Tuesday, September 01, 2009

Options - what I use them for (1)

I use options for two purposes:

1. yield enhancement: discussed below; and

2. speculative trading: discussed in the next post in this series.

What I do

I write put options against cash deposits. These are commonly called equity linked deposits (where the underlying is listed ETFs or shares) or currencies (where the underlying is a currency).

A recent example is here. I was paid a premium equivalent to HK$0.15 per unit. In return for receiving the premium I have agreed to buy the underlying units in the Hong Kong Tracker fund for HK$19.58 on the maturity date. If the price of units in the Hong Kong Tracker fund is below HK$19.58 on the determination date (two business days before the maturity date), I will have purchased the units at an effective price of HK$19.43 (HK$19.58 - HK$0.15). If the unit price is above HK$19.58 I will get back my deposit (as well as keeping the premium).

Why this is generally considered to be a bad idea

Fat tails is the technical term. I am receiving a very small amount of money in exchange for taking a big risk. If the market drops 20% I would end up losing (about) 15% of my investment. There have been months when indexes have dropped by that much or more. For individual stocks, the downside risk is even larger - the shares of a single company could go to zero. In contrast, the upside is limited to that small premium. In simple terms, I am taking a small certain gain in exchange for a potential large loss.

(You can also write calls - the risk/reward analysis depends on whether the calls are covered (you own the underlying) or naked (you do not own the underlying).)

Why I do it anyway

Asset allocation. Risk management. Buying the dips. Yield. Combating inflation.

Like most investors I have some of my assets allocated to cash rather than in equities or real estate (which are my main asset classes). In part this is by default (cash comes in each month from both my job and my investments). In part it is by choice - having some cash reserves is a good thing. Cash in the bank currently yields zero or as close to zero as makes no difference. By writing equity or currency linked options I and achieve annualised yields of anything from 2-3% up to more than 40% depending on how aggressive I want to be. I usually go somewhere in the middle.

So I am earning a lot more on my cash than I would just leaving it in the bank. But I am also taking risk. Given the volatility of the market it is inevitable that I will get hit (have an option exercised against me) at some stage. That is a risk which I (try to) manage as follows:

1. I only write options against assets I would be willing to hold as long term investments - index funds, blue chip stocks and currencies that have a role to play in my long term asset allocation. I am not going to end up owning something which I have no wish to own;

2. I only write at prices which (net of premium) represent a discount to the prevailing market price. If I get hit I am effectively committing to buying the dips;

3. I have cash coming in each month from my savings and investments and keep enough cash uncommitted to ensure that I will always be able to meet my obligations even if I get hit on all my open positions at once. Put differently, I am in a position to replenish the cash position if the need arises. Also, I am not going to end up in a position where I have to sell a loss making position in order to meet my obligations.

For me the incremental returns are worth the risks involved. I would rethink this strategy if (when) the market starts looking over materially valued - the higher the market the greater the risks.

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