3percent annually, since there are more than two years of life in those puts)than that of some money manager who did not buy puts. If he wants cheaperprotection, he can buy out-of-the-money puts or shorter-term puts.
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Earlier, we described the collar, a strategy in which the stockholder not only buys an out-of-the-money put, but also sells an outof-the-money call as a means of financing the put. This has been avery popular strategy with index options in the past few years andhas been somewhat responsible for keeping OEX puts expensive andOEX calls cheap, relatively speaking.
THE COLLARUsing options to protect your portfolio is, for most people, more ofa theoretical exercise than a practical application. By that I meanthat most people think about using puts to protect their stocks—andthey might even look at a few prices in the newspaper and figure outhow much it would cost to hedge themselves—but when it comesright down to it, most people consider the put cost too expensive anddon’t bother buying the protection.Especially in a bull market, an investor may feel that money spentbuying puts was merely flushed down the drain. That laissez faire attitude could get you in trouble, however. Do you have that same perspective on your homeowner’s insurance? It’s something akin tofeeling that fire insurance is unnecessary because the house hasn’tburned down before (or recently). The comparison, admittedly, is nota direct one because a natural disaster can occur on a moment’snotice, while a decline in stock prices is usually less sudden—unlessanother crash were to occur—so you would have some chance tobuy insurance for your stocks as prices started to fall. However, if youare sitting on large stock profits, you should take a serious look atbuying protection using options.One approach that I like that limits the cost of insurance,although it may remove some or all of your upside profit potential, isthe collar. In this protection strategy, you buy an out-of-the-moneyput as insurance and also sell an out-of-the-money call to helpfinance the cost of the insurance. Thus, you have placed a sort of collar on your stock—you have limited downside risk, but you have limited upside profit potential as well. Often, with a collar, it is assumedthat you sell calls and buy puts in equal quantity. However, there is a
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modification to the collar strategy that is useful because you don’tnecessarily have to eliminate all of your upside profit potential.Example: Disney (DIS) was on a strong run in 1995 but suffered a setbackin late November after earnings were announced. The stock was selling atabout 61, and perhaps a holder of 1,000 shares would like to lock in someof the 50 percent–plus gains generated by the stock that year. Assume thathe is willing to risk 10 percent (down to 55) but wants insurance if DIS fallsfarther than that. The following prices exist:DIS: 61
April 55 put: 11⁄8
April 65 call: 21⁄4
Since the call is selling for twice the price of the put, he can sell 5 April65 calls and buy 10 April 55 puts without actually laying out any money.Then, not only is his entire 1,000-share position protected at exactly 55,but he will make profits up to 65 on all of his shares. Even if prices risebeyond 65, he still has 500 shares that are not covered by the calls thatwere sold; and those 500 shares can provide upside profit potential.
This form of the collar is often a more palatable type of insuranceto many investors, since there is no actual cost (in the form of a debit)for the insurance. The cost comes in the form of reduced upsideprofit potential. With this form of collar, however, you don’t evenhave to give up all of your upside profit potential, only a portion of it.This type of collar even works for highly volatile stocks. Try lookingat the option prices on the most extended stock in your portfolio,and you may find a collar that fits like a glove.Collars can often be best constructed with long-term options(LEAPS) because of the way that the long-term options are priced inorder to conform with the lognormal distribution, which is the waythat stock prices behave.Example: In 2000, Advanced Fibrecom (AFCI) wanted to hedge 5 millionshares of Cisco (CSCO) that they owned. At the time, CSCO was trading at$130 per share with a relatively high volatility of 50 percent. AFCIapproached a large underwriting firm that specialized in derivatives to placea “no-cost” collar on their CSCO stock. A no-cost collar is one in which the
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premium from the call exactly covers the purchase price of the put. Moreover, AFCI wanted the put to have a striking price of 130; that is, there wasto be no downside risk. The broker asked AFCI if they minded going outthree years for the hedge; and when they said, “No problem,” the deal wasstructured (these were not exchange-traded options, but over-the-counteroptions created by the underwriting firm). The final terms of the deal mayseem quite amazing, but they are in line with Black-Scholes model theoretical prices for three-year options. The three-year put was bought with a striking price of 130, and the three-year call was sold (completing the collar) ata striking price of 200! Yes, that’s right—a volatile stock such as thisenabled AFCI not only to own a put that completely eliminated their risk forthree years (during which a nasty bear market took place), but also to havethe potential to see their stock appreciate by slightly more than 50 percent,if it continued to rise. This was, indeed, an excellent collar.
