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Gary Trennepohl Jim Bittman Oklahoma State University The Options Institute
Applied Options Strategies
for Portfolio Managers
CHICAGO BOARD OPTIONS EXCHANGE 2
Session Outline
• Typical Fund Objectives
• Strategies for “special situations”
• Six Investor Strategies
• Actual Investment Manager Approaches
CHICAGO BOARD OPTIONS EXCHANGE 3
Using Options to Meet Investment
Objectives
Objectives:
– Increase exposure to equities without
increasing risk
– Buy equities during the next year at lower
prices
– Generate income
– Conserve cash
CHICAGO BOARD OPTIONS EXCHANGE 4
Suitable Option Investment Strategies 1
Invest cash 5%-20% below current market level
and generate income
– Sell cash-secured put
– Sell out-of-the-money put spread
– Ratio put spread
CHICAGO BOARD OPTIONS EXCHANGE 5
Suitable Option Investment Strategies 2
Increase market exposure, limit risk and
conserve cash
– Ratio call spread overlay
– Long a synthetic or split-strike synthetic
Target buy/sell prices and generate income
– Sell covered straddle or strangle
CHICAGO BOARD OPTIONS EXCHANGE 6
Special Situations Defined
Portfolio rebalancing driven by
Unanticipated market moves
Anticipated/unanticipated cash flows
Market timing events
Price entry/exit decisions
Options give investors more strategy
alternatives to manage these
decisions/situations.
CHICAGO BOARD OPTIONS EXCHANGE 7
Prices for Case Studies
November 1 S&P 500 @ 1,425
Strike Mar Mar
Price Calls Puts
1,350 130 65
1,400 95 85
1,450 70 105
1,500 45 130
Quarterly Expiration: March 31, 2013, 150 days
3 Strategies that:
Invest Below the Current Market Level
and Bring in Cash Income
CHICAGO BOARD OPTIONS EXCHANGE 9
Case 1 –
Ready to Buy If Down 8%-10%
Market View: You are willing to commit
funds to the S&P near 1,300
Objective: Bring in cash income and buy
the market near 1,300
Strategy: Sell cash-secured put
Sell SPX Mar 1400 Puts @ 85
T-Bills: $140,000 per put
CHICAGO BOARD OPTIONS EXCHANGE 10
SPX
Level
Sale
Price
Value
at Exp.
P /(L)
1500
1450
1400
1350
1300 (15)
85
85
85
85
85
+85
+85
+85
0
0
0
50
100
+35
Short 1 1400 Put @ 85.00
CHICAGO BOARD OPTIONS EXCHANGE 11
Short 1 1400 Put @ 85.00
+100
+ 50
0 ][ ][ ][ ][
- 50
-100
1350 1400 1450
Put expires
Keep premium
= 6% ann rate
Invest in S&P
Effective price
= 1,315
+85
1,315
1425
1300
CHICAGO BOARD OPTIONS EXCHANGE 12
Case 1 – Sell Put – Outcomes
Market
Up: Puts expire; keep premium,
equal to 6% annual rate
Steady: Same as up
Down: Buy the S&P at 1,315 (8% below
current level of 1,425)
CHICAGO BOARD OPTIONS EXCHANGE 13
Case 2 – Ready to Buy if Risk is Limited
Market View: You are willing to buy near
current levels if risk is limited
Objective: Commit funds with limited risk
and bring in cash income
Strategy: Sell put spread
Buy SPX Mar 1350 Put @ - 65 Dr
Sell SPX Mar 1450 Put @ + 105 Cr
Net Credit 40
T-Bills: $145,000 per put
CHICAGO BOARD OPTIONS EXCHANGE 14
Buy 1350 Put @ 65.00
Sell 1450 Put @ 105.00
Stock
Price
+1350 Put
at 65.00
–1450 Put
at 105.00
P /(L)
1500
1450
1400
1350
1300
(65)
(65)
+40
+40
+105
+105
(65) (10) +55
(65) (60) + 5
(15) (60) (45)
CHICAGO BOARD OPTIONS EXCHANGE 15
Case 2 – Sell Put Spread
+
0 ][ ][ ][ ][
-
1,450 1400 1350
Put expires
Keep 40 Max loss
No position
+40 1410
1425
60 Invest
in S&P
at 1410
40/1410 365/150 = 6.9% (ann. rate)
1,500
CHICAGO BOARD OPTIONS EXCHANGE 16
Case 2 – Sell Put Spread – Outcomes
Market
> 1,450: Puts expire; keep premium
of 40 index points (7%)
1,350-1,450: Buy S&P at level of 1,410
(1.1% below current level)
< 1,350: Max loss of 60 index points
(4.2% max loss)
CHICAGO BOARD OPTIONS EXCHANGE 17
Market View: The market will decline 10-15%
Objective: Bring in cash income and buy
the market down 10%-15%.
