How to use Options to generate income or hedge

Eleanor Creagh

Australian Market Strategist

Summary:  When used in the right way Options can be a great way of enhancing returns, mitigating risk and diversifying your portfolio. An ETO gives you the right but not the obligation to buy or sell a given security at a certain price within a given time.


Generating income with covered calls

Covered calls can be used to enhance returns on top of a well-diversified portfolio of stocks. 

After rapid rebound off the March lows, with the ASX 200 now more than 30% off the March lows, it is fair to assume gains in 2H will be harder to come by. Investors will have to become more selective with respect to stock picking as the patchy recovery and post-pandemic changes shape new investment paradigms.

Example

As the banks sit very much in the eye of the COVID-19 storm, whilst the economic slowdown grips they will face many challenges. With the virus still ruling outcomes for the global economy, and by default the Australian economy, uncertainty is running high. There remains a wide range of probable outcomes and unknowns as it relates to the virus, the economy and the consumer over the coming months, which continues to weigh on the forward trajectory of the economic recovery and the validity of forecasting metrics. Even as Australia looks, on a relative basis, to have managed the COVID-19 outbreak more successfully than many other countries, the economy has by no means escaped unscathed and will continue to suffer the blowback from the rest of the world still dealing with an uncontrolled first wave and the additional drag posed by fresh lockdowns in Victoria. These factors will present a significant drag on the speed of the economic recovery, but the real wild card remains the long-term impacts on consumer and business confidence. With the COVID-19 outbreak lingering well into the third quarter there is an additional layer of fresh uncertainties and job insecurities that will weigh on the marginal propensity to consume post the initial pent up demand phase of the recovery. This could see the growth upturn fizzle and plateau as the long-lasting effects of the global pandemic are realised. 

For Australian banks at the point that the stimulus measures are withdrawn, rising consumer credit defaults, bad debts across residential mortgage books and higher impairment charges will dent returns and draws challenges as the economic recovery plateaus beyond the initial bounce back. 

More broadly, the outlook for credit growth remains subdued which keeps the outlook for profits under pressure. Lower interest rates will also continue to squeeze net interest margins over the years to come, presenting headwinds for the Australian banks. 

Another area where the crisis could be a catalyst for change is the traditionally chunky dividend payments to shareholders from major Australian banks. This crisis has already seen regulators worldwide moving to enforce dividend cancellations or deferrals across financial institutions and Australia has been no different with the majors all cutting or deferring dividend payments following APRA’s guidance. We suspect the crisis could be the harbinger of structurally lower dividend payments to shareholders for some time as payout ratios shift lower in tandem with the economy.

With the bank’s looking increasingly “ex-growth”, investors can look to enhance returns by selling call options over the shares they hold, thus collecting the premium and generating additional income. 

When you sell a call option, you are selling the purchaser the right to buy the underlying shares at a specific pre-determined price (strike price), at a specific point in time (expiry). If you hold the underlying shares in your portfolio then they can be used to fulfil the obligations of the sold call. 

For example, if an investor holds 1000 units of ANZ stock, currently trading at A$18.50, they could sell 10 calls at a strike price of A$20.00 expiring in one month’s time, receiving a A$200.00 premium.  

If ANZ closes above A$20.00 at expiry, there is a requirement for the investor to sell the stock at the $20.00 strike price to the buyer of the call options. Clearly, if the price of the ANZ shares rises significantly, the investor will miss out on that potential upside. 

Some investors may wish to minimise the risk of selling their underlying shares. In which case they can choose to sell an option with a much higher strike price than the last traded price, but this strategy will generate less income due to a reduced premium paid by the buyer of the call option. 

ANZ 8/20/20 C20 – for illustration purposes

At expiry on the 20th of August 2020 ANZ closes at A$20.00 and the option is exercised
Profit: 20.00 - 18.50 = 1.50 per share
Premium received = 0.20
Total return per share from initiation (assuming exercise) = 1.70, 9.19% in 36 days 

If ANZ closes below A$20.00 at expiry, the call option expires worthless but the seller of the option keeps the premium garnered from selling the call option (A$200.00) and still holds the ANZ stock.

Prior to expiry, if the investor thinks the ANZ share price is going to continue well above A$20.00 and wishes to keep the underlying shares to sell on market for greater than A$20.00, the investor can consider buying back the call option before expiry. This strategy could generate a loss depending on the exit price.

Long calls – play the recovery portfolio

Valuations are currently incredibly stretched at an index level, sitting more than two standard deviations above the long-run average. However, in the current environment, the risk vs. reward undertaking has been skewed by the persistently low rate environment set to persist for a number of years. 

Investors increasingly view the equity trade on a relative basis, in which case valuation, or the traditional academic conclusions around valuations, are in turn skewed. 

This paradigm manifests in a powerful force that has laid the foundations of recent bullish momentum across the risk asset spectrum - the lack of alternatives (TINA). That is the alternatives to equities look very unappealing (unless it’s gold!), coupled with the expectation that rates will remain low for an extended period drives investors up the risk spectrum into equities. Essentially giving a green light to the “hunt for yield”, along with a dose of moral hazard. As we have said before, the existence of this dynamic perversely dictates one need not be positive on the expectations of a swift economic recovery, to be long stocks (and by default short efficient markets/price discovery).

In a rising market, buying call options can be used to express a bullish directional view on the price of the underlying asset. Call options give the buyer the right, but not the obligation, to buy the underlying shares at a specific pre-determined price (strike price), at a specific point in time (expiry). 