Individual investors can’t trade three-year options with underwriters such as those in the previous example; but when LEAPS optionsseries are first listed on the option exchanges, they have about twoand a half years of life. Thus, a similar collar could be established foryour own holdings if you act when the LEAPS still have plenty of liferemaining in them.
Using LEAPS as CollarsIt was mentioned earlier that individual investors can establish collarswith listed LEAPS options that might be nearly as attractive as theprevious CSCO example—the collar was established with three-yearoptions, where the put strike was 130 and the call strike was 200(and short-term interest rates were about 5 percent). This collar wasa no-cost collar, meaning that no money was required to establishthe collar (in other words, the put and the call sold for the sameprice). There were two factors that led to this attractive situation: (1)the relatively high volatility of the stock and (2) the length of timeinvolved in the options.Generally stated, the higher the volatility of the stock and thelonger the time horizon involved, the greater will be the difference inthe striking prices between the call and the put trading for the same
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price. Conversely, if an investor were to try to establish a collar withshort-term options, it is unlikely that he could find much difference atall between the striking price of the put and that of the call and stillfind them trading at the same price. The reason behind this is theway stock prices are distributed. Since the markets are lognormal(biased to the upside), a very long-term, out-of-the-money call can bequite expensive (and an at- or out-of-the-money put would be relatively cheap).Using the Black-Scholes option pricing model, one can constructa general guideline for how far apart the striking prices of the putand the call would be for various volatilities and expiration dates.Table 3.4 shows two possible LEAPS expiration—1.5 years and 2.5years—and six different volatilities, ranging from 15 percent to 100percent, assuming interest rates (90-day, T-bill rates) are 5 percent.Lower interest rates will lower all the striking price values in the table,whereas higher interest rates would result in higher striking prices inall cases.Perhaps the table can best be explained by referring to the previous example in CSCO. In that case, the stock and the put strike wereequal—130. The call that paid for the put had a striking price of200, so the call strike was 54 percent higher than the put strike. InTable 3.4, it is assumed that the put strike and the stock price areboth 100, so then the call strike can be viewed as a percentage ofthe put strike. If CSCO were in this table, it would be on the 50 percent volatility row, with 3 years remaining, and the call strike wouldbe 154 (54 percent higher than the put strike). Now look at the 50percent volatility row in Table 3.4. You can see that 2.5-year LEAPSshows the call strike as 141 (again, if the put strike is 100). So thatreduction in time from 3 years down to 2.5 years lowers your potential call strike from 154 (CSCO) to 141 (as in Table 3.4).You can easily see that the longer the time remaining and thehigher the volatility, the higher the call strike will be. In some cases,you may decide not to collar if you can’t get the upside potential youwant. For example, suppose you are looking at a 1.5-year LEAPScollar on a stock with 30 percent volatility. Your call strike will onlybe 20 percent higher than your put strike. Perhaps you are unwillingto cap off your stock’s potential at a 20 percent over the next yearand a half. If so, then the collar would not be your best strategy.