Strategy: Cash-secured ratio put spread
Buy 1 SPX Mar 1400 Put @ 85 (85) dr
Sell 2 SPX Mar 1350 Puts@ 65 ea. 130 cr
T-Bills $135,000 Net Credit 45 cr
Case 3 – Ready to Buy 10%-15%
Lower
+1
–2
Max risk = long 1 unit
CHICAGO BOARD OPTIONS EXCHANGE 18
S&P
Level
+1 1400 P
at 85
–2 1350 P
at 65 ea.
P /(L)
1450
1400
1350
1300
1250
Buy 1 1400 Put @ 85.00
Sell 2 1350 Puts @ 65.00 ea
(85)
(85)
+45
+45
+130
+130
(35) +95 +130
+15 +45 +30
+65 ( 5) (70)
CHICAGO BOARD OPTIONS EXCHANGE 19
+
0 ][ ][ ][
-
1425
Case 3 – Cash-Secured Ratio Put Spread
1400 1350 1300
Puts expire
Keep 45
Buy at a
level of
???
+45 1,255
Long
put
settles
in cash
+95
CHICAGO BOARD OPTIONS EXCHANGE 20
Case 3 – Ratio Put Spread – Outcomes
Market
> 1,400: Puts expire; keep premium
of 45 index points
(3.2% in 150 days)
1,350-1,400: Long put settles in cash for
additional income
< 1,350: Buy the S&P 500 at 1,255
2 Strategies that:
Increase Market Exposure,
Limit Risk and Conserve in Cash
CHICAGO BOARD OPTIONS EXCHANGE 22
Case 4 – Increase Exposure Without Risk
Market View: The market will rise modestly
Objective: Add upside exposure without
increasing downside risk.
Strategy: Ratio Call Spread Overlay
Own SPY (or S&P stocks) @ 1,425
Buy 1 SPX Mar 1,450 Call @ 70 (70) Dr
Sell 2 SPX Mar 1,500 Calls @ 45 ea 90 Cr
Net Credit 20 Cr
CHICAGO BOARD OPTIONS EXCHANGE 23
Ratio Call Spread: Own S&P @ 1,425,
+1 1450 Call @ 70, –2 1500 Calls @ 45 ea
S&P
Level
Long S&P
at 1425
+1 1450 C
at 70
–2 1500 C
at 45 ea
P /(L)
1600
1550
1500
1450
1425
+175
+125
+75
+25
-0-
+145 +80 (110)
+145 +30 (10)
+145 (20) +90
+45
+20
(70)
(70)
+90
+90
CHICAGO BOARD OPTIONS EXCHANGE 24
+
0 ][ ][ ][
-
No market
exposure
1,425
Case 4 – Ratio Call Spread Overlay
1,500 1,450 1400
Long 1
+145
+20
1,570
Long 2
CHICAGO BOARD OPTIONS EXCHANGE 25
Case 4 – Spread Overlay – Outcomes
Market
< 1,450: Long 1
performs 20 points better
than S&P 500
1,450-1,500: Long 2
> 1,500: No market exposure –
maximum profit = +145
(+10.2% in 5 months)
CHICAGO BOARD OPTIONS EXCHANGE 26
Case 5 – Target Buying Lower,
but Can’t Miss a Rally
Market View: Think market will decline, but
worried about missing a rally
Objective: Establish a buy point down 5%
and participate in the upside.
