Cfa Dec 2012

Gary Trennepohl Jim Bittman Oklahoma State University The Options Institute

Applied Options Strategies

for Portfolio Managers

CHICAGO BOARD OPTIONS EXCHANGE 2

Session Outline

• Typical Fund Objectives

• Strategies for “special situations”

• Six Investor Strategies

• Actual Investment Manager Approaches


Using Options to Meet Investment

Objectives

Objectives:

– Increase exposure to equities without

increasing risk

– Buy equities during the next year at lower

prices

– Generate income

– Conserve cash


Suitable Option Investment Strategies 1

Invest cash 5%-20% below current market level

and generate income

– Sell cash-secured put

– Sell out-of-the-money put spread

– Ratio put spread


Suitable Option Investment Strategies 2

Increase market exposure, limit risk and

conserve cash

– Ratio call spread overlay

– Long a synthetic or split-strike synthetic

Target buy/sell prices and generate income

– Sell covered straddle or strangle


Special Situations Defined

Portfolio rebalancing driven by

Unanticipated market moves

Anticipated/unanticipated cash flows

Market timing events

Price entry/exit decisions

Options give investors more strategy

alternatives to manage these

decisions/situations.


Prices for Case Studies

November 1 S&P 500 @ 1,425

Strike Mar Mar

Price Calls Puts

1,350 130 65

1,400 95 85

1,450 70 105

1,500 45 130

Quarterly Expiration: March 31, 2013, 150 days

3 Strategies that:

Invest Below the Current Market Level

and Bring in Cash Income


Case 1 –

Ready to Buy If Down 8%-10%

Market View: You are willing to commit

funds to the S&P near 1,300

Objective: Bring in cash income and buy

the market near 1,300

Strategy: Sell cash-secured put

Sell SPX Mar 1400 Puts @ 85

T-Bills: $140,000 per put


SPX

Level

Sale

Price

Value

at Exp.

P /(L)

1500

1450

1400

1350

1300 (15)

85

85

85

85

85

+85

+85

+85

0

0

0

50

100

+35

Short 1 1400 Put @ 85.00


Short 1 1400 Put @ 85.00

+100

+ 50

0 ][ ][ ][ ][

- 50

-100

1350 1400 1450

Put expires

Keep premium

= 6% ann rate

Invest in S&P

Effective price

= 1,315

+85

1,315

1425

1300


Case 1 – Sell Put – Outcomes

Market

Up: Puts expire; keep premium,

equal to 6% annual rate

Steady: Same as up

Down: Buy the S&P at 1,315 (8% below

current level of 1,425)


Case 2 – Ready to Buy if Risk is Limited

Market View: You are willing to buy near

current levels if risk is limited

Objective: Commit funds with limited risk

and bring in cash income

Strategy: Sell put spread

Buy SPX Mar 1350 Put @ - 65 Dr

Sell SPX Mar 1450 Put @ + 105 Cr

Net Credit 40

T-Bills: $145,000 per put


Buy 1350 Put @ 65.00

Sell 1450 Put @ 105.00

Stock

Price

+1350 Put

at 65.00

–1450 Put

at 105.00

P /(L)

1500

1450

1400

1350

1300

(65)

(65)

+40

+40

+105

+105

(65) (10) +55

(65) (60) + 5

(15) (60) (45)


Case 2 – Sell Put Spread

+

0 ][ ][ ][ ][

-

1,450 1400 1350

Put expires

Keep 40 Max loss

No position

+40 1410

1425

60 Invest

in S&P

at 1410

40/1410 365/150 = 6.9% (ann. rate)

1,500


Case 2 – Sell Put Spread – Outcomes

Market

> 1,450: Puts expire; keep premium

of 40 index points (7%)

1,350-1,450: Buy S&P at level of 1,410

(1.1% below current level)

< 1,350: Max loss of 60 index points

(4.2% max loss)


Market View: The market will decline 10-15%

Objective: Bring in cash income and buy

the market down 10%-15%.

Strategy: Cash-secured ratio put spread

Buy 1 SPX Mar 1400 Put @ 85 (85) dr

Sell 2 SPX Mar 1350 Puts@ 65 ea. 130 cr

T-Bills $135,000 Net Credit 45 cr

Case 3 – Ready to Buy 10%-15%

Lower

+1

–2

Max risk = long 1 unit


S&P

Level

+1 1400 P

at 85

–2 1350 P

at 65 ea.

P /(L)

1450

1400

1350

1300

1250

Buy 1 1400 Put @ 85.00

Sell 2 1350 Puts @ 65.00 ea

(85)

(85)

+45

+45

+130

+130

(35) +95 +130

+15 +45 +30

+65 ( 5) (70)


+

0 ][ ][ ][

-

1425

Case 3 – Cash-Secured Ratio Put Spread

1400 1350 1300

Puts expire

Keep 45

Buy at a

level of

???