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THE VERSATILE OPTIONTable 3.4HIGHEST CALL STRIKE THAT PAYS FOR PUTStock Price = Put Strike = 100
Interest Rate = 5%Call Strike
Volatility (%)
1.5-YearLEAPS
2.5-YearLEAPS
1530405070100
117119120121124130
130134137141150170
Table 3.4 assumes that the underlying stock pays no dividend. Ifit, in fact, does pay a dividend, then the call strike will be lowerbecause the stock price will essentially be discounted by the dividendstream (i.e., the present worth of all the dividends to be paid until theoption expires). Thus, if you try to collar Altria (nee Philip Morris), forexample—which pays a big dividend—then you may find that youcan’t even get 10 points between the strikes. The way to adjust forthis is to first subtract the present worth of all the dividends from thecurrent stock price and then look at the available options. This simple technique will help to visualize what strike’s call will cover the putprice (although that put’s strike will appear to be out of the moneywithout having subtracted the dividend). An example may help.Example: Assume MO is trading at 55 and pays a quarterly dividend of 60cents. You are considering the use of 2-year LEAPS as a collar. However,when you examine the prices, you find this:MO price: 55, in early 2004Jan (2006) 55 put: 9Jan (2006) 60 call: 3.50So, not only can’t you set up a no-cost collar, but you can’t even comeclose! What is going on? Well, the dividend is what’s causing this, along with
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low interest rates (at the time, T-bills rates were below 2 percent). MO isdestined to pay eight dividends of 60 cents each over the 2-year period—$4.80 in total. At the time, interest rates were very low, so the presentworth of those dividends is $4.65.To get a fairer look at things, subtract the 4.65 from the current stockprice, giving you an adjusted stock price of 50.35 (55 – 4.65). Now, try tofind a collar. These prices are now applicable:Adjusted MO price (discounting the dividends) in early 2004: 50.65Jan (2006) 50 put: 6Jan (2006) 55 call: 5.5Thus a collar can be established for a 0.50 debit. Even this does not seemreal attractive, but you must remember that MO is a low-volatility stock, having a volatility of just below 30 percent. If you refer to Table 3.4, the theoretical calculations would show that you could expect the call’s strike for thatlow volatility over a 2-year period to be about 25 percent above the put’sstrike. In real life, though, the call in this example has a striking price of55—10 percent above the put’s strike of 50—and a small debit would beincurred for the 2-year collar in that case. The difference is the decline ininterest rates. When they are as low as 2 percent, the call’s strike in thiscase is expected to be only about 9 percent above the put’s strike, and that’swhat we see.You might well decide not to use the collar in this case, but at least youhave correctly evaluated your alternatives and can make a rational decisionafter having discounted the current stock price to the extent of the dividendsto be paid during the life of the collar.
Since interest rates in recent years have been much lower than 5percent, we have included Table 3.5, which is the same as Table 3.4except for the fact that the risk-free interest rate (90-day, T-bill rate)is 2 percent in Table 3.5, whereas it is 5 percent in Table 3.4. Thefigures in Table 3.5 show that when interest rates are low, the collaris not nearly as attractive a strategy. The call strike is not very farabove the put’s strike. It is ironic that when interest rates are low, thestock market generally does well, so the chances of the stock rising inprice are actually increased—something that also argues againstusing the collar in this case.
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THE VERSATILE OPTIONTable 3.5HIGHEST CALL STRIKE THAT PAYS FOR PUTStock Price = Put Strike = 100
Interest Rate = 2%Call Strike
Volatility (%)
1.5-YearLEAPS
2.5-YearLEAPS
1530405070100
107108108109110112
112113114116119126
Of course, as an alternative, a stock owner could merely buy putsas insurance. The low interest rates will also have lowered the priceof a LEAPS put. Even so, the purchase of a put will incur a debit,which presumably is not as attractive to the stock owner as a no-costcollar would have been.In any case, it is imperative that the stock owner understand theeffect that dividends, volatility, and interest rates can have on the costof the collar. For only then can he assess it accurately to decide if it issomething he wants to use at the current time.
HEDGING WITH OVER-THE-COUNTEROPTIONSAnother avenue that many large institutional stockholders use inorder to hedge their stock portfolios is over-the-counter options. Asdescribed in Chapter 1, these over-the-counter options are transactions between two parties directly, not traded on an exchange. Typically, over-the-counter transactions can be tailored exactly to whatthe portfolio manager wants, so he can buy puts and sell calls on hisexact stock portfolio, and he can utilize nonstandard striking prices ifhe wants to. Tracking error can be completely eliminated in thismanner, for the over-the-counter put can be constructed as a put onexactly the stocks in the money manager’s portfolio at that time.
