Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview

CHAPTER 19

Using Options for Risk Management
Volume in option trading continues to remain robust. In this chapter, we focus on the details of how options provide price insurance. That is, how can a risk manager protect an underlying portfolio from adverse price changes using options? As you learned in earlier chapters, options can be used to limit downside risk while still allowing upside participation. These results can be provided by either the fiduciary call strategy (purchase calls and debt instruments) or the protective put strategy (the owner of an asset buys puts). Also, options can be used to limit upside risk while reaping any benefits from declines in the price of an underlying asset. This can be achieved by buying calls to provide insurance against a short position.Also in this chapter, we will present some necessary technical details concerning how option values change as the factors that influence option values (S, K, r, T, σ) change. Risk managers must be aware of these details to use options effectively. Although option contracts are indispensable tools for risk management, market participants use options for other reasons. These include the following.
Options can generate additional cash flow. The sale of covered calls provides additional cash flow. Of course, the writer of a covered call also hopes that the underlying asset price does not rise much above the strike price. Writing naked puts is a revenue-providing strategy that is used as a substitute for placing limit orders to buy an asset.
Options can be used to exploit tax-related situations. Writing a covered call as a substitute for the outright sale of the asset might defer a capital gain, or stretch a short-term gain into a long-term gain. Many other tax-driven strategies exist, but users should always obtain an opinion from tax accountants or tax attorneys before attempting to use options to reduce taxes.
Options provide leverage. Because the purchase of a call is equivalent to buying the underlying asset and borrowing, the leverage provided by options may exceed that available to many market participants who purchase only the underlying asset. The initial premium of an option is generally only a small fraction of the cost of buying the underlying asset.
Options can circumvent short selling difficulties. If an asset cannot be easily sold short, the purchase of a put may be the most efficient method for generating profits from a price decline in the underlying asset.

An important question every risk manager faces is whether to buy options to insure against adverse price moves or to use forwards, futures, or swaps to hedge against price risks. Unfortunately, there is no easy answer to this question. However, here are some important considerations.

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