Issue: July/August 2005
Derivative - a focus on options
What are they and why use them?
The mere mention of the word "derivative" can send a
shiver down a trustee's spine. The mathematical mystique
surrounding derivatives has led to them being
misunderstood, and even feared. But the effective,
responsible use of derivatives can be a powerful tool in
enhancing and protecting the value of a portfolio. In fact
derivatives were invented for that very purpose - risk
There are two types of derivatives: options and futures.
This article will focus on options.
What is an Option?
An option is a right to buy or sell an underlying asset at a
future date at an agreed price. It is often easiest to
understand through a diagram:
The most defining feature of an option is the very word itself
- option. The buyer of an option has the right, but not the
obligation, to buy or sell the underlying asset. It is a choice
the buyer will make depending on whether or not the
underlying transaction would be profitable.
To illustrate, let us assume that the buyer purchases an
option to buy a share (known as a call option) at R100 in
three months time. If the share price rises to R150 over the
three month period, the buyer will obviously exercise his
option. The reason? The buyer of the option is well "in the
money" - he can purchase a share for R100 that is valued
at R150. However, if the share price has fallen to R80
during the three months, the buyer of the option would
choose not to exercise his right - why pay R100 for a share
that is now worth only R80?
Although the buyer of the option chooses whether to
exercise it or not, the seller (or writer) of the option has no
choice - he cannot refuse to sell the share, nor can he force
the buyer to purchase the share.
The price the buyer pays to have this
choice or option is the premium.
This is payable whether the option is
exercised or not.
Alternatively, an investor can buy an
option which gives him the right to
sell an underlying asset at a future
date at an agreed price, (known as a
put option). Should the investor in
our example above believe that the
price of the share is going to fall, he
may buy a put option, which gives
him the right to sell the share at
R100. If the price does fall to R80,
he will exercise his option - he will
sell the share for R100, although the
ruling market price is R80. If the
share price were to rise above R100,
he would simply let the option expire
without exercising it.
Why use Options?
The buyer of an option is essentially buying insurance.
The buyer would have a view on whether a share is going
up or down, but might consider the risks of being wrong
worth insuring against. The buyer would thus "hedge" his
view when the risks of being wrong are high, or when there
is increasing uncertainty about the outcome. The
maximum loss for the buyer of an option is the premium -
the "insurance" being paid in case the market does not
behave as expected.
Selling or "writing" options is slightly more risky (than
buying options) as the losses on the underlying asset can
be more than the premium received. Writing options can
improve returns through the premium income received.
However, prudent portfolio management means that
options should not be written without the backing of the
underlying asset. For example, one can only write a call
when one already owns the underlying asset.
Risks and Rewards
For a long term investor, the major benefit is the transfer of
risk between parties. In the same way that one takes out
insurance on assets and transfers the risk of loss or
damage to the insurer, so too the buyer of an option
transfers the risk of holding the asset, or of not holding the
asset, to the seller of the option.
Another benefit of buying options is that an investor can
acquire an effective position in an underlying asset, without
having to make the full outlay upfront. This can increase
returns relative to the actual amount invested. However,
options are very carefully priced for the potential risk which
the seller is taking on and are therefore not necessarily
"cheap". Thus they would not replace active fund
However, it is important for trustees to ensure that
derivatives are used responsibly in their portfolios. Options
allow an investor to take an effective position in an
underlying asset by only paying the premium. This
premium is only a percentage of the cost of the underlying
asset (e.g. 5%). Therefore it is possible to buy or sell more
exposure than the actual value of your investment. This is
known as "gearing" your portfolio. To illustrate: assume you
have R5000 of capital, and you use the entire R5 000 as
premium for a R100 000 exposure to an asset. This means
that the value of your exposure is 20 times greater than the
amount of your capital investment (R100 000 / R5 000).
The market need only move 1% against you (thus causing
your option to expire out-the-money) and you will have lost
your entire R5 000. This is clearly a huge loss for such a
small market movement.
The responsible use of derivatives avoids gearing
altogether. Thus taking the above example, one would only
buy R5000 worth of exposure to the underlying asset for
the initial capital investment of R5000. In this case the
premium outlay would be 5% of R5000, or R250.
Therefore, if the market moves down 1% or more, the
investor will only lose R250. Clearly if the market goes up
the investor will have exposure to exactly R5000 worth of
the underlying asset, which is consistent with his initial
investment of R5000.
Derivatives are thus a very important risk management tool
as they provide a useful hedge or 'insurance' in uncertain
markets. Derivatives can also be used as a "sweetener" to
increase returns or to protect a portfolio from unexpected
market movements. However, derivatives must be carefully
implemented and gearing should be avoided. But, to avoid
derivatives altogether because of their perceived riskiness
might, in fact, introduce more risk into a portfolio. The risk
does not lie in the derivative, but in the use of the derivative.
Derivatives are a bit like medicine: properly applied,
medicine can heal a sick patient; incorrectly applied, the
same medicine can harm. As long as derivatives are used
in a responsible way, they can enhance a portfolio's riskadjusted