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The ability to utilize nonstandard strikes can be advantageous.Suppose the stock owner says, “I want to protect my portfolio if themarket declines by more than 8 percent. At what strike can I sell acall that will cover the cost of a put with that protection?” The overthe-counter option dealer (typically a large trading firm such asGoldman Sachs or Morgan Stanley) will then return to him with anoffer such as, “You can sell calls 10 percent out-of-the-money andbuy puts 8 percent out-of-the-money for the same price on each.”This strategy can be used for a single stock or for an entire portfolio;the trading firm will structure the options to fit the portfolio manager’s wishes.There are even more “complicated” options that are being usedin the current markets in order to hedge portfolios. They fall in thecategory of exotic options. Exotic options are ones whose valuesmay be dependent on a vast array of conditional parameters.One simple type of exotic option is called a down-and-outoption. This option behaves like a normal option, except that it hasan additional feature: if the stock drops to a preset price at anytime prior to expiration, the option automatically becomes worthless. For example, if IBM is currently at 110, then someone mightbuy a Dec 110 call that is down-and-out at 100. So, if IBM drops to100 at any time before the December expiration of the option, thecall becomes worthless at that time. Otherwise, if IBM never falls thatfar, then the option behaves just like a normal call and has value ifIBM is over 110 at expiration.You may wonder why anyone would want to buy an option thatcould “disappear” like that. The main reason is that it’s cheaper thanan ordinary listed IBM Dec 110 call. It’s cheaper because there’s agreater chance that the down-and-out option will be worthless. So, ifthe call buyer feels that IBM will not trade at 100 during the life ofthe call, he can buy a cheaper option initially by utilizing the exoticoption as opposed to a listed option.These exotic options can be structured in many different andimaginative ways. An entire book could probably be written justdescribing these exotic options. That is beyond the scope of whatwe are attempting to discuss here. However, there is one interesting exotic option that is being used today as a means of portfolioinsurance: the pay-later option. This kind of exotic option is obtained for free, initially, and only has to be paid for if the option
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finishes in-the-money at expiration. Thus, a money manger whowants downside protection might contact an over-the-counter firmand buy a pay-later put option. If the market goes up, this moneymanager owes no money, and his performance is the same as anyof his competing money managers who did not own insurance. Heonly has to pay for the put if the market does indeed collapse. Hedoesn’t get a completely free ride, of course, for if the market dropsand the put has to be paid for, it will be far more expensive than anordinary listed put would have been. This is just one example of themany ways that exotic options are being used by sophisticatedmoney managers.Whenever over-the-counter options are concerned, the OptionClearing Corporation is not involved. This could present a problem atsome time in the future. Recall that most of these options represent atransaction between a customer (institution) and a large brokeragefirm, which is creating these options. Thus, the large firm acquires aposition that it eventually must hedge. For example, if money managers are repeatedly buying put options as protection—in whateverexotic form they may be—the brokerage firm is selling those puts.There is the possibility that eventually the brokerage firm’s positionmay become quite large: they could be short many puts.The possibility that this might happen worries many regulators,for they realize that these large firms must hedge their positions. If themarket falls and the firms are short a lot of puts, then they must eithersell stocks or sell futures in order to hedge those short puts. Does thathave a familiar ring to it? It’s exactly what happened in the crash of1987, when there was a rush by the portfolio insurance crowd to sellfutures. A similar but less dramatic event occurred in October 1998when the market took a rather nasty nosedive in a short period oftime. It wasn’t exactly a “crash,” but it was certainly panicky selling.That decline was partly fueled by market makers who were short putsand selling futures as a hedge. Eventually, one of the larger firmsremoved its hedge at exorbitant prices, and that put an end to thedecline. But if the decline had gone on a little longer, it could haveturned even bloodier than it was because more and more naked putswould have had to be hedged. Of course, no one wants to see eitherscenario repeated, and the large firms do their best to find over-thecounter sellers of puts to help offset their positions. The worrisome
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part of this situation is that no one knows the total extent of the exposure. There are no open interest figures that need to be reported andno reports that are filed. Therefore, there always exists the possibilitythat a dramatic down market could turn into another crash if there isa rush to hedge the over-the-counter positions.
