An Introduction to Option Strategies - Hang Seng Index...options or combining options with other...

Hang Seng Indexes – Research Paper www.hsi.com.hk

Jul 2019

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An Introduction to Option Strategies:

Covered Call & Short Strangle

July 2019

Hang Seng Indexes – Research Paper

www.hsi.com.hk 2

TABLE OF CONTENTS

EXECUTIVE SUMMARY .............................................................................................. 3

INTRODUCTION .......................................................................................................... 4

UNDERSTANDING THE HONG KONG OPTIONS MARKET ...................................... 4

Open Interest .......................................................................................................... 4

Volume .................................................................................................................... 6

Premium .................................................................................................................. 8

COVERED CALL STRATEGY ................................................................................... 12

Concept ................................................................................................................. 12

Application of the Covered Call Strategy in Hong Kong .................................... 13

SHORT STRANGLE STRATEGY .............................................................................. 19

Concept ................................................................................................................. 19

Application of the Short Strangle Strategy in Hong Kong ................................. 19

CONCLUSION ........................................................................................................... 25


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EXECUTIVE SUMMARY Option has long been used as a tool for hedging and speculation. The unique features of options provide investors with an opportunity to customize a desired return profile by investing in multiple options or combining options with other asset classes. Index compilers have published option strategy indexes more than 15 years ago to provide a systematic solution for investors interested in option strategies. Recently, this trend has spread to Asia, with Korea being one of the market embracing this theme with great interest. In this paper, we will begin with an overview of the Hong Kong options market. The market liquidity has been highlighted and it is observed that the liquidity of the option market is sufficient with large open interest and average daily turnover. The three major factors influencing the Premium, namely Moneyness, Time Value and Implied Volatility are also discussed in the session. Following the market overview, the characteristics of two option strategies, namely Covered Call and Short Strangle, are being explored. Covered Call strategy provides downside protection to the underlying index with the Premium received from short call position at the cost of a limited upside potential. Short Strangle strategy engages in short position in both call and put options without exposure in the underlying index. This strategy enhances income returns but is exposed to unlimited downside risk. Some common findings are observed for both strategies:

Moneyness of the options short sold has significant impact on the return characteristics. The closer the strike level is to the index level, the greater the premium is and the higher probability of incurring loss in short position is.

The return distributions are different from the underlying index, with the range of returns being narrower.

In terms of performance, the covered call strategy in long run displayed a better risk adjusted return while the short strangle strategy illustrated a low correlation when compared to the underlying index. We look into how both strategies perform in Hong Kong market as well and note that historically, in long run, the Covered Call strategy yielded a better risk-adjusted return while the Short Strangle strategy displayed a low correlation when compared to the underlying index.


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INTRODUCTION Option trading is not a new concept. It might sound modern but some claim it can be traced back to ancient Greece when a philosopher named Thales created an agreement similar to an option contract to acquire the right to use olive presses. Option strategies, which involves investing in various different options or combining options with other asset classes, have been widely employed by investors, often to enhance protection of their existing exposure or boost their returns in certain market situations. Back in 2002, the Chicago Board Options Exchange (CBOE) published the CBOE S&P 500 BuyWrite Index1, which was the first of its kind in the world. Over the years, various option strategy indexes have been published by different index compilers and numerous exchange-traded funds (ETFs) that ride on these indexes have been launched in the US and Europe. More recently, this theme has been gaining popularity in Asian markets – particularly in Korea, where a number of exchange-traded notes have been launched and received considerable attention from retail investors. In this guide, we will start from the basics. We will begin with an overview of the Hong Kong options market and some of its key features. We will then take a more detailed look at two options strategies, Covered Call and Short Strangle, explaining how they work and their unique features.

UNDERSTANDING THE HONG KONG OPTIONS MARKET Before considering any investment in an asset class, it is important to understand how the market for that investment instrument operates. We therefore begin with a look at the Hong Kong options market and its key characteristics. Similar to the securities market, one of the criteria that investors should pay attention to is liquidity as this will influence how easy it will be to buy or sell the required options at the desired point in time and if specific types of strategies can be implemented effectively. There are two metrics to measure the liquidity of the market: Open Interest and Volume. We will illustrate how these metrics are determined using the examples of Hang Seng Index (HSI) and Hang Seng China Enterprises Index (HSCEI) options.

