Abstract
The case presents a real-life situation faced by a research analyst to improve the performance of the funds under management by exploring the opportunities in the options market. Golden Chariot Capital (GCC), an investment firm with ₹500 million worth of assets under management, was failing in its objective to provide long-term capital appreciation with a steady income to its investors. GCC had its funds invested in publicly traded common stocks and corporate bonds. In the last 8 months, GCC failed to match up with the benchmark index. Ms Indira, a research analyst at GCC, was given the task to identify and suggest alternate avenues of investment. Indira brought forward a proposal to explore the derivatives market in general and options market in particular to improve the fund performance. After going through Indira’s proposal, few fund managers at GCC were reluctant to expose their funds to the speculative market of options. Hence, Indira was asked to conduct a pilot study on the payoffs resulting from selected income strategies using options. As an illustration, Indira came up with five income strategies comprising covered call, covered put, short straddle, short strangle and long iron condor that involved either selling of options resulting in income or reduction of cost of the portfolio. The case will help the students to learn about options and their payoffs, as well as strategies involving various options. The case is equally useful for practitioners taking a balanced view of the market to develop appropriate options related to income strategies.
Introduction
It was 31 August 2016. Ms Indira confidently sat across the plush conference room carefully glancing through the compiled reports. As she anxiously waited for the others to join in, she quietly rehearsed her opening pitch. Indira had joined Golden Chariot Capital (GCC), a mid-sized investment firm, only 6 months back as a research analyst. This was her first job. Although straight out of university, she was armed with an FRM 1 degree, which brought her the confidence, needed at her job. However, her rapidly expanding role, from a research analyst to a prospective fund manager at GCC made her both enthusiastic and apprehensive about the outcome of the impending meeting.
Golden Chariot Capital
GCC, an investment company, was initiated in the year 2002 by an energetic entrepreneur Arnab Jena. Jena incorporated GCC in 2005 and was instrumental in taking the company from ₹10 to 500 million in just over 11 years. GCC primarily catered to individual investors and was responsible for creating stylized portfolios for them. Since its inception, GCC sought to pursue its investment objectives through a diversified portfolio of common stocks, having a high potential for growth in revenues and earnings, coupled with high-rated corporate bonds. Large-cap and mid-cap stocks prominently featured in their portfolios. As of 31 August 2016, the size of the fund at GCC, that is, asset under management, was approximately ₹500 million, invested mostly in publicly traded common stocks and corporate bonds.
Concerns at Golden Chariot Capital
The investment objective of GCC was to provide long-term capital appreciation with a steady income for its investors. Mildly aggressive, GCC had benchmarked their fund performance with NIFTY50. 2 In most years of its business, GCC was able to match and exceed NIFTY50 with their fund performance. However, in the first 8 months of the year 2016, the Signature Portfolio, one of the biggest and most valuable funds of GCC failed to catch up with the benchmark index. During the period between January and August 2016, their prestigious Signature Portfolio, which had a fund size of ₹100 million, earned a dismal negative 11.20 per cent returns while NIFTY50 registered positive 9.68 per cent returns in the same period (Tables 1 and 2; Figure 1). This was causing fear and doubt among the investors regarding the fund management capabilities of GCC. To restore faith among the investors, GCC decided to rejig its investment strategies.
Capital Allocation in Signature Fund (in ₹)
Performance of Signature Fund (in ₹)
Meanwhile, when Indira joined GCC, her first task was to identify and suggest alternate avenues of investment. Despite bringing a turnaround in their fund performance, Mr Jena directed Indira to pursue research on investment strategies involving stock options.
Investment Strategy with Options
At the last board meeting held on 1 August 2016, Indira brought forth a proposal to explore the derivatives market, particularly in the options segment. She pointed out to the management that as per company’s charter they could engage in derivative trading. She urged them to utilize the leverage, optionality and other characteristics of derivative instruments, particularly options to improve the returns profile of their funds. She further elaborated, that to begin with, they could pursue naive income strategies involving options. Unlike a futures contract, the feature of optionality would lead to non-linear payoff, which was critical to trade on volatility. That means, for example, the seller of the options if the volatility was less than expected, the whole premium received from selling the options would become the income for the seller.
Indira’s rationale for choosing options from other derivative products was that options were derivative contracts that gave the right to the buyer to transact in the underlying asset 3 at a future date and at a specified price. The right to buy and sell options on the underlying was called call options and put options, respectively. This right brought optionality, that is, non-obligation, in the transaction of the underlying asset. This gave a wide range of payoffs and the flexibility to the holder of the option to configure his/her investment aims, accordingly. Further, since an option was a right and not an obligation, the holder of an option would exercise his/her rights only when it was in his/her best interest. Thus, options provide financial insurance against price movements or volatility. However, this was not possible, for example, for the buyer of a call option got the right (not obligation) to buy the underlying asset only if the spot price rose above the strike price. If the spot price fell below the strike price, the buyer might not exercise his/her right to buy the underlying. Thus, any movement in the upside with volatility is profitable for the buyer of the call options. Moreover, the call option buyer was not worse-off even if the market went against her expectation, that is, volatility became negatively biased, since he/she would not exercise the option leading to zero payoff. 4 Thus, the more the volatility, the better it was for the buyer of the call options. The reverse was true for the seller of the call options (refer to Illustration 1).