USING VOLATILITY FUTURES ASPORTFOLIO INSURANCEThe CBOE’s new volatility contracts (futures symbol: VX) were listedon March 26, 2004. These new contracts are dynamic in that theywill provide a hedge for you during a declining market, no matterwhen that decline occurs and no matter where the market iswhen the decline begins. This is a vast improvement over, say, buying puts for insurance purposes. We’ll spell out the mechanics ofoperating such a hedging strategy, and we’ll look at some of theproblems that may occur.We expect this to be a very successful product—perhaps themost successful new listed derivative product since the introductionof index options in 1983.The CBOE’s volatility trading instrument is a futures contract thatis traded on the newly created CBOE Futures Exchange (CFE) (basesymbol: VX). Thus, in order for any trader or investor to be able totrade the new contracts, he or she must open a futures account.Now, this may seem like a formidable impediment to many stockowners, but it shouldn’t be. You don’t have to trade corn, pork bellies, and cattle futures. You merely have to put some cash in a newaccount, fill out a new account form, and, voila, you are ready totrade the VX futures. All stock owners should consider using thesefutures as a hedge against declining markets. Suffice it to say that,during a bearish trend—or a full-fledged bear market—I believe this isthe most efficient way to safeguard your assets that has yet beendesigned for use by the layman in the listed markets. The benefits ofthat ability to hedge are overwhelmingly superior to the minor inconvenience of having to open an additional account—a futuresaccount—at your favorite brokerage firm.
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The Contract DetailsThe Volatility index (VIX)— created to measure implied volatility ofOEX options—was introduced in 1993. In 2003, the CBOEchanged the VIX to be the measure of implied volatility of the S&P500 Index (SPX) options. The “old” VIX became VXO, which stillmeasures the implied volatility of OEX options.The sole initial product of the CFE is futures on the VIX. Toimplement this contract, a new volatility index, called the JumboCBOE Volatility Index (symbol: VXB), was created. VXB is equal to10 times VIX. The futures are futures on the Jumbo VIX and areworth $100 per point of movement. So, one futures contract willmake or lose $1,000 when VIX moves by one full point (from15.00 to 16.00, for example).The futures trade with the base symbol VX and expire in February, May, August, and November, plus there is a contract in each ofthe two nearest months not included in that February cycle. Thereare four months available for trading at any one time. So, if todaywere June 1, then there would be contracts expiring in June, July,August, and November. (If the contracts prove to be successful, therewill probably be additional months added.) The minimum tick in thevolatility futures is 0.10 (which is the same as 0.01 for VIX) and isworth $10.The VX futures have different expiration dates than CBOE-listedindex options do. The last trading day is the Tuesday immediatelybefore the third Friday of the expiration month. The actual settlement price, though, is determined on the Wednesday morning following that Tuesday. In a procedure somewhat similar to the “A.M.settlement” that exists for most cash-based index options, a “SpecialOpening Quotation” (symbol: SOQ) of VIX is calculated from theopening price of the options used to calculate the index on the settlement date (the Wednesday morning in question). The openingprice for any series in which there is no trade shall be the average ofthat option’s bid price and ask price as determined at the opening oftrading. The final settlement price is rounded to the nearest 0.10.The futures then settle for cash at a price equal to 10 times that“Special Opening Quotation.”