Open Interest

Open Interest is the total number of options contracts outstanding and unsettled. Open Interest increases by one contract if a buyer and a seller come together and initiate a new position. It reflects the number of contracts readily available for trading without the need to initiate a new one. A large Open Interest indicates the existence of a high number of potential buyers and sellers. It can be considered as an implicit measure of the size of the secondary market for options.

1 The Buywrite Index is equivalent to a Covered Call strategy, which will be discussed in this paper


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Exhibit 1: Average Daily Open Interest by Option Type: HSI

Source: Figures derived from HKEX data Exhibit 2: Distribution of Average Daily Open Interest by Option Maturity: HSI

Source: Figures derived from HKEX data Exhibit 3: Average Daily Open Interest by Option Type: HSCEI

Source: Figures derived from HKEX data


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Exhibit 4: Distribution of Average Daily Open Interest by Option Maturity: HSCEI


For HSI options, the average daily Open Interest from 2010 to 2018 has been relatively stable, lying within the range of 250,000 and 450,000. On average, put options accounted for around 60% of this Open Interest for each calendar year within this nine-year period. Among different maturities of options, spot-month contracts (i.e. contracts that will expire in the current month) and next-month contracts (i.e. contracts that will expire next month) only accounted for around 45% to 50% of the Open Interest since 2012. In contrast, over the same nine-year time frame as above, the average daily Open Interest for HSCEI options has increased by around 1500% since 2010, overtaking the number of HSI options in 2012 and reaching more than three million contracts by 2018. Similar to the HSI, however, put options have accounted for around 60% of the total Open Interest on average on the time period under consideration. However, longer term contracts constituted a larger proportion of the Open Interest than has been the case for the HSI. Spot-month and next-month contracts collectively only accounted for about 25% of the Open Interest since 2013.

Volume

Volume is another metric for measuring the liquidity of options. It reflects the level of activity in the secondary market for options trading. Exhibit 5: Average Daily Volume by Option Type: HSI



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Exhibit 6: Distribution of Average Daily Volume by Option Maturity: HSI


Exhibit 7: Average Daily Volume by Option Type: HSCEI


Exhibit 8: Distribution of Average Daily Volume by Option Maturity: HSCEI


For HSI options, similar to the situation for Open Interest, the average daily Volume since 2010 has remained quite stable at around 40,000 contracts – about 10%, on average, of the Open Interest. On the other hand, the trading of HSCEI options rose by approximately 800% over the same period, and the ratio to Open Interest had fallen to around 3.1% by 2018.


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If the market is dissected by maturity date, HSI and HSCEI options display completely different trends. The trading of HSI options was increasingly concentrated in spot-month contracts, growing from 60% to 75%. In contrast, the proportion of longer-term HSCEI option contracts went from 23% to around 45%.

Premium Another aspect of concern for investors is cost. The Premium is the amount paid by a buyer of an option or received by a seller of an option. The Option Premium is quoted in terms of index point and it is in proportion to the underlying index level. In the following example, the Option Premium has been converted to a percentage of the underlying index for greater clarity There are several key factors that affect the Option Premium: 1) Moneyness:

Moneyness is the position of the strike level relative to the underlying index level. For call options, the option is In-The-Money (ITM) if the index level is higher than the strike level or At-The-Money (ATM) if the index level is at the strike level. If the index level is lower than the strike level, it is Out-of-The-Money (OTM). The inverse applies to put options (e.g. a put option is ITM when the level of the underlying index is lower than the strike level). If a call option ends up ITM at its maturity date, an investor holding a long position would be in an advantageous position as they would have the right to purchase the underlying asset at a price that is lower than the market price. If the option is OTM, it would be worthless. The higher the probability that an option will end up ITM, the higher the Premium. Accordingly, the Premiums for ITM options will be the highest, followed by Premiums for ATM options. For options that are OTM, the farther away the strike level is from the index level, the lower the Premium. This can be observed in recent data for HSI and HSCEI options. Using the figures for HSI spot-month call options in 2018 as an example, the average month-end Premium of ATM options was around 1.93%, while that of 5% OTM options (strike level 5% above the index level) was only 0.41%.


