Hedging with Options

Scenario:

Let’s say a fund manager achieved returns of 15% on his portfolio over the last 10 months compared to a market return of 10%. The portfolio is a close approximation of the KLSE Composite Index. The fund manager is concerned that there is a strong chance of the market moving down over the next two months. He seeks to preserve the majority of the returns.

Solution:

One possible solution is to use a put option on the KLCI. Assume the following data as at 30 April:

Fund size:	RM 10 million
Portfolio beta:	1.0
Current Composite Index:	1130
Current June KLCI Futures:	1140

KLCI Options	Premium
1075 put	20.00
1100 put	28.00
1125 put	38.00

Number of contracts to be purchased	=
	=
	=	87 contracts

The fund manager decides to use at-the-money puts for downward protection. He subsequently purchases 87 June 1125 puts at 38 points, an outlay of RM 330,600 (87 × 38 × 100).

Profit Pay-off Diagram

As can be seen, the hedged position has removed the risk of loss from a fall in the market. The trade-off for this reduced risk is the outlay of RM 330,600 (3.3% of the portfolio). Since the fund has a 5% buffer between the portfolio performance and the benchmark index, the fund remains ahead of the measure. The fund also has the prospect of significant outperformance if the fund manager’s view of the market proves to be correct.

Billionaire Carl Icahn Leverages Yahoo Options

Carl Icahn has been establishing a big stock position in Yahoo shares using options. Icahn's position of 59 million shares of Yahoo stock was created by using only 9.9 million actual shares. The question now is how can Mr. Icahn hold the rest without actually owning them?

The answer comes from a strategy that might be new to most people, but to options traders it's old hat. Icahn simply created 49 million shares of synthetic stock by buying 490,000 million call options on Yahoo stock and selling 490,000 million put options.

Synthetic positions are how investors and traders can replicate the performance and returns of stock without owning any actual stock. Buying a call and selling a put, usually of the same exercise price and expiration, is equivalent to being long the underlying stock. In other words, since he sold the right for someone else to be short the stock, if the long put holder decides to exercise their right, he will have to buy the stock at the strike price.

Another interesting thing about this trade is that Icahn bought American-style call options, which can be exercised anytime before expiration, and he sold European-style put options, which can only be exercised, and force him to buy the stock, at expiration. Icahn reportedly sold puts with a strike price of $19.50 and an expiration date of November 5th, 2010. Last year, Icahn used billions of dollars worth of options on Motorola stock to gain a significant position and win board seats in the tech company.

Index Options

Stock index options are based on a stock index rather than on specific stocks. The value of index calls increase as the index increases, and the value of index puts increases as the underlying index decreases. These options are similar to stock options, but with some important differences.

Because these options are based on indexes, there is greater diversification, and usually less volatility than with specific stocks. An index is never going to drop to zero, and it will never increase as dramatically as some specific stocks can, especially within a short period of time. Therefore, the risk is more limited, but so is the profit potential. Also, contract adjustments are rarely needed for a stock index. For instance, stock splits of stocks within the index do not affect the index, and thus, no adjustments on the contracts are needed.

The strike price is based on an index value multiplied by the multiplier of the contract, which is usually $100 (USD). These options are settled by the exchange of cash, not securities, which, for obvious reasons, is called a cash settlement. The option writer who is assigned an exercise pays cash to the holder who exercised the option.

Many index options are American-style options that can be exercised for a short time right before expiration. However, this makes little difference for options that are settled in cash, because the option holder can always sell the option on the exchanges for cash at any time before expiration. In fact, Kuala Lumpur Composite Index (KLCI) options are European-style options. They can only be exercised on the last day of trading.

The cash that is paid upon exercise depends on the index, which depends on the component prices of the index. Some contracts have AM settlement and some have PM settlement. In AM settlement, the cash settlement value is calculated using the opening component prices on the day of expiration. In PM settlement, closing prices on the day of expiration are used to determine the cash settlement value of the contract.

