Fixed Income Strategies in Portfolios Using Index Options and Bonds
Investors use bonds and trading options to provide a steady stream of income. In doing so, an investor needs to consider three issues when assessing any particular bond:
i) Creditworthiness of the issuer: the issuer may be willing to borrow money and pledge to make payments to bondholders until maturity, but are they able to fulfill this obligation?
ii) The bond’s coupon rate: given the creditworthiness of the issuer, the anticipated state of the issuer's business, and current interest rates, is the coupon offered enough compensation to assume any risks presented to the bondholder?
iii) The maturity of the bond: Is the bond-holder willing to tie up their investment for the life of the bond?
Options can be used to replicate a bond’s coupon stream. Options can provide the same payment profile of a bond without exposure to the creditor’s creditworthiness nor the need to tie up capital for extended periods of time and can additionally provide flexibility concerning the magnitude of the income stream depending on appetite for risk.
A Primer on Options
Options are a type of derivative, which simply means that they derive their worth from the value of an underlying asset. In the case of options, that underlying asset is most often an equity security, although it could be an index and, in some cases, a futures contract. Options come in two basic styles, calls and puts.
What are Options?
Standardized call options were introduced to the markets in 1973, along with the Options Clearing Corporation and, of course, the Black-Sholes Option Pricing Model. Calls give the purchaser the right but not the obligation to buy the underlying security for a specified price either at (for a European style contract) or up to (for an American style contract) a specified expiration date. Sellers of calls become obligated to deliver underlying securities according to the terms of the contract if the buyer exercises the call, which happens approximately 11% of the time. If the buyer does not exercise the call before it expires, the seller simply gets to pocket the call premium (price paid).
Standardized put contracts were introduced into the market four years after the introduction of calls. Buying a put gives the purchaser the right to sell the underlying security for a specified price either at (for a European style contract) or up to (for an American style contract) a given expiration date. The seller of a put is obligated to receive the underlying security at the specified price from the buyer if the buyer exercises the put before it expires.
As mentioned, investors and traders can both buy and sell options. Given that options are available at any number of strike prices and through a number of expiration dates, there is an untold number of multi-contract or “multi-leg” strategies that investors and traders can establish. Some of these strategies can be used to synthetically replicate underlying exposures. For example, buying an ATM (At The Money) call replicates the upside potential of owning shares of stock, and selling an ATM put replicates the downside potential of owning those same shares. Establishing these positions will provide the same profit/loss profile as holding the underlying stock outright (until the expiration, of course).
For example, establishing a synthetic position in QQQ would (as of the time of writing) would cost $704 ($7.04 x 100, the displayed contract price x the contract multiplier) to buy the ATM ($333 strike) call, and the investor would receive $759 ($7.59 x 100) for selling the ATM ($333 strike) put. 100 shares of QQQ would cost an investor roughly $33,230 ($332.30 x 100, share price x number of shares), and an options investor would get paid $55 to get this same exposure by spending $704 on the call and receiving $759 from selling the put. It is fairly easy to establish a synthetic position in an equity underlying. What other exposures could be created using options? What about replicating a bond?
Options and Bonds
A time-honored way of producing income is by selling things, and sellers of options are no exception to this tradition. However, as said earlier, selling ATM options brings with it the obligation to fulfill the terms of the contract and potentially can expose the seller to unlimited risk. If you sell an uncovered (uncollateralized) call with, say, a $12 strike and the underlying trades up to $412 and the buyer decides to exercise that call, you would be on the hook to deliver (sell to the buyer) shares of the underlying for $12. Bridging the $400 per share difference (which, because of the contract multiplier, would be $40,000) would be your problem to solve.
What is a Strangle?
One way to mitigate this risk is to establish collateralized positions by owning shares in the underlying securities, but collateralization requires large amounts of capital. Another way to mitigate this risk is to sell contracts that are Out of The Money (OTM), which provides some leeway for the underlying price to fluctuate around the then ATM price without crossing the contracts strike price. One strategy that does this is a Strangle, which is set up by selling both an OTM put and an OTM call. This overall risk profile means the underlying is given some room to fluctuate around the current ATM price before the seller starts to feel pain. The net gain potential is limited to the total premium received from selling the two contracts, but the potential loss ranges between the strike price of the sold put less the received premium (Max Put loss) and a theoretically unlimited amount (Max Call loss). Even if strikes just outside a one standard deviation move of the underlying for the time to expiration are used, there is still a lot of risk to this trade.
We can make a Strangle less risky by capping the downside risk of this trade. This is done by picking strikes further OTM from where the initial positions were sold and establishing long positions to offset the short exposures. This creates a strategy known as an Iron Condor. “Condor” for the shape of the payoff diagram and “Iron” as a reflection of the limited exposure to losses. Periodically selling this strategy can simulate the receipt of coupons from the purchase of a bond.
Risks: Bond Vs. Iron Condor
Once the bond has been acquired, all the pre-trade considerations are continually evaluated. Prevailing interest rates are of particular concern. If a bond pays 3% and rates go up, then relatively speaking, that bond is now an underperforming asset as newer bonds will have higher coupons, and that underperformance will be reflected in the bond’s price. Similarly, if rates decrease, then that bond is now offering a higher return than currently available in the market, and it will be worth more to investors. A bond’s sensitivity to changes in interest rates is measured by its Duration. Note that changes in interest rates will not affect the stated coupon rate or the dollar amount received unless the bond is structured to do so.
In as much as bond values are affected by changes in interest rates, option values are affected by, in order of importance: i) Volatility (Vega), ii) Changes in the price of the underlying (Delta), iii) The passage of time (Theta) and, iv) Interest rates (Rho). These four metrics are referred to as “The Greeks” and together account for the extrinsic value (sometimes referred to as “time value”) of an option contract. Option prices are most reactive to volatility to the point where sometimes an underlying can behave exactly as predicted, but the anticipated strategy return is materially affected by changes in overall volatility.
By selecting strikes that are outside the anticipated underlying price moves (the mechanics of which we will discuss in a future article) until expiration, the risk of a max loss scenario is mitigated. However, transacting too far away from the current ATM strike will result in lower collected premiums and ultimately a lower yield on the strategy.
To recap, replicating the cash flows associated with owning a bond using options can be achieved. It takes a little more work to structure, execute, and manage the options strategy than it does to evaluate, acquire, and monitor the bond position, but if done correctly, can provide a relatively steady income stream while not tying up large amounts of capital in the process.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.