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Exhibit 9: Average Month-end Premium Yield in 2018


2) Time Value:

Time Value is directly proportional to the time left until an options contract expires. Generally speaking, the longer the remaining time, the higher the Time Value and, in turn, the higher option Premium. This is reflected in Exhibit 9, which shows that, for comparable strike levels, the month-end Premiums for next-month contracts were consistently 1 percentage point higher than those for spot-month contracts in 2018.

3) Implied Volatility:

Implied Volatility is a more complicated metric. Unlike historical volatility, which measures the level of historical fluctuation, it is not a retrospective metric. It is a market estimation of the future movement of the underlying price. If a bullish market is expected, Implied Volatility decreases. If, on the other hand, the outlook for the market is bearish, Implied Volatility increases.


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Exhibit 10: Month-end Premium Yield and Implied Volatility of HSI Spot Month ATM Call

Options

Source: Option Figures derived from HKEX data; HSI price chart plotted with Hang Seng Indexes data

Exhibit 11: Relationship between Month-end Premium Yield and Implied Volatility of HSI Spot Month ATM Call Options


Exhibits 10 and 11 provide information to better understand the relationship between Implied Volatility and Premium yield. Exhibit 10 shows that the trend of Premium yields for spot-month ATM call options has closely tracked that of Implied Volatility, which indicates a very high correlation between the two measures. In Exhibit 11, the scatterplot chart provides a visual representation of the linear relationship between the month-end Premium yield and Implied Volatility. Comparing the Implied Volatility chart with price movements of the HSI, an inverse relationship is observed and it is especially apparent when HSI declined.


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Exhibit 12: Comparison between the implied volatility of HSI and HSCEI


Implied Volatility is also one of the reasons behind there being a difference in the Premiums for HSI options and those for HSCEI options. The Implied Volatility of the HSCEI has been consistently higher than that of the HSI – six percentage points, on average, over the years. As a result, the Premiums for HSCEI options have been persistently higher than those for HSI options.

A Brief Stop Let’s pause here to recap what we’ve covered so far before jumping into the next section. Regarding the liquidity of the options market, the Open Interest for HSI and HSCEI options has been of a good size in recent years, particularly that for the HSCEI, which has grown by 1500% since 2010. The average daily Volume for both HSI and HSCEI options has also been adequate, although growth in Volume has not been as significant as Open Interest growth. Turning to option types, put options have accounted for a larger proportion (roughly 60%) of both Open Interest and average daily Volume. However, if we dissect the data by option maturity date, different trends emerge for HSI and HSCEI options. Both the size of the Open Interest and average daily Volume activity of longer-term HSCEI options have been increasing. For HSI options, the proportion of longer-term option contracts in the Open Interest has gradually increased and exceeded 50% of the total Open Interest in 2018, but there has a rising focus on spot-month contracts in terms of average daily Volume. Three of the most important factors influencing the option Premiums are: 1) Moneyness, 2) Time Value, and 3) Implied Volatility. Moneyness describes the relationship between the strike level, the index level and the option Premium. Time Value covers the relationship between the option maturity date and the option Premium. Implied Volatility is concerned with market expectations regarding future movement in the value of the underlying index or asset and how this influences option Premiums. We also covered the impact of Implied Volatility on variations in Premiums for HSI and HSCEI options over the years and the difference between the Premium levels for these two types of options.


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With this basic grounding in the nature of the Hong Kong options market, let’s take a more in-depth look at two common Option Strategies:

Covered Call

Short Strangle

COVERED CALL STRATEGY

Concept The Covered Call strategy can be viewed as an enhanced index strategy under which an investor takes a short position in a call option while simultaneously holding a long position in the underlying index. The short call position is settled on the monthly expiration day and a new position is subsequently entered into on the same day. On top of the underlying index return, the additional short call position would generate a call Premium return when entering into the position but a potential loss during settlement if the short-sold call option is ITM (i.e. the underlying index rises beyond the strike level) at expiry.