The cash settlement amount is determined by multiplying the absolute difference between the index and the strike price of the option times $100. For instance, SXY KO-E (2006 Nov 1375.00 Call) is based on the S&P 500 index. If the index should close at 1400 on expiration day, then a call holder would receive (1400 - 1375) x 100 = $2,500, and the assigned call writer would have to pay that much.

Outright Speculation

Amount of fund available	=	RM 1,000,000.00
Number of contracts purchasable	=
	=	18.35 (round down to 18)
Fund balance	=	RM 1,000,000.00 – (RM 50 x 1090.0 x 18)
	=	RM 19,000.00

Thus 18 contracts will be traded. The fund balance will be used to pay off the margin required to trade in the futures market. The exact mechanism of trading is calculated as follow:

Date	Action	Result	Gain/Loss (RM)
8 Jul Tue	Buy 18 July KLSE CI futures contracts at 1090.0. Pay initial outright margin of RM 4,000*. Futures contract closed at 1090.0.	Initial margin: Gain/Loss:	-4,000.00 0.00
9 Jul Wed	July futures price rises to 1116.0. Hold the position. Value increase = 26 points × RM 50 × 18	Variation gain:	23,400.00
10 Jul Thu	July futures price rises to 1125.0.Hold the position. Value increase = 9 points × RM 50 × 18	Variation gain:	8,100.00
11 Jul Fri	July futures price rises to 1142.0.Hold the position. Value increase = 17 points × RM 50 × 18	Variation gain:	15,300.00
14 Jul Mon	July futures price decreases to 1131.0. Sell the contracts. Value decline = 11 points × RM 50 × 18 Redeem initial outright margin of RM 4,000	Variation loss: Initial margin:	-9,900.00 4,000.00
		Net gain:	36,900.00

*Note the latest initial outright margin announced by Bursa Malaysia Derivatives Clearing Berhad is RM 4,000.00.

After embark upon this business dealing, the following cash position is applicable:

Item	Calculation	RM
Contract cost when purchasing: Initial margin:	18 x RM 50 x 1090.0	981,000.00 4,000.00
Initial cost:		985,000.00
Contract value when selling: Redeemed margin:	18 x RM 50 x 1131.0	1,017,900.00 4,000.00
Final contracts value: Fund balance:		1,021,900.00 15,000.00
Total fund available:		1,036,900.00

After the first trading, we decided to watch the market in order to spot for another great purchasing price. The following table shows the futures prices a few days after the first trading was made:

FKLI Prices for Spot Month Contract 2008

Date	Open Int.	Open	High	Low	Closed
08-Jul 09-Jul 10-Jul 11-Jul 14-Jul 15-Jul 16-Jul 17-Jul	37,053 36,606 36,477 34,840 33,841 34,615 34,133 34,261	1,117.0 1,106.0 1,103.0 1,127.0 1,140.5 1,120.5 1,107.0 1,108.5	1,118.5 1,119.0 1,125.0 1,146.0 1,142.5 1,125.0 1,117.0 1,114.0	1,083.0 1,099.0 1,102.5 1,122.5 1,124.5 1,103.5 1,096.0 1,098.5	1,090.0 1,116.0 1,125.0 1,142.0 1,131.0 1,105.5 1,098.5 1,113.0

The table shows that the price drops to 1105.5 and then 1098.5 on 15 and 16 July 2008 respectively. We estimated that the price will drop even further. However, the market rebounded on 17 July 2008 to 1113.0. Thus we knew we had to react fast enough before we lost our trading opportunity. So, we decided to invest the fund we gained in first trading to the second dealing on 18 July 2008.

