The term “derivatives” still has the power to make investors fearful, more than a decade after the Global Financial Crises. Derivatives were a useful scapegoat for the market catastrophe caused by our collective greed; they are complex, and have very little capacity to defend themselves. This fear is costly, as it means many refuse to acknowledge that derivatives are powerful tools that investors can use to reduce risk.
This is not to downplay the damage that uninformed or poorly advised investors can do to their portfolios. A chainsaw may be used to build a log cabin, or create a magnificent ice sculpture. It can also cut off an arm if used carelessly. The problem is not with the chainsaw, it’s the way it’s used. The situation is similar with derivatives.
Investors who’ve put in the time and effort to understand financial instruments like hybrid bonds, options, CFDs and futures generally reap the rewards. One of the most common strategies among these individuals is using put options to reduce share market risk.
Put options are available over the share market index and around seventy top stocks. (A put option confers the right on the buyer to sell the underlying index or share at a specified price). What they all have in common is that they go up in value as the index or respective stock falls. The most an investor can lose on a bought put option position is the amount they originally pay, whereas the increase in value in a dramatic fall can return many times the original premium. This means an investor still enjoys the benefit of a rising market (and any dividends), and is unconcerned if markets fall.
However there is another, less utilised option strategy that can deliver a similar investment profile. Investors nervous about the market can sell their portfolio, put the cash on deposit, and buy call options. (Call options give the buyer the right to buy the underlying share or index). In this case investors are ready to pounce if the share market falls out of bed, and receive interest on their deposit in the meantime. If the market defies expectations, and rises, investors will see their call options increase in value.
Individual circumstances will dictate whether this is a suitable strategy for investors. Overall investment strategy, risk appetite and tax implications are important considerations. An understanding of the risks and effects is paramount. Any investors contemplating this approach should ensure they understand the impact, and if in any doubt seek independent advice.
The reason some consider the cash plus calls strategy superior to the portfolio and puts approach lies in the technical structure of the options markets.
Generally speaking there is much greater demand for options that have a strike price (the agreed sale or purchase price) below the current market. Similarly, because many sophisticated investors generate extra portfolio income by selling options with strike prices above current levels these options are cheaper. Professional option traders refer to this supply and demand effect as the “volatility skew”.
The cash plus calls strategy takes advantage of this difference in supply and demand. In volatility terms buying calls above current market is cheaper than buying puts below market.
With the index at 6,650 a call option with a strike price of 6,700 expiring in October is worth around 115 index points. This equates to 1.7% of an index portfolio’s value. By selling 100% of the portfolio and investing just 1.7% in call options, the investor will still benefit from any significant rise in the market. If the market drops in value, the investor will lose the 1.7% spent on calls, preserving 98.3% of the portfolio value.
This strategy is clearly not suitable for every investor. But for those in a situation to take advantage of the skew this represents a lower risk way to stay in the market while preserving capital. For nervous investors this could mean three months of better sleep at night.