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Protecting your portfolio & generating income with etos

Given we are in uncertain times, protection and income are more important than ever.

A common topic on the desk this month has been around utilisation of exchange traded options (ETOs) to protect portfolios, and/or generate income.

Investors are asking themselves many questions. Should I protect my portfolio with a put? Should I generate income by selling a call over existing stock? Should I do both? While ETOs can prove a very handy tool they can also be a liability for those who don’t understand them and given we are in uncertain times, protection and income are more important than ever.

The monetary policy assumption has been that lower rates would stimulate the economy and corporate activity, but that narrative has morphed to one about unintended risks.

One risk that critics are concerned about is that lower rates have forced investors into riskier assets to achieve returns that match their personal liabilities.

 

Concentration Risk

A criticism of Australian equities is the concentration risk; our index is dominated by a few large institutions. When it comes to hedging equity exposure, concentration constructs are a benefit  deep large markets enable option market makers to efficiently hedge their implied exposure.

Liability matching requires investors to deliver returns that cover their cost of living demands. The issue is what risk adjusted returns are needed to achieve that outcome.

Cash returns are under pressure; the Bank Bill Swap Rate (BBSW) is the Australian benchmark reference rate, the  chart below illustrates the significant change in the BBSW over the last year.
 

Source: Bloomberg

 

Equities and the Relative Value

The rally in equities still has many supporters, given low inflation expectations, low interest rates and ongoing central bank support.

The problem is that, with the exception of the Covid shock period, equities have been rallying for years, as can be seen in the chart below. As markets rally higher investors can be reluctant to chase bull markets and especially in these uncertain times as no one wants to buy if the music stops.

Source: nabtrade

 

Therefore, when all the advice is to buy equities, investors can on occasion “blink”.

 

It’s okay to “blink”

One strategy for those who are unsure if now is the time to buy could be to buy an equity index and also buy option protection.

All investors need to develop strategies that suit their investment goals and if investors are keen to include options within their strategies but are unfamiliar with these instruments, they need to take the time to learn about them and get the basics right. What is a call and what is a put? What is an American option and what is a European option? What influences the price of an option? The ASX has some great courses and material to help investors understand options and covers all the questions above.

 

What drives option pricing?

There are specific key determinants in option pricing; a few of the major drivers of pricing are exercise price, time, volatility and interest rates.

Exercise price: The exercise price (strike price) is the price that will be paid for the underlying if the option is exercised. As an investor you can hedge your investment perfectly or you can be prepared to absorb some of the downside. In the example below, we will ask the investor to accept the possibility of a 10% loss and to completely hedge the position.

Time:  ETOs have a limited life so the investor needs to choose an expiry date, which is the last date the option can be exercised or traded. At the end of the expiry date, unexercised options are cancelled. The longer the expiry, the greater the time value is on the option. This is a key risk investors need to be aware of, as unlike shares, options are a ‘wasting asset.’ We will look at protecting a portfolio for one year in the example. Volatility: A more volatile price of the underlying share/index will result in a higher premium due to the wider movement.

Interest rates: If interest rates rise, we will see a decrease in put option premiums and an increase in call option premiums.

 

What does this all mean?

An investor may decide they want to buy $1 million worth of exposure to the ASX200, but they also want to limit their downside to 10%. If the investor wanted to buy the downside protection for a year the pricing at today’s prices for a 5500 put would be approximately $50,000 per million to hedge. If the desired outcome was a perfect hedge with the purchase of a 6000 put, the cost of 100% hedging would be approximately $90,000 for one year.

The pricing is not static; it can move around with the various determinants.

 

Options as Insurance

If an investor thinks that option pricing is too complex, they could possibly think of options as insurance products.

Life, house, car and other insurances have a huge array of assumptions that the buyers of insurance do not reprice. Insurance costings are ignored in lieu of insurance outcomes; people buy insurance for peace of mind.

When many experts are advising investors to invest they will consider relative value, price earnings growth and theorising on central bank stimulus as a means of suggesting one asset class is a better investment than another. It might make some sense to have a “what if” policy.

For example, the “what if” policy helps investors sleep at night when a G20 summit is taking place. The goal of the “what if” strategy is to answer the question, what if everyone has got it wrong? How do I as an individual investor protect my nest egg?

 

Generating Income

On the flip side, if an investor thinks the price of a particular security they hold could be static for a period, they could think about selling calls over that stock to generate income.

By selling calls over their stock the investor receives a premium as they have taken an obligation to sell those shares at a predetermined price in the future. If the share price behaves as the investor expected and is static through that period or falls, the call won’t be exercised and the stock along with the premium is kept by the investor. The risk to doing this is that the upside is capped as the sell price is predetermined, as mentioned earlier.

Selling calls can also be seen as a risk-reducing strategy as the premium received may offset part of the fall.

 

Conclusion

All investors need to have a plan for their portfolio and the objective of that plan is to decide what the risk is and does it meet the return requirements of an investor on a risk adjusted basis.

Options are just another asset class that needs to be understood. Though options can be traded in their own right the reality is that a large proportion of investors use options as a means of managing their investment exposure or generating income.

If you as an investor are reluctantly considering the equity market you may want to think about which options provide the insurance you need to invest with confidence.