Strategy: Split-strike synthetic
Sell 1 SPX Mar 1350 Put @ 65 Cr
Buy 1 SPX Mar 1450 Call @ (70) Dr
T-Bills $135,000 Net Cost ( 5) Dr
CHICAGO BOARD OPTIONS EXCHANGE 27
Sell 1,350 Put @ 65.00
Buy 1,450 Call @ 70.00
S&P
Level
–1350 Put
at 65
+1450 Call
at 70
P /(L)
1500
1450
1400
1350
1300
+65 +45 (20)
(55) (70) +15
+65 ( 5)
( 5)
( 5)
(70)
(70)
(70) +65
+65
CHICAGO BOARD OPTIONS EXCHANGE 28
+
0 ][ ][ ][
-
1425
Case 5 – Split-Strike Synthetic
1,550 1,450 1350
1,455
5
No market
exposure Long 1 Long 1
CHICAGO BOARD OPTIONS EXCHANGE 29
Case 5 – Split-Strike Syn. – Outcomes
Market
< 1,350: Put assigned
long the S&P 500 at 1,355
1,350-1,450: No market exposure (–5 pts)
> 1,450: Exercise call
long the S&P 500 at 1,455
1 Strategy that:
Targets Buy and Sell Prices
and Generates Income
CHICAGO BOARD OPTIONS EXCHANGE 31
Case 6 – Trading a Range
Market View: The S&P 500 is “range bound”
between 1,300 and 1,600
Objective: Increase exposure near 1,300,
Decrease exposure near 1,600,
and earn income while waiting.
Strategy: Covered Strangle
Sell SPX Mar 1,500 Calls @ 45 Cr
Sell SPX Mar 1,350 Puts @ 65 Cr
Own 10 SPY for each call and put
CHICAGO BOARD OPTIONS EXCHANGE 32
Covered Strangle: Own S&P @ 1,425,
Sell 1350 Put @ 65, Sell 1500 Call @ 45
S&P
Level
Long S&P
at 1425
–1350 P
at 65
–1500 Call
at 45
P /(L)
1600
1500
1425
1350
1250
+175
+ 75
-0-
( 75)
(175)
+185 +65 (55)
+185 +65 +45
+110 +65 +45
+ 10 +65 +45
(165) (35) +45
CHICAGO BOARD OPTIONS EXCHANGE 33
+
0 ][ ][ ][ ][ ][
-
+110
Long 1
1425
Case 6 – Covered Strangle
1500 1450 1350
+185
1400
Puts Assigned
Equal to buying
at S&P 1,315
Calls
Assigned
Sell
S&P 1,610
1300
CHICAGO BOARD OPTIONS EXCHANGE 34
Case 6 – Covered Strangle – Outcomes
Market
> 1,500: Calls assigned; equal to
selling at S&P 1,610
1,350-1,500: Long S&P + 110 points
< 1,350: Puts assigned; equal to
“doubling up” at S&P 1,315
CHICAGO BOARD OPTIONS EXCHANGE
1. CLIFTON GROUP DEFENSIVE EQUITY
2. HARVEST VOLATILITY MANAGEMENT
Actual Money Manager
Strategies Using Options
35
CHICAGO BOARD OPTIONS EXCHANGE
Clifton Group – “Defensive Equity
Strategy
36
Portfolio Construction
Defensive Equity - Fourth Quarter '11 14
Clifton’s Defensive Equity strategy is comprised of a ba se po r tfolio combined wi th an op tion overlay.
Straightforward portfolio that is liquid, transparent and unlevered
50%US Treasury Bills
50%S&P 500 Index
Option Details Short-term expirationsOut-of-the-money, volatility-based dynamic strikesEuropean style, exchange-tradedCash settled upon expiration when new options are sold
Base Portfolio
Higher S&P
Prices
LowerS&P
Prices
0% Option Overlay
S&P 500 Call OverlaySell covered calls above current market price(out-of-money)
S&P 500 Call OverlaySell covered calls above current market price(out-of-money)
S&P 500 Put OverlaySell cash covered putsbelow current market price (out-of-money)
S&P 500 Put OverlaySell cash covered putsbelow current market price (out-of-money)
CHICAGO BOARD OPTIONS EXCHANGE
Selecting the Options to Trade
37
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
1990 1993 1997 2000 2004 2007 2011
SPX - Price Return
Dynamic Strike Prices
Defensive Equity - Fourth Quarter '11 16
In 82% of the monthly periods since 1990, option sales were additive to performance*
See simulated disclosures in Appendices.Source: The Clifton Group
Median Call Strike: +4.03%
Median Put Strike: -4.46%
*Said another way, in 18% of the monthly periods, total premium collected was less than the loss on an option that expired in-the-money.
