The Hang Seng Index 2

CONTENTS

OPTION PRICING VARIABLES Market Volatility ...... 1 The Hang Seng Index ...... 2 Other Pricing Variables ...... 3 Summary of Option Pricing Variables ...... 4 INVESTMENT STRATEGIE Bullish Market Outlook; Volatility Decreasing 1. Short Puts ...... 5 2. Call Ratio Vertical Spread ...... 5 3. Covered Call Write Bullish Market Outlook; Volatility Increasing 4. Long Calls ...... 6 5. Call Backspread Indecisive Market Direction; Volatility Decreasing 6. Short Strangles ...... 7 7. Short Straddles ...... 8 8. Long At-the-money Call Butterflies ...... 8 Indecisive Market Direction; Volatility Increasing 9. Long Strangles ...... 9 10. Long Straddles ...... 9 11. Short At-the-money Call Butterflies ...... 10

Bearish Market Outlook; Volatility Decreasing

12. Short Calls ...... 10 13. Put Ratio Vertical Spread ...... 11 14. Covered Put Write ...... 11 Bearish Market Outlook; Volatility Increasing 15. Long Puts ...... 12 16. Put Ratio Backspread ...... 12 CHARACTERISTICS OF THE SPREADS ...... 13

HANG SENG INDEX OPTIONS AND SETTLEMENT PROCEDURES

Contract Specifications of Hang Seng Index Options ...... 14 Cash Settlement on Exercise ...... 15 Payment of Option Premium ...... 15

GLOSSARY ...... 1 ...... 17

APPENDICES Hang Seng Index Sensitivity Analysis ..... 19 The Mathematics of Option Pricing ...... 20 OPTION PRICING VARIABLES

1. MARKET VOLATILITY

Volatility estimation is important to an option investor. The option investor is not only interested, in the direction of the market, but also extremely sensitive to the speed of the market. If the market fails to move at a sufficient speed, options will have less value because of the reduced likelihood of the market going through an option's exercise price. In that sense, volatility is a measure of the speed of the market.

In practice, volatility estimation is complicated by several factors. The most significant problem is the instability of volatility over time. The following figure traces the volatility for the Hang Seng Index Futures since 1988. The volatility has a mean of approximately 21 % (when the extreme volatilites are trimmed out, the mean value would be 17 %), but there are times when the volatility takes sudden jumps. During the period between May and Jun 1989, the volatility went up above the 100% mark (5 times over the average volatility), due to the Tianamen Square massacre. Besides this event, there are 3 additional events that pushed up the volatility drastically in the past 4 years - namely the Gulf Crisis in 1990, the Russian coup in 1991 and the Sino-British political reform disputes in 1992 and 1993.

The chart in the next page depicts the seasonal volatility for the past 5 years. Extreme volatility values are excluded from the computation. It can be seen that April and October are the two most volatile months. In other words, the market during these two months move swiftly. This phenomenon may presumably account for the earnings result announcements by the blue-chip companies in April and October. During this period, blue-chip companies registered good earnings growth which induced extra demand on the stocks that pushed the share prices up quickly. 2. THE HANG SENG INDEX

The Hang Seng Index (HSI) consists of 33 constituent stocks which have consistently represented between 65 % and 75 % of the total market capitalisation. It is the most widely quoted index in Hong Kong and as such is used as a proxy for the market as a whole. The index is computed arithmetically, weighted by market capitalisation. The computation of the Hang Seng Index has not accounted for dividend payments. Share prices are adjusted downwards by the dividend payable on the ex-dividend date.

