- 2001: Volume 10, No. 5 Managing Risk with Options

Risk and options are frequently linked together, but—managing risk? This article will discuss a few of the opportunities available for use in managing risk within the options market.

Options have suffered a bad reputation and association with speculation and gambling, often conjuring visions of roulette wheels and casinos. Such images may result from past speculative frenzies such as the European tulip craze. These options were traded before there were cars, electronics or even electricity. Yes, options can be and are used in this manner, but that is not their sole function. This wildly maligned financial instrument is a wonderful tool that can be used to increase earnings and decrease risk.

Before we go on, let's start with a few definitions. As you surely know, options can be bought, sold, or both. If an option is sold—be it a put or a call, covered or naked—the seller will be obligated to honor that contract. Under certain circumstances the seller may be forced, contractually, into action. On the other hand, the purchaser of an option has no obligation to do anything. Seem easy? That's because it is.

There are six influences on the price (premium) of an option:

• The price of the underlying instrument.
• The strike price of the option.
• Time left until expiration (decay).
• Volatility of the underlying instrument.
• Short-term risk-free rates of return (T-bills).
• Dividends payable on the underlying instrument.

One of the most conservative options strategies is the "covered write" which works well in equity accounts and can be easily used to increase the earnings of the portfolio. One of the more obvious risks is, of course, that you may have to sell the securities. A covered call seller sells the buyer the right to purchase a fixed number of shares of an equity or future that is owned, at a predetermined price (strike price). This right expires at a date certain in the future (expiration date). For taking this action, the seller is paid cash, and that cash is called the premium. The premium is not the sale price of the equity or future, but is paid to the seller and is a real credit in the seller's account.

For example, say you own 1,000 shares of XYZ, but you think the stock has stalled and will have trouble going up. You would be happy to sell your stock at $50 for a profit. If someone would give you $55 for your stock, you would be thrilled. You sell a call that will expire on the third Friday in September 2001, for a premium of $2, which is equal to $200 per 100 shares or $2,000 dollars. The strike price of the option is $55. Don't worry, you received the price you felt was fair so go on to the next trade. If XYZ is $65 a share by the third week in September 2001, you sold your stock for $55 dollars. Don't worry, you received the price you felt was fair so go on to the next trade. Actually, there are strategies you can use to capture the additional money but we are not going to go into those now. If the stock is under $55 a share at expiration, you still own the stock and can sell calls again. Perhaps you will have to roll the strike down.

Note: the one event that is usually forgotten is the case where the stock goes down. In this case, the strike price can be rolled down. This covered writing can be done in futures accounts as well.

Here is what is considered to be a risky option strategy: do exactly as noted above but don't own the stock. Now you are naked the equity and have sold a naked call. This is risky because you have unlimited upside risk. This also can be managed with other strategies to negate some of the risk. For example, you could capture the premium of $2 per option and use some of that premium to purchase a call with a higher strike, say a strike of $60. Your risk then is only $5 per share. When you use a spread option position, your margin is much less than a position with a naked option. You have actually covered your naked call on the upside.

SELL September 55 CALL $2000.00
BUY September 60 CALL $500.00
RISK = $3500.00 @ $60.00/SHARE
RISK = $3500.00 @ $70.00/SHARE

What if you sell a put? You must really want to own the stock or the future. You are promising to purchase the stock at a given price at a time certain in the future. For this risk, you will be paid a premium (real money). Assume that XYZ stock is nearing its support level and it is a stock you would love to own. You can sell the put for $2. You are agreeing to purchase that stock for $40 a share at a given time in the future. For taking on that risk, you are being paid $2. As above, there are other strategies that can be used to remove some of the risk, e.g. you could purchase the $35 put and limit your downside exposure. This type of put spread will reduce the amount of margin you will have because you have limited your risk.

SELL September 40 PUTS COLLECT $200.00
BUY September 35 PUTS PAY $100.00
RISK = $400.00 Maximum risk

Now let's combine some options and see what happens. You are long XYZ at $50, sold the September $55 calls, and now you purchase the September $50 puts. Just to add some spice to this, the stock goes X-dividend September 1, 2001. So, the situation is that you have agreed to sell your stock, you will get the dividend and if the stock crashed before the third Friday in September, you will not lose money. By purchasing the put, you have bought and paid for insurance until the expiration of that put. You can sell you stock at that price even if it goes to zero as long as that occurs before the expiration date.

Options are either American-style or European-style. Equity options in the United States are the American-style. American-style options can be exercised at any time up to and including the expiration date, while European-style options can only be exercised at option's expiration date. European-style options are used in futures contracts and European equities traded abroad.

These are all simple but usable options strategies. Margins on these types of trades vary from house to house, but the one thing you must remember is that the purchase of options is not marginable—they must be paid for.

Using futures and futures options to create money and manage risk can be more profitable than using equities and with them it is also relatively easy to manage risk and keep the portfolio neutral. All of the previously mentioned strategies can be done in the futures arena.