Exhibit 13: Monthly Payoff Diagram

With reference to the green dashed line in Exhibit 13, if the call option ends up being OTM (i.e. the index level is below the strike level), the return on the short call position would be the Premium received. On the other hand, if the index level goes above the strike level, the return would deteriorate and an overall loss would be incurred once the Premium can no longer compensate for the deterioration in return. When combined with the long position in the underlying index, the total payoff would be in the form of the red line. When compared with a purely long position in the index (blue dashed line), an investor who adopted this strategy would enjoy a better payoff if the index level is below the strike level of the short-sold call since the payoff would be boosted by the Premium. However, if the call option becomes ITM, the gain in the index would be cancelled out by the loss from the short position in the call option. In essence, investors employing the Covered Call strategy are choosing to limit their upside potential in order to enjoy improved downside protection. There are two main groups of investors who may find this an attractive strategy. The first is investors who are already exposed to the underlying index and wish to seek a certain level of downside protection. The second is investors who have a short-


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term neutral view on the market and therefore are adopting the strategy with the aim of generating some extra income from the option Premium.

Application of the Covered Call Strategy in Hong Kong Hang Seng Indexes Company Limited (Hang Seng Indexes) currently compiles four Covered Call indexes that sell one-month, cash-settled options in the HSI and the HSCEI.

Index Long Position In Short Position In

HSI Covered Call Index

(HSICC) HSI HSI ATM call options

HSI 5% OTM Covered Call Index

(HSIOCC) HSI HSI 5% OTM call options

HSCEI Covered Call Index

(HSCECC) HSCEI HSCEI ATM call options

HSCEI 5% OTM Covered Call Index

(HSCEOCC) HSCEI HSCEI 5% OTM call options

The following sections will illustrate the use of the Covered Call strategy using the two HSI Covered Call indexes: Strike Level Does Matter Referring to the table above, it can be observed that two different strike levels (ATM and 5% OTM) have been used in compiling indexes. The following section will explain why two different strike levels are used and what impact this has on the outcome of the strategy. To recap: A Covered Call strategy involves three components: 1) underlying index return, 2) Premium return, and 3) loss on short call options. The strike level of the call options being short-sold will have a significant impact on the latter two components. Premium The call Premium includes both the intrinsic value and the Time Value of a call option. The closer the strike level is to the index level, the higher the probability that the intrinsic value will be positive (i.e. ITM) and, accordingly, the higher the Premium will be. Therefore, the option Premium received from short-selling an ATM call option is higher than that from short-selling a 5% OTM call option (see Exhibit 14). Loss in Call Option On the other hand, since it is a short position, if the call option ends up being ITM, the investor would need to settle the loss in cash. The more OTM the option short-sold is, the smaller the incurred loss. Therefore, short-selling an ATM call option will record a larger loss.


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Exhibit 14: HSI Covered Call Indexes

Source: Hang Seng Indexes data Note: The calculation of Premiums and call losses in this section is a simple summation and does not take reinvestment returns and the compounding effect into account

The Covered Call strategy will be able to outperform a pure long position in the underlying index if the Premium received (with reinvestment) can cover the loss arising from the short call position. Investors should choose the strike level that best aligns with their view on the short-term outlook for the market. For example, if an investor believes that the HSI will go down in the coming month, they would opt for the ATM version in seeking to maximise their income as the risk of incurring a loss would be lower. Changing Return Pattern With reference to Exhibit 13, the payoff structure changes significantly when a short position in call options is added to a long position in the underlying index. Exhibit 15: Histograms with Frequency of Monthly Returns

Source: Hang Seng Indexes data Data from Jan 2005 to Mar 2019


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Exhibit 16: Summary of Monthly Return

HSI HSICC HSIOCC

Proportion of Positive Returns 57.9% 71.9% 62.6%

Proportion of Negative Returns 42.1% 28.7% 38.0%

Highest Return 19.6% 7.7% 10.2%

Lowest Return -19.9% -15.1% -16.9%

Source: Hang Seng Indexes data Data from Jan 2005 to Mar 2019

Exhibit 15 illustrates the range of 171 monthly returns of various indexes from January 2005 to March 2019. The range of returns is much wider for a pure long position in the HSI, with a more even distribution. For Covered Call indexes, monthly returns tend to be more concentrated, especially for the ATM indexes, clustering at a level of around 2%. In general, there are fewer negative returns as the loss in the underlying indexes is compensated for by the Premiums. At the same time, however, there is a lower tendency for returns to reach extremely high levels as upside potential is limited by entering in the short call position. The closer the strike level is to the index level, the more apparent the change in the distributions of returns. Another way to understand the change in the payoff structure is to evaluate the relative performance of the Covered Call indexes and their respective underlying indexes (see Exhibits 17 and 18). Relative Performance (Jan 2005 – Mar 2019) Exhibit 17: HSICC vs HSI

