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 management.

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:

derivatives [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 management.

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 performance.