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Futures must be margined. The margin requirements are set bythe Exchange, and you should check the CBOE web site for theexchange minimum margin (currently $3,750 per contract). TheCBOE allows SPAN margin to be used—a volatility-based margincalculation, which is generally favorable to customers.Example: On April 1, suppose that VIX is trading at 16.48 and that theMay VX futures are trading at 174.301 (they will have some premium inthem, most likely). You buy one May VX futures contract at a price of174.30.Since the futures contract is worth $100 per point and you paid174.30 for this contract, you are therefore “controlling” $17,430 worth ofVIX initially. Let’s suppose the margin for this trade is $3,750. That can besatisfied with equity from your account.Suppose that shortly after your purchase the stock market rallies andVIX drops quickly to 16.05—a drop of 0.43 points. Your futures will dropaccordingly, but not by necessarily that exact comparable amount, whichwould be 4.30. If panic selling sets in, your futures could lose some of theirpremium. Let’s say that the futures you own drop to 169.00 and the market closes. You now have a loss of 5.3 points on your futures. A one-pointmove is worth $100, so you have a $530 loss (unrealized) at this time. Youraccount is debited that amount, and the margin calculations are redone tosee if you are still in compliance. If you fall below maintenance marginrequirements, your broker will ask for more margin (and will sell you out ifyou fail to comply—just as would happen with stock bought on margin).Let’s say you hold on; VIX rallies over the next few weeks, and expiration day has arrived. You decide not to sell your futures in the open market,but rather to let them settle for cash on expiration day. Remember, eachday, the daily profit or loss is credited to or debited from your account. Onthe last day, suppose that the SOQ for VIX is 21.40. Your futures wouldthen settle at a price of 214. That’s a profit of 29.70 points from your initial purchase price of 174.30. You would have made $2,970, less commission, on the trade. Since you held them all the way to settlement, the lastday’s profit/loss is credited or debited, and the futures disappear from youraccount. The sum of all the daily credits and debits will total $2,970; so thatmuch cash would have accumulated in your account (assuming you didn’tuse it for something else in the meantime), and the futures would no longerbe in your account.
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Strategies for Protecting a Portfolio ofStocks with VX FuturesThe reason that VX futures are a good hedge in a down market isthat implied volatility (i.e., VIX) shoots up when the market falls,especially if it falls sharply. The long-term graph of VIX presented asFigure 4.19 clearly shows this. Any long-term chart of VIX verifiesthat it rises strongly during declining markets.So a simple hedge for a portfolio of long stocks would be to buysome volatility futures. Furthermore, a hedge of this sort isdynamic—it works for you no matter when the market starts todecline (as long as it’s prior to the expiration of the VX futures contract you own) or from what level. This is distinctly different frombuying put options as protection. In the latter case, if you buy puts asprotection and market rallies strongly for a while, your puts are thenso far out-of-the-money as to be essentially worthless for insurancepurposes should the market suddenly decline from that elevatedlevel. That is not the case with VX futures. They will shoot up whenever and wherever the market declines.Example: Suppose that you own a broad portfolio of stocks worth$100,000. Furthermore, you agree with the premise of hedging by buyingVX futures. Let’s say you are cautious about the idea, though, and buy onlyone futures contract, as shown in the following.With VIX near 15 in April, you buy one August VX futures contract at aprice of 159. Note: this means that there is a premium in the futures (150would be parity, so you are paying 9 points, or $900, above parity to buythe futures). Such a premium is likely to be built into the futures, especiallywhen they are trading at low levels; so that there is an expense to this hedging strategy—the premium in the futures.Furthermore, let’s assume that your stock portfolio moves more or lessin line with the broad market.Shortly after your purchase, the market starts to head south and gainsmomentum. By the time it has fallen 10 percent, VIX has traded up to20. Your future contract is now trading at 205, say. So, you have a$10,000 loss (on paper) in your stock account and a 46-point gain($4,600) in your futures contracts. Now, the one futures contract has notcompletely hedged away the loss in your stock account, but it has certainly helped.
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However, suppose that the market continues to decline and a bit ofpanic sets in. With the market now down 20 percent from the top andfalling rapidly, VIX shoots up to 30. The futures should be trading somewhere near 300—a gain of 141 points from your purchase price. So, whilethere is a $20,000 loss on paper in your stock account, you have a$14,100 gain in your futures account.
Thus, the futures in the preceding example provided an excellenthedge against a declining market. A complete hedge could have beenconstructed by buying more than one futures contract, of course.Once VIX has made its move, you could remove the hedge or keepit, realizing that if the market rallied, you would lose back some of theprofits on your futures. Of course, if the market continued to declinerapidly, your VX futures would shoot through the roof.