Amount of fund available	=	RM 1,036,900.00
Number of contracts purchasable	=
	=	18.93 (round down to 18)
Fund balance	=	RM 1,036,900.00 – (RM 50 x 1095.0 x 18)
	=	RM 51,400.00

Again, the fund balance above will be used to pay off the initial outright margin. The mechanism for the second trading is shown below:

Date	Action	Result	Gain/Loss (RM)
18 Jul Fri	Buy 18 July KLSE CI futures contracts at 1095.0. Pay initial outright margin of RM4,000.Futures contract closed at 1095.0.	Initial margin: Gain/Loss:	-4,000.00 0.00
21 Jul Mon	July futures price rises to 1105.0. Hold the position. Value increase = 10 points × RM50 ×18	Variation gain:	9,000.00
22 Jul Tue	July futures price dips to 1102.5. Hold the position. Value decline = 2.5 points × RM50 × 18	Variation gain:	-2,250.00
23 Jul Wed	July futures price rises to 1142.0. Hold the position. Value increase = 39.5 points × RM50 × 18	Variation gain:	35,550.00
24 Jul Thu	July futures price decreases to 1134.0. Hold the position. Value decline = 8 points × RM50 × 18	Variation loss:	-7,200.00
25 Jul Fri	July futures price remains at 1134.0. Hold the position. Value change = 0 points × RM50 × 18	Variation gain:	0.00
28 Jul Mon	July futures price rises to 1150.5. Hold the position. Value increase = 16.5 points × RM50 × 18	Variation gain:	14,850.00
29 Jul Tue	July futures price decreases to 1145.5. Hold the position. Value decline = 5 points × RM50 × 18	Variation loss:	-4,500.00
30 Jul Wed	July futures prices increases to 1160.5. Sell the contracts. Value increase = 15 points × RM50 × 18 Redeem initial outright margin of RM 4,000.00.	Variation gain: Initial margin:	13,500.00 4,000.00
		Net gain:	58,950.00

After the second trading as shown, the latest cash position is as follow:

Item	Calculation	RM
Contract cost when purchasing: Initial margin:	18 x RM 50 x 1095.0	985,500.00 4,000.00
Initial cost:		989,500.00
Contract value when selling: Redeemed margin:	18 x RM 50 x 1160.5	1,044,450.00 4,000.00
Final contracts value: Fund balance:		1,048,450.00 47,400.00
Total fund available:		1,095,850.00

Conclusion

After the speculation, we have successfully turned RM 1,000,000.00 to RM 1,095,850.00. It was a net gain of RM 95,850.00. We have produced 9.59% return for our speculation within two weeks. This is rather an astounding achievement for short-term speculation.

However, we also encountered various risks in this trading. Even though we were able to purchase at market bottom, we could not close out our position at the highest price possible. For example, we should sell at 1142.0 but only managed to do so at 1131.0. But this is something very difficult to practice in the real market because the trend of the market is unlikely to appear exactly as predicted.

Moreover, it is sometimes hard whether to remain patience or to act quickly in the market. This is due to patience may sometimes result in observing a market decline. On the other hand if we acted too fast, the real advance in the market may not fully materialize yet. Thus, this can be said as a matter of market timing and correct judgment. Besides, it is important for us to be confident with our analysis and stick with one principle rather than hopping to other so-called techniques if the market moves against us.

Finally, a good speculator will not follow the crowd blindly. We need to focus on our reasoning and make decisions base on appropriate analysis rather than following broker’s tips, friend’s recommendation or insider’s information.

Recommendations

Besides speculation, other methods such as hedging and arbitraging may also be very profitable if they are practiced with fine scrutiny. In fact, arbitraging is the riskless way to make profit in the futures market as arbitrageurs are taking advantage of the anomalies or mispricing of the futures prices in relation to the fair values of the instruments.

Moreover, other analysis style such as fundamental analysis should not be ignored because this type of analysis may be more accurate and reasonable. Key factors like industrial life cycle, business cycle and the interest rate should be taken into account when analyzing the performance of the market. In the sense of short-term speculation, the stance of monetary policy and the supply of money in the market should also be aware of in order to thoroughly examine the outlook of the market.

Speculation Opportunity

Let’s look at the FKLI futures prices recently. 2 June 2008 closed at 1267.0 and the overall prices of the futures are declining over the month. At the end of the month, the price has dropped to 1186.5. This may be the lower point of the month and it should be taken advantage of.