Source: Hang Seng Indexes Data

Exhibit 18: HSIOCC vs HSI

Source: Hang Seng Indexes Data


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The two scatterplot charts in Exhibits 17 and 18 illustrate the relative performance of 171 monthly returns. Each dot represents the monthly performance of the Covered Call index relative to the monthly performance of the underlying index in the same month. If the dot lies above the black line, the monthly return of the Covered Call index outperformed that of the underlying index, and vice versa. The dots lie on or above the black line if the monthly returns of the underlying index are lower than the designated strike level of the Covered Call indexes, reflecting the ‘cushion’ that has been provided to reduce losses in those circumstance. If returns of the underlying index go above the strike level, there is an increasing proportion of dots lying below the black line. When does the Covered Call strategy lead to positive results? With reference to the previous section, there are two scenarios in which the Covered Call strategy can result in outperformance:

When the underlying index goes down

When the underlying index mildly rises but remains lower than the strike level In these two scenarios, the Covered Call strategy would provide an additional source of returns to enhance the gain or cover the loss. However, if the underlying index rises above the strike level, there is no guarantee as to whether the Covered Call strategy will outperform or underperform. The following example illustrates the type of scenario in which the strategy could outperform if even the underlying index level is higher than the strike level. Case 1: December 2012 (Short ATM HSI Call Option)

Underlying Index Return

Premium Return (%) (without reinvestment)

Loss in Short Call Option

Covered Call Index Return

5.1% 1.6% -4.6% 2.2%

Case 2: November 2008 (Short ATM HSI Call Option)




Covered Call Index Return

5.0% 7.5% -5.7% 7.3%

The above example clearly demonstrates the significant degree of difference there can be in the level of strategy returns in cases where the level of returns from the underlying index is broadly the same. The extraordinarily large Premium return generated in November 2008 was a result of the high market volatility that was prevalent at that time. The market volatility drove up the call Premium, resulting in a high Premium return, which was more than sufficient to cover the loss in the short call position. This implies that if the market is trending upward in a volatile manner, the Covered Call strategy might still be able to outperform the underlying index by generating a higher than normal Premium return.

Better Risk Adjusted Return Since 2005, the HSI Covered Call indexes have outperformed the underlying index on an overall basis, with HSICC and HSIOCC outperforming the HSI by around 20 percentage points and 40 percentage points respectively. During the same period, there were six calendar years in which both covered indexes recorded an outperformance compared with the HSI. On top of providing a cushion in a down trending market, the change in returns distribution (i.e. the narrower range of returns) reduces the index volatility, which is associated with less market risk. With the overall returns being comparable with the underlying indexes, the Covered Call indexes achieve a better risk-adjusted return than their respective underlying indexes in the long run.


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Exhibit 19: Index Performance

*Year-end HIBOR rate is used as risk free rate in Sharpe Ratio calculation Source: Hang Seng Indexes data

Exhibit 20: Performance of Covered Call Indexes Relative to HSI HSI HSICC (ATM) HSIOCC (5% OTM)

Year Return Outperform Underperform Return Outperform Underperform Return

2007 39.3% 6 6 20.9% 9 3 24.2%

2008 -48.3% 11 1 -23.5% 11 1 -32.4%

2009 52.0% 7 5 55.5% 9 3 61.6%

2010 5.3% 6 6 11.9% 11 1 10.5%

2011 -20.0% 10 2 -11.7% 10 2 -18.5%

2012 22.9% 6 6 11.5% 10 2 21.4%

2013 2.9% 9 3 1.6% 10 2 2.1%

2014 1.3% 8 4 3.7% 11 1 1.8%

2015 -7.2% 10 2 -10.9% 10 2 -13.4%

2016 0.4% 6 6 1.4% 9 3 1.4%

2017 36.0% 5 7 17.2% 11 1 35.7%

2018 -13.6% 10 2 -8.3% 10 2 -14.9%

Source: Hang Seng Indexes data

Exhibit 20 shows the number of months the Covered Call indexes has outperformed the HSI (i.e. the Premium exceeded the losses arising from the short call position) in the past 12 years. Although the HSIOCC outperformed the HSI more frequently on a monthly basis when compared with the HSICC, this does not necessarily mean that the overall return was better. For example in 2010, the HSICC only outperformed the HSI for six months, while the HSIOCC outperformed the HSI in 10 out of the


