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An Introduction to Option Strategies

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An Introduction to Option Strategies Jul 2019 An Introduction to Option Strategies: Covered Call & Short Strangle July 2019 Hang Seng Indexes – Research Paper www.hsi.com.hk 1 TABLE OF CONTENTS EXECUTIVE SUMMARY .............................................................................................. 3 INTRODUCTION .......................................................................................................... 4 UNDERSTANDING THE HONG KONG OPTIONS MARKET ...................................... 4 Open Interest .......................................................................................................... 4 Volume .................................................................................................................... 6 Premium .................................................................................................................. 8 COVERED CALL STRATEGY ................................................................................... 12 Concept ................................................................................................................. 12 Application of the Covered Call Strategy in Hong Kong .................................... 13 SHORT STRANGLE STRATEGY .............................................................................. 19 Concept ................................................................................................................. 19 Application of the Short Strangle Strategy in Hong Kong ................................. 19 CONCLUSION ........................................................................................................... 25 Hang Seng Indexes – Research Paper www.hsi.com.hk 2 EXECUTIVE SUMMARY Option has long been used as a tool for hedging and speculation. The unique features of options provide investors with an opportunity to customize a desired return profile by investing in multiple options or combining options with other asset classes. Index compilers have published option strategy indexes more than 15 years ago to provide a systematic solution for investors interested in option strategies. Recently, this trend has spread to Asia, with Korea being one of the market embracing this theme with great interest. In this paper, we will begin with an overview of the Hong Kong options market. The market liquidity has been highlighted and it is observed that the liquidity of the option market is sufficient with large open interest and average daily turnover. The three major factors influencing the Premium, namely Moneyness, Time Value and Implied Volatility are also discussed in the session. Following the market overview, the characteristics of two option strategies, namely Covered Call and Short Strangle, are being explored. Covered Call strategy provides downside protection to the underlying index with the Premium received from short call position at the cost of a limited upside potential. Short Strangle strategy engages in short position in both call and put options without exposure in the underlying index. This strategy enhances income returns but is exposed to unlimited downside risk. Some common findings are observed for both strategies: Moneyness of the options short sold has significant impact on the return characteristics. The closer the strike level is to the index level, the greater the premium is and the higher probability of incurring loss in short position is. The return distributions are different from the underlying index, with the range of returns being narrower. In terms of performance, the covered call strategy in long run displayed a better risk adjusted return while the short strangle strategy illustrated a low correlation when compared to the underlying index. We look into how both strategies perform in Hong Kong market as well and note that historically, in long run, the Covered Call strategy yielded a better risk-adjusted return while the Short Strangle strategy displayed a low correlation when compared to the underlying index. Hang Seng Indexes – Research Paper www.hsi.com.hk 3 INTRODUCTION Option trading is not a new concept. It might sound modern but some claim it can be traced back to ancient Greece when a philosopher named Thales created an agreement similar to an option contract to acquire the right to use olive presses. Option strategies, which involves investing in various different options or combining options with other asset classes, have been widely employed by investors, often to enhance protection of their existing exposure or boost their returns in certain market situations. Back in 2002, the Chicago Board Options Exchange (CBOE) published the CBOE S&P 500 BuyWrite Index1, which was the first of its kind in the world. Over the years, various option strategy indexes have been published by different index compilers and numerous exchange-traded funds (ETFs) that ride on these indexes have been launched in the US and Europe. More recently, this theme has been gaining popularity in Asian markets – particularly in Korea, where a number of exchange-traded notes have been launched and received considerable attention from retail investors. In this guide, we will start from the basics. We will begin with an overview of the Hong Kong options market and some of its key features. We will then take a more detailed look at two options strategies, Covered Call and Short Strangle, explaining how they work and their unique features. UNDERSTANDING THE HONG KONG OPTIONS MARKET Before considering any investment in an asset class, it is important to understand how the market for that investment instrument operates. We therefore begin with a look at the Hong Kong options market and its key characteristics. Similar to the securities market, one of the criteria that investors should pay attention to is liquidity as this will influence how easy it will be to buy or sell the required options at the desired point in time and if specific types of strategies can be implemented effectively. There are two metrics to measure the liquidity of the market: Open Interest and Volume. We will illustrate how these metrics are determined using the examples of Hang Seng Index (HSI) and Hang Seng China Enterprises Index (HSCEI) options. Open Interest Open Interest is the total number of options contracts outstanding and unsettled. Open Interest increases by one contract if a buyer and a seller come together and initiate a new position. It reflects the number of contracts readily available for trading without the need to initiate a new one. A large Open Interest indicates the existence of a high number of potential buyers and sellers. It can be considered as an implicit measure of the size of the secondary market for options. 1 The Buywrite Index is equivalent to a Covered Call strategy, which will be discussed in this paper Hang Seng Indexes – Research Paper www.hsi.com.hk 4 Exhibit 1: Average Daily Open Interest by Option Type: HSI Source: Figures derived from HKEX data Exhibit 2: Distribution of Average Daily Open Interest by Option Maturity: HSI Source: Figures derived from HKEX data Exhibit 3: Average Daily Open Interest by Option Type: HSCEI Source: Figures derived from HKEX data Hang Seng Indexes – Research Paper www.hsi.com.hk 5 Exhibit 4: Distribution of Average Daily Open Interest by Option Maturity: HSCEI Source: Figures derived from HKEX data For HSI options, the average daily Open Interest from 2010 to 2018 has been relatively stable, lying within the range of 250,000 and 450,000. On average, put options accounted for around 60% of this Open Interest for each calendar year within this nine-year period. Among different maturities of options, spot-month contracts (i.e. contracts that will expire in the current month) and next-month contracts (i.e. contracts that will expire next month) only accounted for around 45% to 50% of the Open Interest since 2012. In contrast, over the same nine-year time frame as above, the average daily Open Interest for HSCEI options has increased by around 1500% since 2010, overtaking the number of HSI options in 2012 and reaching more than three million contracts by 2018. Similar to the HSI, however, put options have accounted for around 60% of the total Open Interest on average on the time period under consideration. However, longer term contracts constituted a larger proportion of the Open Interest than has been the case for the HSI. Spot-month and next-month contracts collectively only accounted for about 25% of the Open Interest since 2013. Volume Volume is another metric for measuring the liquidity of options. It reflects the level of activity in the secondary market for options trading. Exhibit 5: Average Daily Volume by Option Type: HSI Source: Figures derived from HKEX data Hang Seng Indexes – Research Paper www.hsi.com.hk 6 Exhibit 6: Distribution of Average Daily Volume by Option Maturity: HSI Source: Figures derived from HKEX data Exhibit 7: Average Daily Volume by Option Type: HSCEI Source: Figures derived from HKEX data Exhibit 8: Distribution of Average Daily Volume by Option Maturity: HSCEI Source: Figures derived from HKEX data For HSI options, similar to the situation for Open Interest, the average daily Volume since 2010 has remained quite stable at around 40,000 contracts – about 10%, on average, of the Open Interest. On the other hand, the trading of HSCEI options rose by approximately 800% over the same period, and the ratio to Open Interest had fallen to around 3.1% by 2018. Hang Seng Indexes – Research Paper www.hsi.com.hk 7 If the market is dissected by maturity date, HSI and HSCEI options
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