+45 1,255

Long

put

settles

in cash

+95


Case 3 – Ratio Put Spread – Outcomes

Market

> 1,400: Puts expire; keep premium

of 45 index points

(3.2% in 150 days)

1,350-1,400: Long put settles in cash for

additional income

< 1,350: Buy the S&P 500 at 1,255

2 Strategies that:

Increase Market Exposure,

Limit Risk and Conserve in Cash


Case 4 – Increase Exposure Without Risk

Market View: The market will rise modestly

Objective: Add upside exposure without

increasing downside risk.

Strategy: Ratio Call Spread Overlay

Own SPY (or S&P stocks) @ 1,425

Buy 1 SPX Mar 1,450 Call @ 70 (70) Dr

Sell 2 SPX Mar 1,500 Calls @ 45 ea 90 Cr

Net Credit 20 Cr


Ratio Call Spread: Own S&P @ 1,425,

+1 1450 Call @ 70, –2 1500 Calls @ 45 ea

S&P

Level

Long S&P

at 1425

+1 1450 C

at 70

–2 1500 C

at 45 ea

P /(L)

1600

1550

1500

1450

1425

+175

+125

+75

+25

-0-

+145 +80 (110)

+145 +30 (10)

+145 (20) +90

+45

+20

(70)

(70)

+90

+90


+

0 ][ ][ ][

-

No market

exposure

1,425

Case 4 – Ratio Call Spread Overlay

1,500 1,450 1400

Long 1

+145

+20

1,570

Long 2


Case 4 – Spread Overlay – Outcomes

Market

< 1,450: Long 1

performs 20 points better

than S&P 500

1,450-1,500: Long 2

> 1,500: No market exposure –

maximum profit = +145

(+10.2% in 5 months)


Case 5 – Target Buying Lower,

but Can’t Miss a Rally

Market View: Think market will decline, but

worried about missing a rally

Objective: Establish a buy point down 5%

and participate in the upside.

Strategy: Split-strike synthetic

Sell 1 SPX Mar 1350 Put @ 65 Cr

Buy 1 SPX Mar 1450 Call @ (70) Dr

T-Bills $135,000 Net Cost ( 5) Dr


Sell 1,350 Put @ 65.00

Buy 1,450 Call @ 70.00

S&P

Level

–1350 Put

at 65

+1450 Call

at 70

P /(L)

1500

1450

1400

1350

1300

+65 +45 (20)

(55) (70) +15

+65 ( 5)

( 5)

( 5)

(70)

(70)

(70) +65

+65


+

0 ][ ][ ][

-

1425

Case 5 – Split-Strike Synthetic

1,550 1,450 1350

1,455

5

No market

exposure Long 1 Long 1


Case 5 – Split-Strike Syn. – Outcomes

Market

< 1,350: Put assigned

long the S&P 500 at 1,355

1,350-1,450: No market exposure (–5 pts)

> 1,450: Exercise call

long the S&P 500 at 1,455

1 Strategy that:

Targets Buy and Sell Prices

and Generates Income


Case 6 – Trading a Range

Market View: The S&P 500 is “range bound”

between 1,300 and 1,600

Objective: Increase exposure near 1,300,

Decrease exposure near 1,600,

and earn income while waiting.

Strategy: Covered Strangle

Sell SPX Mar 1,500 Calls @ 45 Cr

Sell SPX Mar 1,350 Puts @ 65 Cr

Own 10 SPY for each call and put


Covered Strangle: Own S&P @ 1,425,

Sell 1350 Put @ 65, Sell 1500 Call @ 45

S&P

Level

Long S&P

at 1425

–1350 P

at 65

–1500 Call

at 45

P /(L)

1600

1500

1425

1350

1250

+175

+ 75

-0-

( 75)

(175)

+185 +65 (55)

+185 +65 +45

+110 +65 +45

+ 10 +65 +45

(165) (35) +45


+

0 ][ ][ ][ ][ ][

-

+110

Long 1

1425

Case 6 – Covered Strangle

1500 1450 1350

+185

1400

Puts Assigned

Equal to buying

at S&P 1,315

Calls

Assigned

Sell

S&P 1,610

1300


Case 6 – Covered Strangle – Outcomes

Market

> 1,500: Calls assigned; equal to

selling at S&P 1,610

1,350-1,500: Long S&P + 110 points

< 1,350: Puts assigned; equal to

“doubling up” at S&P 1,315

CHICAGO BOARD OPTIONS EXCHANGE

1. CLIFTON GROUP DEFENSIVE EQUITY

2. HARVEST VOLATILITY MANAGEMENT

Actual Money Manager

Strategies Using Options

35


Clifton Group – “Defensive Equity

Strategy

36

Portfolio Construction

Defensive Equity - Fourth Quarter '11 14

Clifton’s Defensive Equity strategy is comprised of a ba se po r tfolio combined wi th an op tion overlay.