Monthly Call and Put Strikes (% Out- of- Money)
Since 1990 the S&P 500 Index price at expiration:
• Rallied above the call strike 20.8% of the time
• Declined below the put strike 10.2% of the time
• Remained between the call and put strikes 69.0% of the time
Since 1990 the S&P 500 Index price at expiration:
• Rallied above the call strike 20.8% of the time
• Declined below the put strike 10.2% of the time
• Remained between the call and put strikes 69.0% of the time
S&P 500 Index: Monthly Price Change versus Option Strike Prices1/1/1990 to 12/31/2011
The dynamic strike process adapts to volatility changes, selling further out-of-money options when expected volatility is higher
CHICAGO BOARD OPTIONS EXCHANGE
Monthly Trading Strategy
• Using S&P 500 index options or SPY
• It is Friday, Nov 21st and SPY is at 140. Assume you
own 3,500 shares of SPY and hold $500,000 in cash.
• Strategy: Sell SPYoptions with Δ≅.20.
• Sell 35 Dec 145 Calls ($60×35) = $ 2,100
• Sell 37 Dec 135 Puts ($500,000/13,500)
($90 × 37) = $ 3,330
• Net Premium Income $ 5,430
• You have sold covered calls and cash secured puts, so
you can cover either position if it ends in the money.
38
CHICAGO BOARD OPTIONS EXCHANGE
Recent Actual Performance
39
Actual Performance
Actual performance for the Defensive Equity strategy
Date: 12/31/2011
Month:
Actual
Defensive Equity
(net)
S&P 500 Total
Return Difference
09/30/11 -2.62% -7.03% 4.41%
10/31/11 6.75% 10.93% -4.18%
11/30/11 0.96% -0.22% 1.19%
12/31/11 1.14% 1.02% 0.12%
Monthly Returns
-2.62%
6.75%
0.96% 1.14%
-7.03%
10.93%
-0.22%
1.02%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
Sep-11 Oct-11 Nov-11 Dec-11
Actual Defensive Equity (net) S&P 500 Total Return
20Defensive Equity - Fourth Quarter '11
Note: The inception date for Clifton's Defensive Equity strategy was September 2011. The returns are presented net of 35bps fee. (unified fee is inclusive of investment management, administrative and custody fees)
*See the GIPS® Performance Presentation and Disclosure Statement in Appendices.Past results are not indicative of future performance.
CHICAGO BOARD OPTIONS EXCHANGE
Simulated Long Run Returns
40
0
100
200
300
400
500
600
700
800
900
1990 1993 1997 2000 2004 2007 2011
S&P 500 Total Return
Simulated Defensive Equity (Gross)
50% S&P 500 / 50% T-Bills
Defensive Equity Strategy Simulation – Summary of Results
Defensive Equity - Fourth Quarter '11 17
Return Period: 12/31/1989 – 12/31/2011
*See simulated disclosures in Appendices.
Gro
wth
of
$1
00
S&P 500 outperforms in major bull markets
Defensive Equity seeks to outperform in major bear markets
1 Defensive Equity (Gross) simulated returns are gross of management fees and net of expected transaction costs2 Defensive Equity (Net) simulated returns are net of fees (35bps) and net of expected transaction costs
Source: The Clifton Group, CBOE
0 SimulatedDefensive Equity1
(Gross)
SimulatedDefensive Equity2
(Net) S&P 50050% S&P 500/
50% T-Bills
Defensive Equity vs. S&P 500
(Gross)
Annualized Return 10.3% 9.9% 8.2% 6.2% 2.1%
Standard Deviation 8.3% 8.3% 15.2% 7.6% (6.9)%
Sharpe Ratio 0.81 0.76 0.30 0.34 0.50
Insurance Risk Insurance Risk Premium Capture
Equity Risk Equity Risk Premium Give Up
CHICAGO BOARD OPTIONS EXCHANGE
HARVEST VOLATILITY
MANAGEMENT
41
CHICAGO BOARD OPTIONS EXCHANGE
Harvest Strategy
• “Harvest” offers a strategy which involves
selling put and call spreads against a cash
portfolio that’s used to support margin
requirements for trading.
• Similar to Clifton, they sell a “strangle” using
S&P 500 index options, but they buy a
further out call and put to reduce required
margin.
42
CHICAGO BOARD OPTIONS EXCHANGE 43
CHICAGO BOARD OPTIONS EXCHANGE 44
CHICAGO BOARD OPTIONS EXCHANGE 45
CHICAGO BOARD OPTIONS EXCHANGE
Harvest November Example
46
• Friday, Nov 9: S&P 500 at 1390
• Buy Dec 1515 Call
• Sell Dec 1480 Call
• Sell Dec 1300 Put
• Buy JAN 1160 Put
• Receive $6.70/share (credit spread)
• Manage position if market makes dramatic
move up or down.
• Trade out of position if market dictates
Sell a Call Spread
Sell a Put Calendar Spread