Futures have a favored tax status. Sixty percent of the profit or loss is considered long-term and the IRS considers only 40 percent short-term. (Equity trades that are short-term in duration are considered ordinary income.) So, if you have a short-term gain of $100, all of the income will be viewed as ordinary income for equities. With that same amount in the futures arena, $60 is given long-term capital gains treatment and the remaining $40 is ordinary income. Thus right away you see there is an advantage in futures. Another advantage is the margin requirements which, because futures are in the future, the deposit to purchase those futures (in the future) is lower than the margin required to purchase stock now or the margin required for equity option trades. In the futures markets, T-bills are usually used to meet margin requirements; of course, you could use a T-bill for equities as well. (The interest earned on the T-bills is yours.) The bottom line is that you need less margin in a futures trade vs. its stock counterpart.

For example, the margin that is required to purchase one mini Russell 1000 contract is $1,500. The contract's value is 624 times 50, which is $31,200. If you were to purchase an equivalent amount of the IWB shares, which is the AMEX Russell 1000 product, you would use the same $31,200 but your initial margin would be $15,600. With the IWB, you would have purchased 500 shares of stock. True, you could sell five covered rights, but the premiums will be less. Why? Because there is a difference in the strike prices between futures and equities in this case.

In the futures for the Russell 1000 contract option strikes are in $2 increments. For example, 624, 626, 628, 630 and so forth. In the equity equivalent, the strikes are in $5 increments. For example, $65, $70, etc. Perhaps you have noticed another difference: the strike price of the futures seems to be high because it is. This allows the seller, or the buyer, more flexibility. By using the futures, you have more flexibility and a much better tax advantage then by using the equity equivalent.

We now have to introduce delta. Delta tells you how much an option will move for a one point move in the underlying security or futures contract. Delta is also a measure of probability and therefore helps you determine your margin requirements. Another term to introduce is Theta. Theta is the amount the option will decrease in value as one day passes. Vega is the measurement of how a stock or futures volatility affects the price of the option. Rho is a value that a change in interest rates would have on the option. For this article, Rho will not be considered. It must be stated, however, that Rho is important when considering either the purchase or the sale of a LEAP option. As defined by Larry McMillan in his book McMillan On Options, Gamma "...measures how much the option's delta changes, when the underlying changes in price by one point. Essentially, it is a measure of how fast the delta changes." The art of the option seller is to remain gamma- and delta-neutral.

Let us say, for example, that the delta of the option on XYZ stock's September $60 call is .14. Call options have deltas ranging from .000000001 (the small number was made up) to 1.00. Put options have the same range but the numbers are negative. A delta of 1 or of -1 tells you that the option will move point-for-point with the equity or future. This option has a .14 delta, which lets you know that for every point the stock rises, the option will also rise but only $.14. The delta helps you calculate your risk. In the futures market, it is always desirable for the option seller to remain delta neutral.

Another example, you sell the September Russell 1000 calls with a strike price of 650, which is sold on the Russell 1000 futures contract. The Russell 1000 contract is 616. You receive $1.75 for selling that option ($875.00 premium collected). To keep the position neutral, you must go long .14 of one contract. The options are sold against the regular size Russell 1000 contract. What you now know is that your position is short. There are things you can do to correct this, for instance just buy two mini Russell 1000 futures contracts. You certainly don't need a whole contract and two minis will do just fine, as a matter of fact, you will be a tiny bit long. What if you don't want to buy a future anything? Well, we can neutralize most of the position by selling a Russell 1000 September 570 put. For this we will collect $2.90 ($1450.00). The delta on that put is -.12. Adding +.14 and -.12 gives .02, which is pretty neutral, and we don't own a futures contract.

SELL RUSSELL 1000 September 650 CALL 1.75
SELL RUSSELL 1000 September 570 PUTS 2.90
TOTAL PREMIUM COLLECTED 4.65 (divide by 2 for dollars/option)

This position can be adjusted easily with the addition or subtraction of the mini contracts. If the market goes up, buy the appropriate amount of minis needed and, if the market goes down, sell the appropriate amount of minis. Your delta will change especially with any big change in your vega. Notice also that you are not adjusting the option position, which is called a strangle. The position is a time-decaying one. Time is the enemy of the option buyer and the friend of the seller. In this position, you are the seller. The theta of the position is .10 for the call and .15 for the put. So, you can measure the decay of the position. Even as the position nears the strike price, the erosion of the option keeps that position making money. This is only one small example of what can be created with options.

Options are flexible and offermany strategies that can be used to create income and manage risk. If you can imagine it, then it probably can be done with options. Let your imagination go wild and you will create strategies for fun and profit.

Jeanette Young, C.F.P. is a floor broker on the NYFE, Technical Analyst with S.G. Martin Securities and a Winner in the National Investment Challenge Pro Option's division. She can be contacted at optnqueen@aol.com. Weekly market letters can be found on, www.ICE.com, www.gertfehu.com, and coming in the fall of 2001, www.financialfirefighters.com.