Traders Corner Blog


Top40 options structure for downside participation with limited loss

Posted by: Garth Mackenzie Posted on: 2013-09-30

On Traders Corner this week (week of 30 September 2013) I am highlighting an option structure which I have created in order to give some downside participation on the Top40 Index, with limited risk. Effectively this is a short position with a limited loss, and a fairly good participation in the event that the market were to see a correction of around 5% - 10% at some point during the final quarter of the year. These options structures can be complex, and are sometimes difficult to explain easily in a 13 minute TV slot, so I have written this blog article to compliment the TV show and to explain the option structure in more detail.


But first of all, what is my market view, as this is important when entering a structure such as this?


My view is that the overall bull trend of the JSE remains well intact, but it is at lofty levels in terms of being technically overbought, as well as at a pretty stretched valuation on a PE (Price to Earnings) metric. The JSE overall index is currently on a PE multiple of around 19 times, versus a historical long term average of 14 times. The market has seldom been this stretched in terms of valuation, and in the past the market has often corrected from such extended valuations. (A correction can happen in the form of a price pullback to more reasonable valuations, or in the form of time whereby the market trends sideways for a period while the earnings catch up to reflect a better level of valuation in the market). More often than not, a price pullback happens as money leaves the market to seek better value elsewhere.


Having said this, markets can sometimes remain at elevated valuations for a lot longer than one would expect and can often go higher than one would expect. Hence shorting the market outright when the upward momentum is strong is not advisable. Shorting against strong upward momentum often leads to short squeezes which result in naked short positions being forced to cover to avoid greater losses. For this reason, I am seldom comfortable taking naked short positions when the trend is firmly upwards. This is why I prefer to try and capture any downside in the market by making use of options strategies.


Options strategies can be tailored to your view and can be structured in such a way that you are able to limit your risk, while having the benefit of profit if your view plays out as you expect it to.


As a first point, I have attached a chart which illustrates my bigger picture view for the Top40 Index (chart 1). It shows that the market has been trending higher for 2 years within a well-defined upward channel. The channel boundaries have provided support and resistance on numerous occasions over this period. We are currently very near the upper boundary of this channel which comes in at around 40500. The lower boundary of the channel comes in at 36000 which is close to the level of the 200 day-moving-average (notice how the 200dma has provided support to past corrections). To my mind, a retracement towards the middle to lower end of the channel is fairly likely, but that’s not to say that we won’t have one final thrust higher towards 40500 – 41000 first.


In order to profit from my view here, and to limit my risk, I have entered the following three trades in order to effect a limited risk short position:


(1) Buy 2 contracts DEC13ALSI 40 000 strike call options at R10 371 each (effective premium paid = R20 742)
(2) Sell 4 contracts DEC13ALSI 37 000 strike put options at R4531 each (effective premium received = R18 124)
(3) Sell 2 contracts DEC13ALSI futures at 39800


The combination of these three trades enables me to profit on the market falling below 39650, and my loss is limited to R6618 in the event that the market should continue to move higher above 40000. If the market were to fall to 37000 (7.5% down from the recent high), the structure makes a profit of R53382. If the market were to fall to below 34350 (14% down from the recent high) then the structure would start to lose money at a rate of R20 for every 1 point fall.


So let’s get into the meat of how this structure is created by breaking it up into its individual components, and then seeing how they all tie together.




First, let’s examine the 40000 strike call option. A call option gives the buyer the right to buy an asset at a pre-determined price on a set date. I have bought (gone long) on this option, so I pay a premium for that option. If this option expires above the strike price, then the option is “in the money” and I will exercise my right to the option by buying the underling asset (in this case, ALSI futures) at the 40000 level. If it expires below the strike price, then the option is “out the money” and I won’t exercise it and will lose my premium. In this case, I have bought 2 options with a strike level of 40000 and an expiry date of 19 December 2013. I have paid a premium of R10 371 for each of these options. Thus the cost of the two contracts together is R20 742. The payoff profile of this call option is illustrated in chart 2. (Note that the exposure of each of these options contracts is R10 per point, so this means that I have an effective exposure of R800000 on these two call options (40000 x R10 x 2)). As can be seen in chart 2, my premium that I pay away on these two options is R20742. The options begin to move into the money above the strike level of 40000 but because of the premium that I have paid away, I will actually only begin to make a profit on these options above 41004. Beyond that level, the call options make a profit of R20 per point.


But remember that my view is that the market is going to fall, so you’re probably asking why I am taking an exposure to a call option which allows me to get exposure to the market going up, right? Well, this call option is actually being put in place as my hedge against the market moving higher, and will effectively protect my short ALSI future position which is the third leg of this trade (see (3) below).