Hedging with put options – Liquidity buys time, not solvency

Heading into the Q2 earnings season in the US, equities are treading water with most major indices remaining range-bound searching for a catalyst to breakout, with the exception of the Nasdaq 100 where mega-cap tech stocks continue to set new highs. This as investors weigh policy support against the rising COVID-19 case count ahead of what will be a tumultuous ride with respect to quarterly updates. Investors have been flying blind when it comes to corporate earnings with many companies withdrawing guidance, leading to a lack of visibility and increased dispersion amongst analyst estimates. For the technology sector in particular, the bar is high. Valuations are extended as investors have sought refuge in the sector with the acceleration of online trends like working from home, digitisation and e-commerce as a result of the global pandemic, alongside lower debt levels, higher free cash flow yields, and earnings duration profiles with high forecast future cash flows. These extended valuations leave little margin for error should the companies disappoint the lofty expectations. With cross-asset correlations remaining high, and elevated volatility indicating a degree of underlying fragility remains, ructions in the technology sector have the capacity to overflow quickly to the broader risk asset spectrum, which of course includes the ASX 200. With the Nasdaq having rebounded over 50% from late March, momentum is on side will the bulls and resistance seems futile. However, we remain vigilant as risk typically builds slowly, but when sentiment shifts liquidity quickly disappears and the previous stability in the seemingly never ending melt-up is destabilising in itself with everyone rushing for the exits at once. 

Although risk assets have rebounded rapidly alongside an abundance of liquidity and a resumption in activity post lockdown, there is a growing fault line between reality and market pricing. The scars of the global pandemic that leave realities of persistently high unemployment with permanent job losses mounting, prolonged social distancing measures and other restrictions impinging business margins, and resounding uncertainties that weigh on business and consumer confidence are yet to be felt. Governments and central banks have stepped in quickly in response to the global pandemic, with liquidity taps turned in full force to cushion the impact the sudden economic stop. This liquidity has papered over the cracks for now, but the new “liquid insolvent” business model will eventually wear thin as these actions buy time, not solvency and fundamentals eventually trump liquidity. This alongside the growing COVID-19 case count globally, with many countries still battling the virus into Q3, the lifting of restrictions is pausing and high frequency data shows consumers are becoming more cautious with confidence, mobility, footfall, and restaurant bookings dropping off. Beyond the initial bounce back following a period of pent up demand, it seems the recovery is now plateauing and caution remains which means the speed of the initial bounce back will not be maintained. The resurgence of the virus within Australia where community transmission has taken off in Victoria has seen Melbourne once more in lockdown and we will soon find if the contact testing and tracing strategy has worked in NSW with cases beginning to creep higher. With consumers becoming more cautious, the marginal propensity to spend declines thus weighing on both the speed and shape of the nascent recovery. Covid-19 may have started as a health crisis, but it quickly morphed into an economic and social one. However, the problem with the root cause of this crisis being a global pandemic, there remains a huge amount of uncertainty as no one, not even the epidemiologists can tell us definitively how this plays out, and some experts are on record saying it could be 2 years before a vaccine can be successfully implemented. 

So far, the concerns above have mattered little with respect to price action and risk assets have managed to shrug off the prospect of a stalling economic recovery in favour of a broad based melt up with global equities rebounding close to 40% since March lows. The underlying support from central banks, who incipient bubble or not, have pledged to continue to do whatever is necessary in order to detach asset prices from fundamentals puts a floor under risk assets for now. Investors who have for years been conditioned by the central bank put to buy dips have set aside the economic realities in favour of momentum and speculative stimulus-driven markets. 

With this dynamic in the play, the dissonance between market pricing and reality grows, leading to bumps along the road. This fault line will become more visible as a failure to flatten the first wave of the virus prevents activities from normalising in 2H. For both businesses and consumers, the uncertainty is pervasive. Investors have been looking through the earnings hit, to the recovery, but the realities of a plateauing recovery and failure to return to pre-crisis levels of output that sees businesses operating revenues and cash flows squeezed for a prolonged period will eventually catch up. 

With risk assets oscillating between the prospect of continued government and central bank support matched with a stalling global recovery, price action could remain range-bound with volatility elevated for some time. When we look volatility, the VIX remains elevated, currently at 27 and well above the 22 level, which is generally considered to be the long-term equilibrium in the term structure. With respect to this signal, it is fair to say volatility has failed to settle back within a lower range and has not given investors the signal that the “bear market” is over, in many ways, this is not a “normal” bull market and confirms the speculative flavour of the current environment. Perhaps unsurprising when the only real bull market is in the intervention.  

For investors wishing to lean into this more cautious stance whilst maintaining a long-term allocation within their portfolio, protective put options can provide an effective and accurate hedging mechanism to offset losses when the value of the underlying asset falls. Acting in many ways like an insurance policy, where an investor pays the cost of the option premium to protect against downside in the share price. For more cyclical companies a stalling recovery that lags expectations will weigh more heavily on sales and profits. 

Alternatively buying put options outright, without owning the underlying shares, can be an effective way of exercising a bearish directional view. A put option grants the buyer of the put, the right but not obligation to sell the underlying shares at a specific pre-determined price (strike price), at a specific point in time (expiry). In this scenario, the buyer of the put options will profit when the underlying share price falls. 

Another strategy that can be used to generate income and acquire shares below the current market value is selling put options. When you sell a put option on a stock, you’re selling someone the right, but not the obligation, the right but not obligation to sell you the underlying shares at a specific pre-determined price (strike price), at a specific point in time (expiry).

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