Options - Risk Management Using Options

Risk Management Using Options

I. Hedging

a. Long Positions (inventory/long futures)

i. Purchase puts - Their value increases as that of the actuals decreases. The premium is the only cost of this strategy. The underlying may well increase in value.

ii. Sell futures - The short position gains with falling prices and reduces profit on the underlying if values increase.

iii. Sell calls - A bearish approach, this strategy is less effective than the previous two as the only gain that inures to the seller is the premium that he or she receives.

iv. Sell Covered Calls (Long futures and short calls) - This strategy provides protection for a long position with limited profitability. The strategy is covered as the investor is long futures should the call be exercised. The futures are offset at the strike price. In the call holder does not exercise his or her position, the call writer keep the premium which enhances the position's return because no exercise occurred.

v. Long Futures and Long Puts - The investor purchases puts with a strike price at or close to the price he paid for the futures. Should prices decline below the strike price, he may exercise and sell. Should prices rise, the investor loses only the premium, but retains unlimited gain on the long futures position.

b. Short Positions (short cash market position or anticipated purchase/short futures)

i. Purchase Calls - The intrinsic and time value gain in a rising market, offsetting the higher cash market prices. If they decline below the strike price, then the owner has paid for insurance that was not used.

ii. Purchase Futures - The value of the contract gains with the increase in value of the actuals.

iii. Sell Puts - Doing so is of limited effectiveness as the writer receives only the premium, but has to go to the cash market if prices rise to deliver on the owner's exercise of a put. He or she has to buy, and possibly in a rising market.

iv. Short Futures and Long Calls - As upside risk on a short futures position is unlimited, exercising the call if prices exceed the strike price limits the upside on the short position. Should futures prices decline, then the investor has only spent money on the call premium.

v. Short Futures and Short Puts - This strategy is of limited use in protecting a short futures position from an increase. As the upside is unlimited, the investor's loss is mitigated only by the premium received.

II. Synthetic Options: both futures and options may be used simultaneously to create a synthetic options

a. Synthetic Long Call = long futures + long put on the same underlying. Like a long call, prices can increase without restriction. The long put protects the risk of a price decrease. Like a long call, the only cost of this synthetic transaction is the premium for the long put.

b. Synthetic Put = short futures + long call on the same underlying contract. The investor makes money in a declining market. Should prices rise, the long call enables the investor to exercise the option once the underlying exceeds the strike price, effectively "stopping" it on the way up. As with a real put, the sole cost of a synthetic put is the cost of the long call.

III. Conversion: Long Futures + Long Puts + Short Calls. Long futures benefit from rising prices. Long puts protect against falling prices. Short calls furnish premium income. If prices rise and the call is not assigned, the investor makes money. If the call is exercised against her, she has the futures to deliver against the call holder. The strategy helps to secure a futures price and generate premium income greater than the premium paid.

IV. Delta Hedging: Delta measures how volatile an option on futures premium is relative to the underlying, expressed by the formula: change in option premium/Change in futures price. The greater the extent to which the option is in the money, the greater its delta and vice versa. Delta is measured on a continuum from 0 to 1. High delta options are close to one. Deep out of the money options are close to 0. Delta is a metric for hedgers to determine how volatile the underlying is that they are attempting to hedge and the degree to which a hedge might be effective. Knowing the delta helps the investor determine the number of options needed to hedge one's position.

V. Use of Multiple Options: These are protective strategies that use more than one option to manage risk and return. These approaches partially hedge as they assume the bullish and bearish sides of the market. If one side rises, the other falls.

a. Spreads - The simultaneous purchase and sale of options of the same class, but of different series (strike prices and/or expiry dates may differ).

i. Call Spreads - An investor purchases a call and sells a call

1. Price (vertical) spread - The strike prices differ.

2. Calendar (time or horizontal) spread - Expiry dates differ.

3. Diagonal - Both price and expiry dates differ.

ii. Put Spreads - An investor purchases a put and sells a put.

b. Straddles - This strategy entails the simultaneous purchase (long) of a call and put or sale (short) of a call and put, on the same underlying futures contract. The options have the same strike price and expiration month. The former is profitable when prices of the underlying rise or fall by amounts that exceed the two premia paid; the latter when the underlying prices move by less than the combined premia received.

c. Combinations - There are both long and short strategies of this type, where the investor buys both a call and put or sells both a call and put. They differ from straddles to the extent that the strike prices and/or expiration dates differ.

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