The relative weightings and the sensitivity factors of the Hang Seng Index stocks are listed in Appendix I. The top 3 largest capitalised stocks are HSBC Holdings, Hang Seng Bank and Hongkong Telecommunications. Hence the market movement is strongly influenced by these counters. If all the constituent stocks edge one spread higher, the Hang Seng

Index will approximately go up 48 points. The right chart analyses the seasonal pattern

of the HSI. The HSI normally drifts higher during the first three months of a year with a mild consolidation in April and May. The rising momentum reaches a peak in June. A retracement then takes place and the market likely reaches its low between September and November. With the aid of the HSI seasonality index coupled with trend analysis, a trader can get some direction about the market movement. 3. OTHER PRICING VARIABLES

By far we have discussed the two major index option pricing determinants, the market volatility and the Hang Seng Index. There are three other key variables that will affect the price of the option:-

1. Time to expiry 2. Interest rates 3. Dividend flow

Options are a wasting asset which will decrease in value towards expiration even if there is no adverse move in the underlying instrument. On expiry day options that have not been exercised will expire worthless.

Dividends and interest rates are less important when looking at changes in option price. The Hang Seng Index has an average yield of 3 % to 5 %. There are about 248 points to be paid by HSI stocks during 1993 in which 100 points will be paid in the second half of the year.

Interest rates were ' kept at a low level. The right chart displays the interest rate movement over the past three and an half years. It has formed a downtrend line and is expected to bottom out. The local currency has been pegged against the US currency at HK$7.80 to US$1 since 1983. Hence the domestic interest rate movement is strongly influenced by the US monetary policy.

4. SUMMARY OF OPTION PRICING VARIABLES

Directional Effect On The Option Price

Variable Call Put Index Price Increase Decrease Time to Expiry Increase Increase Volatility of the Index Increase Increase Interest Rate Increase Decrease Dividend Flow Decrease Increase INVESTMENT STRATEGIES

The principal result of any option transaction is to alter the risk characteristic of investors' portfolio positions. The net effect is a reallocation of risk and reward between the buyer and writer. Ignoring transaction costs, option investment is a zero sum game. However, options provide a significant expansion of the patterns of portfolio returns available to investors.

While actual uses of options in investments are many and varied, it is beyond the scope to describe them all. An analysis of some of the more general types of strategies, however, will illustrate the peculiar investment characteristic of options. The following chart suggests some types of strategies based on various market outlook and volatility expectations.

SELECTING STRATEGIES

The following option prices and corresponding futures level are taken on 9 June 1993 to create the payoff diagrams.

Expiry Month: JULY 1993

Strike price Call Put 7000 495 165 7100 430 200 7200 370 240 7300 310 280 7400 260 330 7500 220 390 7600 180 450 Futures level : 7,350 A. BULLISH MARKET OUTLOOK

I. Volatility Is High And Expected to Decrease:

1. Short Puts • Puts will be high-priced because of increased volatility, and other traders trying to pick tops bid up put premia.

• Should closely monitor the positions because of unlimited risk. •Maximum profit is limited to the premium received.

• Both a fall in volatility and time decay are beneficial to Put writers.

2. Call Ratio Vertical Spread. Long one low strike call; short two higher strike calls.

 This trade normally carries low cost or a small positive income when the position is entered.  Limited reward but have to face huge loss if the market shoots up.

 It is worthwhile after a strong rally and the market's surge is expected to slow down.

 Maximum profit will be realised at expiration when the index finishes at the short option's strike price.

- 3. Covered Call Write. Long futures; short out-of-the-money call.

 The high priced calls offer extra income on the upside plus some downside protection.  A good strategy when the market has just penetrated above the long-term resistance level.  Compare with the short put strategy, as the position is a synthetic short put.

II. Volatility Is Low And Expected To Increase:

4. Long Calls.

 Look at the implied volatilities of different strike prices, preferable to low

implied volatilities. - • Buying a deep-in-the-money call will give action similar to a futures. Although there is little time value, cost will be relatively expensive even though implied volatility is low.

• Higher strike price calls offer higher gearing but will react slowly to initial market moves.

- Downside loss is limited to premium paid

with unlimited reward potential. 5. Call Backspread. Short low strike call; long 2 higher strike calls.

