In times of market uncertainty like we are seeing now, many investors turn to options for the protection they can provide. Although the markets have recouped a good portion of their losses of the past few months, we cannot rule out another plunge that could test the depths of the recent decline. The high volatility in today’s markets has made options more expensive than they were before the crisis. Volatility measures the dispersion of returns around their average over a given period. In simple terms, one could say that it measures a security’s ability to fluctuate over a given period of time, and the higher a security’s volatility, the more likely the security’s price will move abruptly, either up or down. Volatility is therefore a measure of the risk one faces when buying stocks. We can also use the price of options to deduce investors’ expectations regarding future volatility. This is called implied volatility. For example, the price of a stock with a quoted price of $50 and an annual volatility of 20% may be expected to fluctuate up or down by 20%, 68.2% of the time, over a year. This means that 68.2% of all the recorded prices will be between $40 and $60. The greater the volatility, the wider this range will be. Since a stock with higher volatility poses a greater risk of loss, investor demand for put options on that stock will also be greater, and this will increase their value.
Using options for protection
The simplest strategy for obtaining protection against a downturn is to buy put options. Just choose the strike price and a desired number of contracts and you will be protected against a decline in the stock price below that strike price, from now until the options expire. For example, an investor interested in limiting a potential loss on shares in a stock to 10%, and the stock is currently quoted at $50. The investor could choose a put option with a strike price of $47 that is offered at a price of $2 per share. So if the stock is trading at $40 when the put option expires, this represents a loss of 20% ([$40 – $50]/50 = -20%). In this case, the investor has the right to sell 100 shares per contract at a price of $47 per share. Subtracting the $2 premium paid gives an effective selling price of $45. Now let us consider a loss equal to exactly 10% ([$50 – $45]/$50 = 10%). In this case, the investor chooses protection against a 10% decline, believing that the stock price will not fall by more than 10%. If it does, the investor is prepared to suffer the consequences.
Vertical bear spread using put options
First of all, we should define “vertical spread.” There are several types of spreads: vertical, horizontal and diagonal. Our example will only cover vertical spreads. Implementing a vertical spread involves purchasing one option and simultaneously selling another option of the same type (whether a call or a put), with the same expiration date but a different strike price. The premium received on the options sold partly offsets the cost of the options purchased. In this way, a vertical spread reduces the cost of hedging against a specific risk.
Let us consider the previous example, where the stock is quoted at $50 and the investor, in this case, estimates that it will not fall below $45. The investor makes the following transactions, choosing from among the available put options:
Purchase of put options with a strike price of $50 for $4 each (debit)
Sale of put options with a strike price of $45 for $1 each (credit)
The total cost of the strategy is $3 per share or $300 per contract ($3 x 100 shares per contract). With this strategy, the investor is protected against the stock price declining to $45, but losses will be incurred if it falls below that price. Now let us look at the case where the stock closes at exactly $45 when the options expire, and another case where the stock closes at $40.
Case where the stock closes at $45
If the stock closes at $45 when the options expire, the investor will lose $5 per share on the stock ($50 – $45), but the vertical bear spread will provide a profit of $2 per share. With the stock at $45, the put options will have the following values:
Put options with a strike price of $50 = $5 ($50 strike price – $45 stock price)
Put options with a strike price of $45 = $0 ($45 strike price – $45 stock price)
As we can see, the spread is worth $5 per share. However, since we paid $3 per share, the total profit on the spread is $2 per share ($5 – $3). This results in a loss of $3 (-6%) instead of $5 (-10%).
Case where the stock closes at $40
If the stock closes at $40 when the options expire, the investor will lose $10 per share on the stock ($50 – $40), but the vertical bear spread will still provide a profit of $2 per share. With the stock at $40, the put options will have the following values:
Put options with a strike price of $50 = $10 ($50 strike price – $40 stock price)
Put options with a strike price of $45 = $5 ($45 strike price – $40 stock price)
As we can see, the spread is still worth $5 per share. However, since we paid $3 per share, the total profit on the spread is $2 per share ($5 – $3). This results in a loss of $8 (-16%) instead of $10 (-20%).
In conclusion, by using a vertical spread the investor managed to reduce the loss on an equity position, but only partially. When an investor does not expect the price of the underlying security to drop sharply, a vertical bear spread using put options can provide limited protection at a lower cost. If, on the other hand, the investor is convinced that a sharp decline will occur and still wants to hold onto the shares, purchasing put options is one way to limit the losses to a floor price for the stock (equal to the chosen strike price).
“Before you start using the strategies mentioned in this article, we suggest that you test them using the Montréal Exchange’s trading simulator.”
In addition, if you would like more information, we encourage you to watch the webinar “Making the most of volatility in these uncertain times” held on June 25, 2020 in collaboration with TD Direct Investing.
Good luck with your trading, and have a good week!
Originally Posted on July 7, 2020 – Using Options in Times of Market Uncertainty
Dollars expressed are in CAD
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
 This article was written on June 30, 2020.
 To learn more about volatility, see the blog “Making the most of volatility in these uncertain times” published on March 26, 2020.
 Implied volatility is calculated using an algorithm based on an option pricing model, such as the Black, Scholes and Merton model.
 This percentage assumes that returns follow a normal distribution, but this is not always the case. The larger the sample used, the closer we get to this percentage. With a very small sample, this percentage may no longer be valid.
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