To pay away such a hefty premium for the call options mentioned in (1) above is not particularly attractive, as the premium pay away is expensive. So to help me fund the cost of these call options, I have sold some “out the money” put options in order to collect some premium. To do this, I have decided to short 4 contracts of a 37000 strike put option. A put option gives the buyer the right to sell an asset at a pre-determined price at a future date. The buyer of a put option will pay a premium for that option. If the underlying instrument’s price expires below the strike price, the option is said to be “in the money”. If the underlying instrument’s price expires above the strike price, it is said to be “out the money”.  In this case, I have decided to sell that put option to somebody else, and as I am the option seller, I will collect the premium. I have sold 4 put options with a strike level of 37000 at a price of R4531 each. This enables me to collect a premium inflow of R18124 which goes a long way towards helping me fund the cost of the 2 call options mentioned in (1) above. The payoff structure of these put options is shown in chart 3. (Note that the exposure of each of these option contracts is R10 per point, therefore 37000 x R10 x 4 = R1480000 exposure). As can be seen in chart 3, my premium received on these 4 option contracts is R18 124. The options begin to move into the money below 37000 but only start to lose me money below 36546 on the Top40. Below that level, they start to lose money at a rate of R40 for every 1 point movement lower.


These two options legs above are basically put in place to effect my hedge on this structure. The leg that comes next is the one that I look to to make this trade profitable if the market should come down.




The third and final leg of this structure is a short position on the Top40 future (DEC13ALSI) which I have entered at a level of 39800. I have sold short 2 of these contracts. Each point on these contracts represents R10 so 2 of them at 39800 effectively puts me short of R796 000 worth of market exposure. I have shown the payoff profile of these two contracts in chart 4. It is a simple linear payoff. If the market moves below my entry point, this short position yields a profit of R20 for each point that the market falls, and it will lose R20 per point for every point that the market rises.


Remember however that since I have the two options legs of this trade in place, they effectively create a hedge if the market should continue to move higher, beyond 40000. This will limit my losses if the market should continue to power ahead. To the downside, these 2 ALSI future contracts will be allowed to make profits all the way down to 37000 and then below that level, their profits will begin to be offset by the losses incurred on the 4 short put options in (2) above.


The net payoff profile of these three legs of the trade are illustrated in chart 5. It shows clearly that losses are limited if the market should move above 40 000. But if the market does begin to move lower, it makes its maximum profit at 37000. This is a profit of R53382. Below that level, the profits begin to erode and only below 34 350 will the structure start to lose money. This structure expires on 19 December 2013. The idea will be to leave this structure on until it expires as it provides a good level of protection against any market pullback in the next three months.


Many may ask why I am going to such complex lengths to do this trade. Why not just do a naked short and have a simple stop loss in place? My reasoning is that this structure allows me to take a greater degree of leverage than I would typically be comfortable to take on the short side. It also limits my risk in the event that the market should spike aggressively higher in the type of move that normally shakes out all the short positions.


When markets fall, they typically fall hard and fast, and give you a very small window of opportunity to get involved. For this reason, shorting is inherently difficult and risky. Doing a trade this way means that I don’t have to try and time an entry. I can sit in this trade until it expires and not sweat too much if the market continues to move higher. The risk is limited to less than 2% of my trading capital if the market should continue to move higher, but my maximum reward is 8 times greater than my risk if the market begins to fall to 37000.


In the unlikely event that the market should start to fall below 34 350, I can sell short more futures contracts to hedge out the downside.


One point to note about this trade is that it is part of a larger trade that I have enacted and I have sliced a small portion of the trade off for the TV show that I run on Business Day TV. Ordinarily, options market makers will not provide pricing for a trade as small as this one illustrated here, but I have published it here for educational purposes and for high net worth traders to consider if they share my view that the market may be vulnerable to a correction.


I do hope that one day the options market in South Africa will develop to a point where these types of strategies are more easily accessible to smaller traders. There are moves afoot at the JSE to encourage more on-screen liquidity in the options market, but it is still difficult to effect these types of trades, and hence it usually requires one to get pricing from one of the banks to effect a trade. In most cases the banks only look at larger trade sizes, so this unfortunately limits these types of trades mostly to sophisticated traders with sizable trading accounts.


By Garth Mackenzie (Founder and editor of Traders Corner)





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Reply to this post 1 MJ Sophisticated but useful trade. I still believe you could short outright to avoid the likelihood of near term pull back.  

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