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12 months. However, in terms of the overall performance, HSICC outperformed HSIOCC by 1.4 percentage points. Another interesting observation is that even when the Covered Call indexes outperformed the underlying index for most of the months in a particular year, they could still underperform in terms of return. For example, in 2015 both the HSICC and the HSIOCC managed to beat the HSI in 10 out of the 12 months. But in the two months that they underperformed, the HSI rose sharply by 11% and 14%, leading to huge losses from the short call position, which eroded all the outperformance achieved in the other 10 months. In conclusion, the Covered Call strategy provides additional downside protection but limits upside potential. The effectiveness of this strategy depends on the strike level. As the strike level gets closer to the index level, the return from the Premium but so will the likelihood of incurring a loss on the short call position. Furthermore, the return distribution is altered to the effect that the range of returns is narrower and more concentrated. In long run, the Covered Call strategy should yield a better risk-adjusted return due to lower volatility and achieve outperformance when compared to the underlying index under a few scenarios:

1) The underlying index falls; 2) The underlying index rises mildly but remains below the strike level; and 3) The underlying index rises beyond the strike level in a volatile manner such that the Premium is sufficient to cover the loss.


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SHORT STRANGLE STRATEGY

Concept If the Covered Call strategy is considered as a hybrid tactic where positions in the options and the underlying index are held simultaneously, the Short Strangle strategy is a more pure design as holding a position in the underlying index is not involved. In the Short Strangle strategy, a short position in a call option and a short position in a put option with same Moneyness are entered every month and are settled at expiration before rolling into the contracts for the next month. As there is no underlying index involved, there is no underlying return. The sole source of income comes from the Premiums received from short selling the call and put options, and as with the Covered Call strategy, there is potential for loss during settlement due to the short positions in call and put options. Exhibit 21: Monthly Payoff Diagram As shown in Exhibit 21, the maximum payoff is capped because the sole income is the total Premiums received from the short positions. But if the index level goes above the call strike level or below the put strike level, a loss in the relevant short position would be triggered and the payoff will diminish as a result. This means the maximum return can only be earned if the index fluctuates within the two strike levels. For example, assume 5% OTM call option and 5% OTM put option are short sold. If the index at the end lies outside this 10% range at expiry, the final return will be less than the Premiums received. In summary, an investor using the Short Strangle strategy is exposed to capped upside potential and unlimited downside risk. This strategy is suitable for investors who are looking for income and do not believe that the market will fluctuate significantly in the short run. Should the market behave in line with this belief, the Short Strangle strategy will enable them to boost their income returns.

Application of the Short Strangle Strategy in Hong Kong Strike Level Strikes Again As with the Covered Call strategy, the strike level will have an impact on the Premium and the potential losses arising from the short positions.


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Premium With reference to Exhibit 22, looking at the historical data it can be seen that the closer the strike level was to the index level, the higher the Premium yield. On average, short selling 3% OTM options yielded around 10 percentage points more than short selling 5% OTM options. Exhibit 22: Premiums vs Losses Arising from Holding Short Positions in Options

3% OTM 5% OTM 7% OTM

Year Premiums Losses in Short

Position in Options Premiums Losses in Short

Position in Options Premiums Losses in Short

Position in Options

2007 57.5% -72.0% (9) 43.5% -54.5% (7) 32.6% -43.4% (5)

2008 109.0% -107.3% (12) 92.3% -82.9% (10) 76.9% -64.2% (8)

2009 87.9% -45.5% (9) 72.5% -29.9% (6) 58.6% -18.6% (6)

2010 38.0% -14.9% (6) 26.6% -7.5% (4) 17.6% -1.7% (2)

2011 38.9% -41.3% (6) 27.7% -31.0% (5) 19.4% -20.6% (4)

2012 30.6% -29.7% (6) 20.6% -17.9% (5) 13.8% -9.9% (3)

2013 26.8% -28.3% (7) 16.6% -14.9% (6) 10.1% -6.9% (3)

2014 20.4% -15.1% (6) 11.9% -6.7% (3) 6.9% -1.3% (2)