Good to trade if the market has a great upside potential.

When the market surges significantly, implied volatility will likely increase, hence this position becomes quite attractive.

' If the market reverses, loss is little if any or small profit may be earned.

Danger if the market advances only slightly.

B. INDECISIVE MARKET DIRECTION

I. Volatility Is High And Expected To Decrease:

6. Short Strangles. Short out-of-the-money call; short out-of-the-money put.

The position should be closely monitored, because loss potential is boundless.

A trader should be patient to hold on to this position in order to maximize profits.

The breakeven points are wider apart when the deeper out-of-the-money call and put are sold short. In this case, potential maximum profit will be less.

The passage of time benefits the holders of the position.

- 7. Short Straddles. Short both a call and a put at the same strike price.

The position has limited profit, and unlimited risk if the market moves violently in either direction.

The spread realises maximum profit - when the market stays close to the call and put strike price at expiration.

Again time decay favours the holders position.

The short straddle is a more aggressive trade than a short strangle.

8. Long At-the-money Call Butterflies. Long an in-the-money call; long an out-of-the- money call; short 2 at-the-money calls.

Suitable for an investor who like having a position without much risk.

The position consists of 4 different contracts, thus commissions are costly.

The payoff for the butterfly spread improves with the passage of time and depreciates with a movement of the future price.

It will worth zero if the index finishes below the lowest exercise price or above

the highest exercise price.

- II Volatility Is Low And Expected To Increase.

9. Long Strangles. Long an out-of-the-money call and out-of-the-money put.

Less expensive than a straddle, but the entire premium cost can be lost.

The position requires a sharp and swift market move to gain profit, otherwise the trader will lose time value on both the calls and puts.

When the deeper out-of-the money call and put are purchased, the combined strategy will be cheaper. However, the breakeven points are further away from the current market levels.

10. Long Straddles. Long both a call and a put at the same strike price.

An expensive trading strategy, but at least one of the options will likely expire with intrinsic value, so there is practically no chance of losing the entire premium.

The position will be profitable if the market is expected to have a big move in either direction.

The longer the holding period, the larger the price movement is necessary to pass

the breakeven point. 11. Short At-the-money Call Butterflies. Short an in-the-money call; short an out-of-the money call; long 2 at-the-money calls.

The position consists of 4 different contracts, thus commissions are large.

Require the index to move further outside the extreme exercise prices to reap profit. Time erosion will hurt the position's

value '" -

i Less costly than the straddle.

Lower potential for profiting from price - instability.

- C. BEARISH MARKET OUTLOOK

I. Volatility Is High And Expected To Decrease:

12. Short Calls.

Usually sold out-of-the-money.

As price stablises moderately and volatility starts dropping, nice profits will be made on options sold.

Liquidate the position if the market continues to soar, as potential loss is unlimited.

Combining with long positions in the underlying stocks (usually called a protective put strategy) will improve return on capital in the short term.

. 13. Put Ratio Vertical Spread. Long higher strike put; short 2 lower strike puts.

This trade normally carries low cost or a small positive income when it is entered.

Limited reward but exposed to downside risk if the market takes a dive.

It is worthwhile when the market outlook is slightly bearish.

Maximum profit will be earned at expiration when the index finishes at the short option's strike price.

14. Covered Put Write. Short futures, short out-of-the money put.

Take advantage of high volatility to enter short futures and short high priced put. upside. Will also help if market trades in a

narrow range because time decay will - favour the option writers.

Compare with short call position, the covered put write is a synthetic short call strategy.

- .II Volatility Is Low And Expected To Increase:

15. Long Puts.

• Examining the volatilities of different strike prices, low volatility puts are preferred.

• Buying a deep-in-the-money put will have action parallel to a future. Cost will be relatively expensive even though implied volatility is low, although there is little time value.

• A nice trade if implied volatility jumps immediately coupled with further price drop.