To ascertain the downward movement of the market, we decided to wait for a few days in order to buy in at the lowest price possible. The following shows the market prices a few days before the real purchase is made:

Date	Open Int.	Open	High	Low	Closed
01-Jul 02-Jul 03-Jul 04-Jul 07-Jul	33,945 35,738 36,978 36,539 36,438	1,172.0 1,152.0 1,126.5 1,119.5 1,113.0	1,175.5 1,159.0 1,132.0 1,121.0 1,121.5	1,152.0 1,137.5 1,110.0 1,104.5 1,106.5	1,152.0 1,144.0 1,117.0 1,110.0 1,119.0

By referring to the table, the prices dropped from 1152.0 on 1 July 2008 to 1110.0 on 4 July 2008. This has proved that our prediction about the market is correct. However, the futures prices closed 9 point higher from 1110.0 on 7 July 2008. Thus we decided to take the opportunity by purchasing the July futures contracts on 8 July 2008 in order to avoid further advances of the price in the market.

FKLI Futures Prices (2 Jan 2008- 30 June 2008)

*Note: Click on the picture above to view full size image.

By referring to the graph, it can be seen that a peak (head) was formed during 9 January 2008 to 16 January 2008. After the “head”, a sharp dip occurred in 22 January 2008. The market rebounded in the subsequent weeks and formed the shoulder to the head (peak) stated earlier.

Sharp downturn can be observed from the graph after the position of the “shoulder” and the downturn started from 27 February 2008 until the graph forms a trough on 17 March 2008. That was a very good opportunity to short the FKLI and then close out the position by taking the long position at the bottom of the market. However, the opportunity has been missed. Whatever it is, the same market pattern may repeat again later in the market.

FKLI futures recovered from the bottom of the market and fluctuated from 19 March 2008 through 16 April 2008. It formed “Double Top” and tended to go side line during the same period. On 21 May 2008, another downturn started to crystallize and it seemed like it would reach another market bottom soon. This is the opportunity that should not be missed by any skillful speculator.

Market Analysis

Below are the historical prices of FKLI Contract from 2 January 2008 to 30 June 2008:

Historical Price for FKLI Contract 2008

Date	Open Int.	Open	High	Low	Closed
02-Jan 03-Jan 04-Jan 07-Jan 08-Jan 09-Jan 11-Jan 14-Jan 15-Jan 16-Jan 17-Jan 18-Jan 21-Jan 22-Jan 24-Jan 25-Jan 28-Jan 29-Jan 30-Jan 31-Jan	27,907 28,178 29,202 29,663 29,966 28,843 31,900 32,047 32,183 34,730 35,675 37,257 35,030 31,583 32,500 31,926 27,844 26,810 10,857 0	1,435.5 1,427.0 1,431.0 1,460.0 1,466.5 1,490.0 1,512.0 1,521.5 1,530.0 1,488.0 1,457.0 1,431.0 1,431.0 1,345.0 1,392.0 1,390.0 1,398.5 1,405.0 1,387.5 1,373.0	1,450.0 1,436.5 1,470.0 1,470.5 1,499.5 1,509.0 1,531.0 1,535.0 1,536.0 1,490.0 1,472.0 1,463.0 1,439.0 1,352.0 1,397.0 1,421.0 1,398.5 1,409.0 1,402.0 1,395.0	1,432.5 1,426.5 1,431.0 1,455.0 1,466.0 1,482.5 1,510.5 1,510.5 1,502.5 1,436.0 1,429.0 1,425.0 1,479.0 1,296.0 1,360.0 1,389.5 1,358.0 1,378.5 1,372.0 1,373.0	1,440.0 1,433.5 1,469.0 1,466.0 1,490.5 1,503.0 1,524.0 1,522.0 1,504.0 1,443.5 1,472.0 1,444.0 1,387.5 1,335.0 1,360.0 1,413.0 1,383.5 1,385.0 1,377.0 1,387.5
04-Feb 05-Feb 06-Feb 11-Feb 12-Feb 13-Feb 14-Feb 15-Feb 18-Feb 19-Feb 20-Feb 21-Feb 22-Feb 25-Feb 26-Feb 27-Feb 28-Feb 29-Feb	30,267 29,110 29,505 28,965 29,548 31,908 31,945 31,616 31,453 31,271 30,640 31,114 32,262 30,585 34,541 21,263 18,717 0	1,419.0 1,426.0 1,407.0 1,396.0 1,408.0 1,432.0 1,436.0 1,429.0 1,433.0 1,422.0 1,410.5 1,417.0 1,373.0 1,371.0 1,374.5 1,382.0 1,366.0 1,355.0	1,434.5 1,440.5 1,411.0 1,413.0 1,423.0 1,446.5 1,445.0 1,434.0 1,434.0 1,426.5 1,415.5 1,417.5 1,374.5 1,374.0 1,377.5 1,384.0 1,372.0 1,363.0	1,416.0 1,422.0 1,396.0 1,391.5 1,407.5 1,411.0 1,423.0 1,422.5 1,408.5 1,410.0 1,397.0 1,381.5 1,344.5 1,353.5 1,362.0 1,373.0 1,362.0 1,348.0	1,430.0 1,435.0 1,404.0 1,402.0 1,417.5 1,416.0 1,441.0 1,425.0 1,412.0 1,412.0 1,400.0 1,385.0 1,361.0 1,367.0 1,375.0 1,373.0 1,365.0 1,360.0
03-Mar 04-Mar 05-Mar 06-Mar 07-Mar 10-Mar 11-Mar 12-Mar 13-Mar 14-Mar 17-Mar 18-Mar 19-Mar 21-Mar 24-Mar 25-Mar 26-Mar 27-Mar 28-Mar 31-Mar	37,261 38,146 38,114 37,775 37,002 38,996 40,735 41,833 40,545 41,134 40,900 38,435 38,895 37,142 36,628 37,541 39,933 19,993 13,834 0	1,298.0 1,304.0 1,293.0 1,279.0 1,278.5 1,163.0 1,165.5 1,220.0 1,213.5 1,192.0 1,158.5 1,159.5 1,210.0 1,181.0 1,172.5 1,205.0 1,230.0 1,222.0 1,246.0 1,252.0	1,314.0 1,314.5 1,294.0 1,305.0 1,291.0 1,209.5 1,198.0 1,231.5 1,219.0 1,193.0 1,160.0 1,183.0 1,225.0 1,181.0 1,193.0 1,231.0 1,243.5 1,255.0 1,266.0 1,258.0	1,290.0 1,281.5 1,266.5 1,277.0 1,269.5 1,152.0 1,159.0 1,214.0 1,165.0 1,161.0 1,142.0 1,147.0 1,153.0 1,158.0 1,172.5 1,201.5 1,216.5 1,218.0 1,243.5 1,247.0	1,294.5 1,287.0 1,275.0 1,299.0 1,269.5 1,177.0 1,192.5 1,227.0 1,168.0 1,184.0 1,147.5 1,183.0 1,163.0 1,168.0 1,190.5 1,223.0 1,230.0 1,255.0 1,260.0 1,249.5