2015 42.2% -49.1% (7) 30.1% -35.9% (6) 21.1% -25.4% (5)

2016 29.7% -22.9% (5) 20.4% -14.5% (2) 14.6% -12.4% (2)

2017 15.8% -9.2% (6) 8.5% -1.1% (2) 4.6% 0.0% (0)

2018 30.5% -28.7% (7) 19.2% -15.0% (4) 11.8% -8.5% (3)

Source: Results simulated by Hang Seng Indexes Number in parentheses refers to the number of months in which losses were recorded Note: The calculation of Premiums and call losses in this section is a simple summation and does not take reinvestment returns and the compounding effect into account

Losses Arising From Short Positions in Options Same applies to the loss in short position in options. The closer the strike level is to the index level, the narrower the interval would be, thus higher chance that the underlying index would lie out of the interval and result in a loss. It could clearly be observed in the table that 3% OTM version incurred larger loss at higher frequency while 7% OTM version were less likely to be hit by a loss in short position.


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Looking at Payoff Structure Exhibit 23: Histograms showing Frequency of Returns (Jan 2007 – Mar 2019)

Source: Results simulated by Hang Seng Indexes

Exhibit 23 illustrates the range of 147 monthly returns of various Moneyness from January 2007 to March 2019. The range of returns is much wider for a long position in the HSCEI, with the distribution being flatter and more even. The monthly returns of the three Short Strangle strategies tended to be more concentrated and clustered around the interval of 0% to 2.5%. This phenomenon is more evident for 7% OTM options as both the monthly received Premiums and the losses arising from the short position were lower, resulting in a return closer to zero. Relative Performance (Jan 2007 – Mar 2019) Exhibit 24: Short Strangle (3% OTM) vs HSCEI



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Exhibit 25: Short Strangle (5% OTM) vs HSCEI


Exhibit 26: Short Strangle (7% OTM) vs HSCEI


Exhibits 24, 25 and 26 cover the same timeframe as the histogram and, again, illustrate the payoff structure of Short Strangle strategies. When the monthly returns of the HSCEI were close to zero, the dots clustered at a level above 0%. The cluster is more concentrated when the designated strike level is closer to the index level and more evenly distributed if it is farther away. The dots start to fall below the x-axis once the monthly returns of the HSCEI exceed the designated strike level. When does the Short Strangle strategy lead to positive results? It is apparent from the previous section that if the underlying index moves within the designated strike level range of the short-sold call and put options, positive returns can be achieved. But if underlying index moves outside this range, are there instances in which a Short Strangle strategy is still achieve a positive result? February 2008: 3% OTM version




Short Strangle Return

10.1% 13.1% 6.5% 6.6%


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In the above example, despite the underlying index rising beyond the strike level range, the highly volatile market environment at that time drove the Premium upward to make it high enough to generate a positive return. Thus, in certain market conditions, a positive return is possible even when the underlying index moves beyond the strike level range. Low Correlation with Underlying Index The Short Strangle strategy shares very few similarities with the underlying index in terms of trends. Looking at Exhibit 27, the Short Strangle strategy slowly accumulated returns while the underlying index (HSCEI) fluctuated significantly throughout the period. The table highlights this phenomenon, with the overall correlation of the three option versions with the HSCEI being as low as 0.2. Further, since the exposure of the strategy to the performance of the underlying index is only reflected in short positions in options (losses are incurred when the return from the underlying index is too high or too low), the overall volatility of the strategy was also lower, ranging from 15% to 19%, compared with 30.5% for the HSCEI. Exhibit 27: Index Performance

^Since 26 Jan 2006 Source: Results simulated by Hang Seng Indexes


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Exhibit 28: No. of months with positive return per calendar year