16. Put Ratio Backspread. Short high strike put; long 2 lower strike puts.

• A great downside move is necessary to make the trade profitable, a very bearish strategy.

• Major reverse should not hurt this trade because it should be entered at either a credit or little cost.

• Risky if the market drifts slightly downwards. CHARACTERISTICS OF THE SPREADS HANG SENG INDEX OPUONS AND SETI LETMENT PROCEDURES

CONTRACT SPECIFICATIONS OF HANG SENG INDEX OPTIONS -

Options, like futures, are leverage investments, but they have an attractive asymmetric risk return characteristic. HSI Options provide a natural trading partner for HSI futures, and many of the specifications are similar. The main features of HSI Options are that they are European style, cash-settled contracts of difference. Trading Fees#

Exchange Fee HK$9.50 per contract per side SFC Levy HK$2.00 per contract per side Compensation Fund Levy HK$0.50 per contract per side Special Levy HK$5.00 per contract per side Total HK$17.00 per contract per side

All fees should be charged in addition to the commission.

# 7hese fees are subject to change.

Exercise Fees

Options that are exercised on Expiry Day shall attract an Exercise Fee of HK$10.00 per contract.

Contracts that are not exercised will be deemed to have expired worthless and will not attract an Exercise Fee.

Cabinet Bids

These are options that are considered worthless and may be closed out at a nominal value of HK$10.00 per contract which includes all Trading Fees. These contracts will be displayed on the price reporting screens as 'CAB' bid since options cannot otherwise be traded at less than the Minimum Fluctuation of one index point.

CASH SETTLEMENT ON EXERCISE

On the Expiry Day the Exchange uses an average of index prices taken at five-minute intervals over the trading day to determine the Official Settlement Price of the index. The Clearing House will then automatically exercise all call options with strike prices below the Official Settlement Price and all put options with strike price above the Official Settlement Price. All other options will expire worthless.

PAYMENT OF OPTION PREMIUM

Payment of option premium depends on the type of Client account held. Clients with cash accounts may only carry long positions and will be required to pay the full contract value of the option on the day of purchase. The contract value is equal to the purchase price of the option in index points multiplied by HK$50 per point (the Contract Multiplier). Clients who wish to trade both long and short positions and futures contracts will do so through a margin account. An investor may not be required to pay the full premium if the position has been offset against a future or other option position*. Clients should be aware that this system of offset will mean that investors who sell options short do not receive the full option premium on the day of trading but receive it through the daily variation adjustment. Offsettable trades can be allocated on an one for one basis according to the following combination.

1. Long Future, Long Put 2. Long Future, Short Call 3. Long Future, Short Future 4. Long Call, Long Put 5. Long Call, Short Call 6. Long Call, Short Future 7. Short Put, Long Put 8. Short Put, Short Call 9. Short Put, Short Future 10. Conversion 11. Reversal

Apart from conversions and reversals, the other positions can be allocated regardless of strike price and contract month. Only trades within the same Client account and with the same beneficial owner may be allocated. GLOSSARY

American Option An option which may be exercised at any time prior to expiration.

At-the-money The strike price of an option equals to the market price of the underlying stock.

Backspread A spread in which more options are purchased than sold, and where all options have the same underlying and expire at the same time.

Bear Spread Any spread in which a decline in the price of the underlying will theoretically increase the value of the spread.

Breakeven Point This is the level of the underlying commodity where an option position makes neither a profit nor a loss.

Bull Spread Any spread in which a rise in the price of the underlying will theoretically increase the value of the spread.

Call Option A negotiable instrument that gives the holder the right to buy an underlying commodity at a fixed price within a specified period from the issuer.

Conversion A long underlying position together with a short call and long put, where both options have the same exercise price and expiration date. Delta The sensitivity of an option's theoretical value to a change in the price of the underlying.

European Option An option which may only be exercised on the expiration date.

Expiry Day The last, or only, day on which an option can be exercised. Gamma The sensitivity of an option's delta to a change in the price of the underlying.