01-Apr 02-Apr 03-Apr 04-Apr 07-Apr 08-Apr 09-Apr 10-Apr 11-Apr 14-Apr 15-Apr 16-Apr 17-Apr 18-Apr 21-Apr 22-Apr 23-Apr 24-Apr 25-Apr 28-Apr 29-Apr 30-Apr	35,878 37,272 37,675 37,878 38,460 37,887 38,123 36,834 36,719 36,584 36,086 36,232 35,728 36,287 36,456 35,377 35,357 36,957 38,130 34,015 15,559 0	1,237.0 1,270.0 1,224.0 1,220.0 1,218.0 1,207.0 1,213.0 1,218.0 1,258.0 1,230.0 1,230.0 1,257.0 1,270.5 1,253.0 1,280.0 1,280.0 1,284.5 1,295.0 1,302.0 1,301.0 1,296.0 1,280.5	1,250.0 1,273.0 1,234.0 1,226.5 1,219.5 1,214.0 1,228.0 1,251.5 1,260.0 1,237.5 1,250.0 1,263.5 1,272.5 1,270.0 1,287.0 1,290.0 1,302.0 1,309.5 1,306.0 1,303.0 1,303.5 1,285.0	1,218.5 1,222.0 1,208.0 1,212.5 1,206.5 1,201.0 1,213.0 1,218.0 1,243.5 1,225.0 1,230.0 1,250.0 1,251.0 1,251.0 1,275.5 1,276.5 1,282.5 1,286.0 1,289.0 1,295.5 1,283.0 1,276.0	1,241.0 1,222.0 1,215.0 1,220.0 1,219.0 1,208.0 1,223.5 1,243.5 1,255.0 1,234.0 1,246.0 1,260.5 1,251.0 1,269.0 1,282.5 1,284.5 1,299.5 1,289.5 1,303.0 1,301.0 1,283.0 1,283.5
02-May 05-May 06-May 07-May 08-May 09-May 12-May 13-May 14-May 15-May 16-May 20-May 21-May 22-May 23-May 26-May 27-May 28-May 29-May 30-May	31,028 31,003 31,255 31,031 32,552 30,184 30,384 30,719 30,840 31,278 31,873 32,622 30,254 29,099 29,683 31,679 30,661 25,667 16,089 0	1,295.0 1,277.0 1,271.0 1,288.0 1,273.0 1,272.0 1,283.0 1,300.0 1,289.0 1,293.0 1,301.5 1,293.5 1,286.0 1,276.0 1,275.0 1,264.0 1,264.5 1,270.5 1,265.5 1,267.0	1,295.0 1,280.0 1,285.0 1,288.5 1,279.0 1,286.5 1,297.5 1,301.5 1,298.5 1,300.5 1,306.5 1,297.5 1,290.5 1,279.5 1,292.0 1,267.0 1,271.0 1,271.0 1,269.0 1,274.0	1,278.0 1,270.0 1,270.0 1,275.0 1,263.0 1,272.0 1,282.0 1,284.5 1,286.5 1,292.5 1,294.0 1,284.0 1,282.5 1,271.5 1,270.0 1,256.0 1,263.0 1,257.0 1,263.0 1,265.5	1,280.5 1,274.0 1,283.0 1,278.0 1,275.0 1,284.0 1,296.5 1,286.5 1,295.0 1,298.0 1,297.5 1,293.5 1,287.0 1,277.0 1,270.0 1,261.0 1,267.0 1,259.0 1,265.5 1,269.5
02-Jun 03-Jun 04-Jun 05-Jun 06-Jun 09-Jun 10-Jun 11-Jun 12-Jun 13-Jun 16-Jun 17-Jun 18-Jun 19-Jun 20-Jun 23-Jun 24-Jun 25-Jun 26-Jun 27-Jun 30-Jun	32,438 33,862 36,039 39,366 38,706 37,866 37,668 36,868 37,067 36,222 37,154 36,491 36,694 35,121 36,485 37,340 36,765 33,398 23,118 15,022 0	1,266.0 1,261.0 1,249.0 1,218.0 1,223.0 1,204.0 1,219.5 1,213.0 1,209.0 1,219.0 1,223.0 1,237.5 1,218.5 1,182.0 1,184.5 1,176.0 1,186.5 1,194.0 1,201.0 1,182.0 1,183.0	1,276.0 1,262.5 1,249.5 1,221.0 1,237.0 1,218.5 1,219.5 1,223.0 1,223.0 1,219.5 1,237.5 1,237.5 1,219.0 1,186.0 1,199.0 1,190.0 1,196.0 1,202.0 1,205.5 1,188.5 1,187.0	1,266.0 1,245.0 1,226.0 1,204.0 1,222.0 1,203.0 1,201.0 1,208.5 1,201.5 1,211.0 1,220.0 1,221.0 1,189.0 1,169.0 1,174.0 1,172.0 1,186.5 1,189.0 1,195.0 1,180.0 1,182.5	1,267.0 1,253.0 1,232.5 1,217.0 1,230.0 1,214.5 1,204.0 1,221.5 1,217.0 1,214.5 1,237.0 1,222.0 1,199.0 1,181.0 1,192.5 1,186.5 1,191.0 1,202.0 1,198.0 1,187.0 1,186.5