HSCEI 3% OTM 5% OTM 7% OTM

Year Return # Positive

Return # Negative

Return Return

# Positive Return

# Negative Return

Return # Positive

Return # Negative

Return Return

2007 55.9% 8 4 -11.9% 8 4 -8.5% 8 4 -7.9%

2008 -51.1% 6 6 -0.6% 6 6 7.5% 6 6 11.5%

2009 62.1% 10 2 49.5% 10 2 50.1% 10 2 46.9%

2010 -0.8% 9 3 25.8% 11 1 21.0% 12 0 17.2%

2011 -21.7% 8 4 -2.9% 9 3 -3.6% 9 3 -1.3%

2012 15.1% 7 5 0.0% 8 4 2.2% 9 3 3.6%

2013 -5.4% 7 5 -1.9% 8 4 1.6% 9 3 3.2%

2014 10.8% 8 4 5.0% 9 3 5.2% 12 0 5.7%

2015 -19.4% 7 5 -7.6% 7 5 -6.3% 7 5 -4.5%

2016 -2.8% 10 2 6.1% 10 2 5.5% 10 2 1.9%

2017 24.6% 8 4 7.0% 12 0 7.9% 12 0 4.9%

2018 -13.5% 9 3 1.9% 9 3 4.7% 11 1 4.0%


With reference to Exhibit 28, it is obvious that the Premium was able to cover the loss in short option positions for at least six months every year in the past 12 years. But similar to the Covered Call indexes, the high frequency of achieving positive returns does not guarantee a positive return in that particular year. For example, in 2007, a positive return was achieved in eight of the 12 months, but due to sharp changes in the underlying index that year, large negative returns were recorded in the other four months, which drove down the overall return for the year. In essence, a Short Strangle strategy offers potential to achieve a higher income, but with capped upside potential and unlimited downside risk. This strategy is appropriate if an investor anticipates that the market will not fluctuate significantly in the coming month. Similar to the Covered Call strategy, the strike level will have an impact on the effectiveness of the strategy in that narrower OTM option versions potentially yield higher Premiums but also come with a higher chance of incurring losses. In terms of the return distribution, a more concentrated distribution can be observed, with a cluster in the range of 0% to 2.5%. Historically, in the long run, all three versions outperformed the underlying index despite having a capped upside potential and displayed a low correlation with the underlying index.


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CONCLUSION

Various option strategies have been adopted by investors over the past several decades. From an investment perspective, the Hong Kong options market is well established and has sufficient liquidity for Hong Kong investors to apply option strategies as part of their overall investment strategy. The average daily Open Interest for HSI options approached 450,000 in 2018, while that for HSCEI options reached 3 million in the same year. The average daily Volumes are also satisfactory, with HSI and HSCEI options close to 50,000 and 100,000 respectively in 2018. Investors adopting a Covered Call strategy will enjoy a cushion in down trending markets but this comes at the cost of capped upside potential. Short Strangle investors will potentially receive additional income from Premiums but are exposed to unlimited downside risk due to holding short position in put and call options. A Covered Call strategy would suit investors who already have exposure to the underlying index and would like to have the potential for extra income while enjoying some degree of downside protection. A Short Strangle strategy would suit investors who anticipate minimal fluctuation in the underlying index and would like to potentially enhance their income returns. We note that Moneyness has significant impact on both strategies in that narrower OTM option versions would potentially generate higher Premium income but have a higher chance of incurring losses arising from holding short positions, while broader OTM option versions would potentially have a lower chance of incurring loss and yet a reduced Premium. The return distributions of the two strategies also deviate from a pure long position in the underlying indexes, in that they are narrower and more concentrated. In terms of performance, in the long run, the Covered Call indexes were less volatile and yielded a better risk-adjusted return compared with the underlying index. The Short Strangle strategy displayed a low correlation with the underlying index while still recording an overall outperformance despite having a capped upside potential.


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Disclaimer The information contained herein is for reference only. Hang Seng Indexes Company Limited (Hang Seng Indexes) ensures the accuracy and reliability of the information contained herein to the best of its endeavours. However, Hang Seng Indexes makes no warranty or representation as to the accuracy, completeness or reliability of any of the information contained herein and accepts no liability (whether in tort or contract or otherwise) whatsoever to any person for any damage or loss of any nature arising from or as a result of reliance on any of the contents of this document, or any errors or omissions in its contents and such contents may change from time to time without notice. The information contained herein does not constitute any express or implied advice or recommendation by Hang Seng Indexes for any investments. Investment involves risks. Prospective investors should seek independent investment advice to ensure that any of their decisions is made with regard to their own investment objectives, financial circumstances and other particular needs. Prospective investors should also note that value of securities and investments can go down as well as up and past performance is not necessarily indicative of future performance. © Hang Seng Indexes Company Limited 2019. All rights reserved.

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