Implied Volatility The value of the volatility variable that buyers and sellers appear to accept when the market price of an option is determined.

In-the-Money A term referring to an option which has intrinsic value because the current market price of the stock exceeds the strike price of a call or is below the strike price of a put.

Intrinsic Value The positive difference, if any, between the market price of a stock and the strike price of an option.

Out-of-the-Money A term referring to an option that has no intrinsic value because the stock price is below the strike price of a call or above the strike price of a put. Premium The price of an option

Put Option A negotiable instrument that gives the holder the right to sell an underlying commodity at a fixed price, within a specified period to the issuer.

Ratio Spread Any spread where the number of long market contracts and the number of short market contracts are unequal.

Ratio Vertical A spread where more contracts are sold than are purchased, with all Spread contracts having the same underlying and expiration date.

Reversal A short underlying position, together with a long call and short put, where both options have the same exercise price and expiration date.

Rho The sensitivity of an option's theoretical value to a change in interest rates.

Spread A long market position and an offsetting short market position usually, but not always, in contracts with the same underlying.

Strike Price The price at which the underlying will be delivered in the event an option is exercised.

Synthetic Call A long (short) underlying position together with a long (short) put.

Synthetic Put A short (long) underlying position together with a long (short) call.

Theta The sensitivity of an option's theoretical value to a change in the amount of time to expiration.

Time Spread A spread consisting of one long and one short option of the same type and with the same exercise price, but which expire in different months. All options must have the same underlying commodity.

Vega (Kappa) The sensitivity of an option's theoretical value to a change in volatility.

Vertical Spread A spread in which one option is bought and one option is sold, where both options are of the same type, have the same underlying, and expire at the same time. The options differ only by their exercise prices.

Volatility The annualised standard deviation of the market return on the underlying commodity. Used as a measurement, of the degree to which the price of an underlying tends to fluctuate over time. APPENDIX 1: MANG SENG INDEX SENSMVITY ANALYSIS

Market Weighting and Sensitivity Analysis of Hang Seng Index Stocks

Stock Market Capitalisation Sensitivity Factor# Weighting % Finance Secto Bank of East Asia 1.72 0.82 Hang Seng Bank 9.07 5.60 HSBC Holdings 14.74 7.30 Utilities Sector China Light 5.18 2.40 HK China Gas 1.81 0.91 HK Electric 2.86 1.17 HK Telecom 9.58 6.46 Prooerties Sector Cheung Kong 4.86 1.21 Great Eagle 0.58 0.26 Hang Lung 1.23 0.71 Henderson Land 2.73 0.92 HK Land 3.59 1.56 Hopewell 1.71 0.62 Hysan 1.17 0.50 New World 2.64 0.89 SHK Properties 6.03 2.80 Commercial and Industrial Cathay Pacific 2.46 1.66 CITIC Pacific 2.50 1.05 Dairy Farm Int'l 1.80 0.96 HAECO 0.48 0.27 HK&S Hotels 0.62 0.30 Hutchison Whampoa 5.85 1.94 Jardine Matheson 3.42 2.04 Jardine Strategic 2.02 0.55 Lai Sun Int'l 0.33 0.15 Mandarin Oriental 0.43 0.20 Miramar 0.70 0.31 Shun Tak 0.66 0.35 Swire Pacific 'A' 3.19 1.41 TV Broadcasts 0.72 0.24 Wharf 3.49 1.22 Winsor 0.28 0.15 World Int'l 1.56 0.59 Hang Seng Index 100.00

# Change in HSI (points) per spread change in stock price APPENDIX II: THE MATHEMATICS OF OPTION PRICING

The following formulas compute the Black-Scholes Model and its variations. The variable, in the expressions are:

S security price t time to expiration E exercise price r risk-free interest rate 6 cashflow from security a volatility N(x) cumulative normal distribution* N'(x) normal density function; where