you can simply allow the
  option to lapse. The maximum loss is limited to
  the premium, plus any commission or other
  transaction charges. However, if you buy a call
  option on a futures contract and you later
  exercise the option, you will acquire the future.
  This will expose you to the risks described under
  futures and contingent liability investment
  transactions.
• Writing options
• If you write an option, the risk involved is
  considerably greater than buying options. You may
  be liable for margin to maintain your position
  and a loss may be sustained well in excess of the
  premium received. By writing an option, you
  accept a legal obligation to purchase or sell the
  underlying asset if the option is exercised
  against you, however far the market price has
  moved away from the exercise price. If you
  already own the underlying asset which you have
  contracted to sell (when the options will be
  known as covered call options) the risk is
  reduced. If you do not own the underlying asset
  (uncovered call options) the risk can be
  unlimited. Only experienced persons should
  contemplate writing uncovered options, and then
  only after securing full details of the
  applicable conditions and potential risk
  exposure.
• Traditional options
• Certain London Stock Exchange member firms under
  special exchange rules write a particular type of
  option called a traditional option. These may
  involve greater risk than other options. Two-way
  prices are not usually quoted and there is no
  exchange market on which to close out an open
  position or to effect an equal and opposite
  transaction to reverse an open position. It may
  be difficult to assess its value or for the
  seller of such an option to manage his exposure
  to risk.
• Certain options markets operate on a margined
  basis, under which buyers do not pay the full
  premium on their option at the time they purchase
  it. In this situation you may subsequently be
  called upon to pay margin on the option up to the
  level of your premium. If you fail to do so as
  required, your position may be closed or
  liquidated in the same way as a futures position.

22
TRADED OPTIONS

• Risk Warning
• Contingent liability investment transactions
• Contingent liability investment transactions,
  which are margined, require you to make a series
  of payments against the purchase price, instead
  of paying the whole purchase price immediately.
• If you trade in futures, contracts for
  differences or sell options, you may sustain a
  total loss of the margin you deposit with your
  firm to establish or maintain a position. If the
  market moves against you, you may be called upon
  to pay substantial additional margin at short
  notice to maintain the position. If you fail to
  do so within the time required, your position may
  be liquidated at a loss and you will be
  responsible for the resulting deficit.
• Even if a transaction is not margined, it may
  still carry an obligation to make further
  payments in certain circumstances over and above
  any amount paid when you entered the contract.
• Save as specifically provided by the FSA, you
  firm may only carry out margined or contingent
  liability transactions with or for you if they
  are traded on or under the rules of a recognised
  or designated investment exchange. Contingent
  liability investment transactions which are not
  so traded may expose you to substantially greater
  risks.
• Limited liability transactions
• Before entering into a limited liability
  transaction, you should obtain from your firm or
  the firm with whom you are dealing a formal
  written statement confirming that the extent of
  your loss liability on each transaction will be
  limited to an amount agreed by you before you
  enter into the transaction.
• The amount you can lose in limited liability
  transactions will be less than in other margined
  transactions, which have no predetermined loss
  limit. Nevertheless, even though the extent of
  loss will be subject to the agreed limit, you may
  sustain the loss in a relatively short time. Your
  loss may be limited, but the risk of sustaining a
  total loss to the amount agreed is substantial.