For example, if we buy shares at 100 and write the 150 calls
for 10, the maximum profit possible (unless the option is closed out)
is 60.
The shares rise to 190. In our portfolio we are showing a profit of
90 on the stock. However, the option price has risen to 50 so we are
also showing a loss of 40 on the option position. The net result is
that we are showing a profit of 50 so that is OK. However, if we failed
to reflect the loss on the option revaluation we would be overstating
the portfolio’s performance by 90.
Then the option position is assigned and we deliver the shares at
150 realising a profit of 50 and though yesterday we showed a profit
of 90 the share price has not moved! If the option premium of 10 has
been ‘lost’ elsewhere in the records as income then not only is the
performance measurement unrealistic but the valuation of the funds
assets is wrong, the published price of the fund is wrong and reports
to the investors may be wrong. It will take some explaining to the
investors.
More importantly it will take some explaining to the auditors, the
trustee and the regulator and will hardly fill them with confidence
that the fund is using derivatives safely and properly.
Hedging
The fund manager is reviewing the portfolio and is concerned that
the UK stock market may fall in the short term. However, they does
not wish to change the weighting in the portfolio. They, therefore, are
not looking at an asset allocation or to sell stock. They look at two
possibilities. First, they can sell FTSE Futures Contracts which will
provide them with a profit as the market falls thereby offsetting the
fall in value of the stocks. Secondly, they could buy a three-month
FTSE Put option.
With the futures contracts the fund manager risks incurring a loss
if the market should rise until they decide to close the position. With
the put option they can determine how much the ‘insurance’ against
a fall in the market will cost and has the comfort that if the market
should rise they will never pay more than the original cost of the
option.
Index stands at 6960 on January 3rd
The March Futures contract is trading at 6975.
The FTSE Feb 6950 Put is quoted at 50p.
118 Clearing and settlement of derivatives