Straightforward portfolio that is liquid, transparent and unlevered

50%US Treasury Bills

50%S&P 500 Index

Option Details Short-term expirationsOut-of-the-money, volatility-based dynamic strikesEuropean style, exchange-tradedCash settled upon expiration when new options are sold

Base Portfolio

Higher S&P

Prices

LowerS&P

Prices

0% Option Overlay

S&P 500 Call OverlaySell covered calls above current market price(out-of-money)

S&P 500 Call OverlaySell covered calls above current market price(out-of-money)

S&P 500 Put OverlaySell cash covered putsbelow current market price (out-of-money)

S&P 500 Put OverlaySell cash covered putsbelow current market price (out-of-money)


Selecting the Options to Trade

37

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1990 1993 1997 2000 2004 2007 2011

SPX - Price Return

Dynamic Strike Prices


In 82% of the monthly periods since 1990, option sales were additive to performance*

See simulated disclosures in Appendices.Source: The Clifton Group

Median Call Strike: +4.03%

Median Put Strike: -4.46%

*Said another way, in 18% of the monthly periods, total premium collected was less than the loss on an option that expired in-the-money.

Monthly Call and Put Strikes (% Out- of- Money)

Since 1990 the S&P 500 Index price at expiration:

• Rallied above the call strike 20.8% of the time

• Declined below the put strike 10.2% of the time

• Remained between the call and put strikes 69.0% of the time

Since 1990 the S&P 500 Index price at expiration:

• Rallied above the call strike 20.8% of the time

• Declined below the put strike 10.2% of the time

• Remained between the call and put strikes 69.0% of the time

S&P 500 Index: Monthly Price Change versus Option Strike Prices1/1/1990 to 12/31/2011

The dynamic strike process adapts to volatility changes, selling further out-of-money options when expected volatility is higher


Monthly Trading Strategy

• Using S&P 500 index options or SPY

• It is Friday, Nov 21st and SPY is at 140. Assume you

own 3,500 shares of SPY and hold $500,000 in cash.

• Strategy: Sell SPYoptions with Δ≅.20.

• Sell 35 Dec 145 Calls ($60×35) = $ 2,100

• Sell 37 Dec 135 Puts ($500,000/13,500)

($90 × 37) = $ 3,330

• Net Premium Income $ 5,430

• You have sold covered calls and cash secured puts, so

you can cover either position if it ends in the money.

38


Recent Actual Performance

39

Actual Performance

Actual performance for the Defensive Equity strategy

Date: 12/31/2011

Month:

Actual

Defensive Equity

(net)

S&P 500 Total

Return Difference

09/30/11 -2.62% -7.03% 4.41%

10/31/11 6.75% 10.93% -4.18%

11/30/11 0.96% -0.22% 1.19%

12/31/11 1.14% 1.02% 0.12%

Monthly Returns

-2.62%

6.75%

0.96% 1.14%

-7.03%

10.93%

-0.22%

1.02%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

Sep-11 Oct-11 Nov-11 Dec-11

Actual Defensive Equity (net) S&P 500 Total Return

20Defensive Equity - Fourth Quarter '11

Note: The inception date for Clifton's Defensive Equity strategy was September 2011. The returns are presented net of 35bps fee. (unified fee is inclusive of investment management, administrative and custody fees)

*See the GIPS® Performance Presentation and Disclosure Statement in Appendices.Past results are not indicative of future performance.


Simulated Long Run Returns

40

0

100

200

300

400

500

600

700

800

900

1990 1993 1997 2000 2004 2007 2011

S&P 500 Total Return

Simulated Defensive Equity (Gross)

50% S&P 500 / 50% T-Bills

Defensive Equity Strategy Simulation – Summary of Results


Return Period: 12/31/1989 – 12/31/2011

*See simulated disclosures in Appendices.

Gro

wth

of

$1

00

S&P 500 outperforms in major bull markets

Defensive Equity seeks to outperform in major bear markets

1 Defensive Equity (Gross) simulated returns are gross of management fees and net of expected transaction costs2 Defensive Equity (Net) simulated returns are net of fees (35bps) and net of expected transaction costs

Source: The Clifton Group, CBOE

0 SimulatedDefensive Equity1

(Gross)

SimulatedDefensive Equity2

(Net) S&P 50050% S&P 500/

50% T-Bills

Defensive Equity vs. S&P 500

(Gross)

Annualized Return 10.3% 9.9% 8.2% 6.2% 2.1%

Standard Deviation 8.3% 8.3% 15.2% 7.6% (6.9)%

Sharpe Ratio 0.81 0.76 0.30 0.34 0.50

Insurance Risk Insurance Risk Premium Capture

Equity Risk Equity Risk Premium Give Up


HARVEST VOLATILITY

MANAGEMENT

41


Harvest Strategy

• “Harvest” offers a strategy which involves

selling put and call spreads against a cash

portfolio that’s used to support margin

requirements for trading.

• Similar to Clifton, they sell a “strangle” using

S&P 500 index options, but they buy a

further out call and put to reduce required

margin.

42





Harvest November Example

46

• Friday, Nov 9: S&P 500 at 1390

• Buy Dec 1515 Call

• Sell Dec 1480 Call

• Sell Dec 1300 Put

• Buy JAN 1160 Put

• Receive $6.70/share (credit spread)

• Manage position if market makes dramatic

move up or down.

• Trade out of position if market dictates

Sell a Call Spread

Sell a Put Calendar Spread

Documents

Cfa Dec 2012