Emerald Lake

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.

The Look Out

Courage Vs Wealth

Mr. Benjamin paid all of his children's tuition. His daughter and sons all attended private elementary and high schools, prestigious private colleges, medical colleges and graduate schools. Mr. Benjamin paid for all of it - room, board, tuition, books and related expenses. Who is this man who demonstrated the ability to fund these enormous tuition bills - a highly paid physician or perhaps CEO of a major public corporation?

 

Before he retired, Mr. Benjamin was a school-bus driver who generated enough income to send his children to private colleges, medical school, and graduate school. He was frugal but being frugal is not enough to pay six-figure tuition bills.

 

When they were young, Mr. Benjamin realized that his children were extremely bright. He realized that each would greatly benefit from a top-quality education. So he constantly worried about funding that education with his low-paying job. Consequently, Mr. Benjamin began a 'self improvement' reading program. The central topic of it was investing.

 

Being a bus driver had one side benefit. It gave Mr. Benjamin several hours of free time each day. His fellow drivers often used this time for snoozing, reading newspapers and magazines, drinking coffee or chatting. Mr. Benjamin used his downtime more wisely. He read about various types of investments. Early in his self-study program, he discovered the truth about the long-run returns generated by corporate bonds, passbook savings accounts, treasury bills, municipal bonds, CDs, stocks, precious metals and real estate.

 

Mr. Benjamin concluded that after adjusting for inflation and taxes, only stocks paid a real return on one's investment dollars. However, his mother had always told him never to invest in the stock market. She was around during the stock market crash in 1929. But the 1929 downturn was included in Mr. Benjamin's calculations and he knew that in spite of the crash, the stocks outperformed all other investment alternatives in the long run.

 

Mr. Benjamin eventually became a serious investor in the stock market. Every extra dollar he and his wife would muster was earmarked for stocks but not just any stocks. Mr. Benjamin spent much of his free time studying specific corporations and their stock offerings. Over the years, he became an expert in his chosen vocation.

 

The result of Mr. Benjamin's self-improvement reading and investing program was that when he recently retired, the former bus driver had a net worth in excess of $ 3 million. That is $ 3 million after sending his children to the finest, most expensive schools in the country.

 

What is the point? Mr. Benjamin became financially independent because he had courage. It takes courage to invest in the stock market. The market guarantees nothing. It goes up and down! Often, people get in the market late and get out early and they lose a lot of money. Mr. Benjamin was always a long-term investor. He never let fear outweigh the knowledge he obtained from his reading program. When he bought a stock, he rarely sold it within ten years of his initial investment. In good times and bad, he held on to his picks. He frequently had some fears and concerns but dealing with fear in a positive manner is a foundation stone of becoming wealthy.

 

It takes courage to invest in public corporation as well as in one's own business enterprise. However, it takes even more courage to hold on to one's investments when the public mood is full of fear and panic. Without courage Mr. Benjamin's children would not be doctors today.

(Adapted from The Millionaire Mind)

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