Similarly, the put option buyer had the right to sell the underlying asset if the spot price fell below the strike price or allowed it to expire worthless if the spot price moved above the strike price. Thus, the buyer of the put options had limited 5 profit potential with downside risk restricted to the amount of premium paid, in a highly volatile market. Again, the reverse was true for the writer of the put options (refer to Illustration 2).
The payoff for the call buyer was linear if the spot price of the underlying moved above the strike price, and zero if the price fell below the strike price. Conversely, the payoff for the put buyer was linear if the spot price fell below the strike price, and zero if it went above the strike price. Thus, as a special class of derivative, options provided protection to the holder from the downside risk associated with the underlying asset, all the while, keeping open the full upside potential.
However, some fund managers at GCC were sceptical about using options as an instrument of investment. Being a traditionalist, 6 they were apprehensive about the high volatility and uncertainty associated with the options market. Moreover, they cited their lack of experience in the derivative segment as a hindrance to adopt options trading.
To address the concerns raised by the fund managers, Indira assured them that by using options, an investor could make profit in three ways: (a) from the predicting market direction, (b) from perception of risk or volatility and (c) from the passage of time.
Option Characteristics
Indira elaborated that in trading, the choice of option (i.e., call or put) depended on one’s view on the volatility and direction of the market (refer to Table 3).
Naked Positions in Options and View on Volatility and Direction
Further, the value of an option comprised an intrinsic value as well as the time value. The intrinsic value depended on the ‘moneyness’of the options, which resulted from the temporal effect when the option was exercised (refer to Illustration 3). Changes in the intrinsic value were associated with movement in the underlying market (i.e., market direction), while changes in the time value depended upon the uncertainty associated with the price movement of the underlying asset (i.e., volatility) and the passage of time. As long as there was time left for expiration, an option would always have a time value premium and would be close to zero on the day of expiry.
Indira explained that the longer the time to expiry, the more valuable was the option (refer to Illustration 4). As the time to expiration decreased, the time value premium of an option decayed. Decay property of options could be exploited to develop suitable strategies. For example, for the seller of options, time decay was favourable for the short positions in call or put options as it decreased the cost of the option, thereby generating profit opportunities for the short seller. Similarly, for the buyer of options, the cost could be minimized by choosing suitable options with longer expiration periods.
Furthermore, Indira informed them that implied volatility (IV) was another significant factor to determine an option’s price. IV was central to option trading as it was a determinant of the relative worth 7 of an option. IV referred to the expected level of volatility of the underlying asset for the remaining life of the option, implied from its option’s observed price. As the option’s price was affected by market volatility, over or under estimation of volatility results in overpricing or underpricing of the option, respectively. An opportunist options trader could take advantage of such price differentials by purchasing the under-priced option and selling the overvalued options. Another important feature of IV was its ₹mean revertingness’. When IV of an underlying deviated from its mean value 8 in either direction, it tended to revert back to the mean value over time. Therefore, options traders could take advantage of the mean-reverting characteristics of the IV of an option to book profit.
Appropriate Options Strategy
Indira’s efforts paid off. The sceptics looked convinced, yet they preferred caution. Hence, it was decided that, without committing funds to options trading, Indira would conduct a pilot study on returns resulting from selected income strategies using options. As the meeting concluded, the director Mr Jena, assured Indira that if her research on options trading strategies looked promising, she would manage the new fund.
Indira decided to look at the following five short-term income strategies: covered call, covered put, short straddle, short strangle and long iron condor.
In a covered call strategy, an out-of-money call option was sold against the long position in the underlying stock with a moderately bullish view on the stock. For a moderately bearish view on the underlying, a covered put strategy could be initiated by shortening both the underlying stock and an out-of-money put option. When the volatility of a stock was expected to remain stable, range bound strategies, such as short straddle and short strangle could be initiated. In a short straddle strategy, both call and put options were sold for the same strike price and same expiry. While in a short strangle strategy, both call and put options were sold with the same date of expiry but at different strike prices. When the direction was neutral and no abnormal price movement was expected of the stock, long iron condor strategies where two call options (short on higher middle strike price and long on higher strike price) and two put options (long on lower strike price and short on lower middle strike price) could be initiated.
By initiating these option strategies, Indira expected to earn a range of notional income given the price movement in the underlying asset.
To prepare a research report, Indira decided to look at the market sentiment on the stocks in the existing portfolio 9 as well as the overall market. Out of eight stocks, she was keen on the stocks of State Bank of India (SBI) (refer to Table 4). It was reported by GCC’s technical analyst that SBI will trade in a particular range in the coming days. Her assessment of the overall market was that it would be trading with a positive bias with potential for upside movement for the same period. Hence, she collected data on SBI’s trading activities in the futures and options segment to develop the strategies (refer to Figure 2 and Table 5). Also, she had collected the estimated historical volatility of SBI and the data on market volatility VIX (refer to Figure 3). The lot size of SBI was a multiple of 3,000 units in the options segment. Indira decided to initiate all the five option strategies for the month of September 2016, based on the option prices of SBI as traded on 31 August 2016 (Tables 6 and 7). The contracts were to notionally expire on 29 September 2016.
Spot Market Information of SBI (in ₹)
SBI Futures Market Cost of Carry, Change in Open Interest and Rollover (%)
SBI 29 September 2016 Call Option Strike Price Along with Day’s Respective Open Price, High Price, Low Price and Closing Price, Total Value of Contracts Traded and No. of Contracts Outstanding (open interest) as Traded on 31 August 2016 (in ₹)
SBI 29 September 2016 Put Option Strike Price Along with Day’s Respective Open Price, High Price, Low Price and Closing Price, Total Value of Contracts Traded and No. of Contracts Outstanding (open interest) as Traded on 31 August 2016 (in ₹)
Illustration 1
Suppose, Mr X bought a call option at a price of C (i.e., the premium of the call option) on a stock with a strike price (K) of ₹100 when the stock was trading at ₹100 (St) in the spot market. His final payoff would be max {St – K, 0}. Thus, if spot price St remained above the strike price K, on or before the date of expiry of the option, the payoff from exercising the call option would be St – K, otherwise 0. On the other hand, if spot price St remained below the strike price K, maximum loss would be the amount of premium paid, that is, C. For the seller of the option contract, if spot price St remained above the strike price K, on or before the date of expiry of the option, the payoff from exercising the call option would be (St – K). However, St remained below the strike price K, maximum profit would be the amount of premium received, that is, C.
Illustration 2
Suppose, Ms Y bought a put option at a price of P (i.e., the premium of the put option) on a stock with a strike price (K) of ₹100 when the stock was trading at ₹100 (St) in the spot market. Her final payoff would be max {K – St, 0}. Thus, if spot price St remained below the strike price K, on or before the date of expiry of the option, the payoff from exercising the put option would be K – St, otherwise 0. On the other hand, if spot price St remained above the strike price K, maximum loss would be the amount of premium paid, that is, P. For the seller of the put option contract, if spot price St remained below the strike price K, on or before the date of expiry of the option, the payoff would be (K – St). However, if St remained above the strike price K, maximum profit would be the amount of premium received, that is, P.
Illustration 3
Suppose, stock Z was trading at ₹45 and the call option on the stock with a strike price of ₹40 was trading at ₹6.50. The intrinsic value of the call option was ₹45– 40 (i.e., spot price – strike price) = ₹5. While, the time value of the call option was ₹6.50 – 5 (i.e., option premium – the intrinsic value of option) = ₹1.50. In this case, it was called in-the-money (ITM) call option. Similarly, for a call option with a strike price of ₹50, the intrinsic value would be zero and the total premium amount consisted of the time value only. It was called out-of-money (OTM) call option. Finally, if the spot price = strike price of the stock, it was called at-the-money (ATM) call option.
In case of a put option with a strike price of ₹50, trading at ₹7. The intrinsic value would be a maximum of strike price – spot price or zero (i.e., ₹50 – ₹45 = ₹5). The time value would be ₹7 – ₹5 = ₹2. In this case, the put option was ITM. In case. the strike price was below the spot price it was called OTM put, and if the strike price was at par with the spot price of the stock, it was called ATM put.
Illustration 4
An option expiring in 3 months was more valuable than the option expiring in 2 months, because, with more time till expiration, there was a good chance that the option would become ITM. Conversely, as each day passed the time till expiration decreased, leading to a decrease in the time value premium.
For example, stock XYZ was trading at ₹55 and in 2 month XYZ ₹50 call option was trading at ₹9. The intrinsic value of this call option was ₹5 and the remaining ₹4 was the time value. On the day of expiry of the ₹50 call options, let the spot price of XYZ stock be ₹55. Since there was no time left on the day of expiry, the ₹50 call option would have no time value premium and would be valued precisely at its intrinsic value (i.e., ₹5). Thus, the net depreciation in the value of the call option would be ₹4 due to the loss in time value premium (assuming all other factors, such as volatility, dividend, interest rate, etc., remain constant).
Declaration of Conflicting Interests
The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of this case.
Funding
The authors received no financial support for the research, authorship and/or publication of this case.