The case for options – Part II…
We recently wrote of our surprise at a further deterioration in the relative take-up rates of option products across financial markets. Ultra-low options usage has been a feature of markets since the big bang, but do such low rates make any sense? We think it points to a likely lack of understanding of the when and why use-cases (plural) for options.
In this blog, we use a simple model to show why a blanket aversion to options use is not rational and can limit choices and potentially increase the costs of hedging.
The tired old use-case arguments
The first text we point to when we are asked how clients can gain a better understanding of financial options is Sheldon Natenberg's "Option Volatility & Pricing: Advanced Trading Strategies and Techniques." First published in 1994, this is a market classic containing the clearest explanation of pricing we’ve read. It adds to this with a comprehensive exploration of the trading domain and of a wide array of various trading strategies.
What’s unusual about Natenberg’s work is that it doesn’t delve into defining clear use cases for financial options, relative or otherwise. Though the use cases are implied throughout, there’s no depiction of the kind of market settings or circumstances in which using an option could hold advantages over, for example, outright forwards.
Given this, we list below some of the classic arguments for when options use is generally considered to hold advantages in comparison to alternates:
When a participant has elevated decision-making uncertainty about the future path of a financial market. For example, when there is an event such as a close election of high consequence or a piece of likely market-moving economic data. We have seen these types of environments before in the form of Brexit and the 2016 US Presidential Election.
When a participant anticipates a period of elevated market volatility that could make decision-making fraught. Most market participants will recall 2007-2009.
When a participant wants the certainty of a known cost versus the (theoretically) unlimited loss of a fixed hedge, for example in a situation where a contingent risk is confronted.
These are particularly relevant for managers who face performance benchmarks or are in a highly competitive trade-exposed industry. In these cases, the quality of decision making and application of the right product in the right environment takes on added importance since a performance light will eventually be shed on the quality of collected decisions.
A forgotten use case argument
But what of the state of the market itself? Should this be a factor?
At this point it is worth considering a hypothetical example of a historic state-of-the-market conundrum; one in which the use of options could be considered advantageous. While the example below is hypothetical, it will remind many market participants of actual events. This may or may not be a coincidence.
Consider the case of a heavily trade-exposed Australian importer with USD obligations in a highly competitive industry segment:
Dateline March 2001, the AUDUSD exchange rate is trading at 0.4975, having just broken below 0.5000 for the first time in history,
The company’s long-run viability is compromised if import invoices are met at an exchange rate below their breakeven hedge rate of 0.5000 for an extended period,
Having elected not to hedge (i.e., sell AUD forward) at levels above 0.5500 over prior months the company’s management calls a crisis meeting,
The company’s treasurer has prepared advice on whether the company:
Should hedge using a series of outright FX forwards to try to protect against a solvency problem.
Do nothing, thus taking a currency view.
Purchase a series of AUD Put options with amounts and expiries corresponding to those of the proposed outright forwards.
In such a difficult situation the existential risk to the firm is obvious but less obvious is the fact that the decision of management should also factor in a reasonable assessment of competitor behaviour given the market state. Have competitors hedged? Are they similarly exposed?
Here we have deliberately avoided pricing up forward rates and/or option strategies for this hypothetical. Why? Because they are unnecessary.
In such a situation the use case for an options solution becomes much greater than it might be if the AUDUSD were higher since use of outright forwards can lock the company into hedges at unfavourable levels (at breakeven) that simply defer a potential solvency problem.
By locking in forwards, the company cannot participate in the economic relief that might arise if the exchange rate were to recover (from all-time lows) – over the tenor of the forwards put into place. Others who make “better” decisions have a chance to participate in a market state recovery.
Hence, options are of clear relative attractiveness given this state-of-the-market.
For Australian exporters, a similar hypothetical example could easily be constructed for the extended period where AUDUSD sat above 1.1000 USD.
A test of this argument
What if we can test the state of the market argument in favour of options usage?
To do this we established a simple decision rule set-up for exporters and importers – and again we will use the AUDUSD exchange rate for our test. The arbitrary decision rules we will test using historic data run as follows:
Exporters always BUY Forward, except when AUDUSD is above +1 standard deviation “dear,” in which case they use an ATM Call option.
Importers always SELL Forward, except when AUDUSD is below -1 standard deviation “cheap,” in which case the use an ATM Put option.
The analysis presented here is based on averages that imply a daily process, which is of course quite unrealistic. Nonetheless, for both exporters and importers the average results are meaningful in the sense that on average they can expect to gain advantages of a similar dimension over time. The analysis holds whether they trade occasionally and on non-defined framework as far as timings are concerned.
The mean and standard deviation statistics are simply based on the complete historic AUDUSD dataset since 1990, not some arbitrarily picked moving average (from which we could be accused of playing around with stats to make things fit our argument).
Testing for 6-month AUD exposures on a serial basis (daily test), we compared the outcomes of serially using outright FX forwards versus the use of options when the market was unfavourably positioned above or below one standard deviation from long run mean. The options payoffs assumed hold-to-expiry conditions rather than a discretionary exploitation of, for example, periods of high volatility.
Our findings demonstrate that on average a forward-only strategy produced a rate of 0.78593. This becomes the benchmark against which our test “model” can be compared, and we found that the model improved all-in FX rates for both exporters and importers by the following amounts:
Exporter improvement from using the model +0.0011,
Importer improvement from using the model +0.0022,
Which is consistent with our intuitive feel for this simplest of hedging models.
Couldn’t these results be the result of dumb luck?
To ensure that the results are not simply the result of randomness, we decided to test the model across multiple tenors, with interesting results that are consistent with the original Black-Scholes paradigm (the advantage gets larger with tenor).
Testing for 3-month through to 6-month tenor horizons we found our model demonstrated the following economic advantages versus serial use of forwards:
Which tends to validate the state-of-market use case argument which we could summarise as:
It can be beneficial to consider options use versus locking in unfavorable forward rates when the market has moved materially against your interests.
Which implies hedgers should assess their product of choice in a proper framework (not simply copying this simplistic approach).
Put another way:
It could be considered irrational to use only one type of financial markets product in all market circumstances and states.
Is 11 beeps a big deal?
While the gains from this simple model appear small, this is again a question of relativities. A gain of 0.0011 for a firm that exports A$100,000 of goods or services amounts to U$110.00, but what if you were importing or exporting billions quarterly?
Our point is not about scale perse – it’s about appropriate strategy and having robust frameworks that can provide benefits, not least of which is the demonstration of best practice.
And if all firms employed such frameworks, with the associated controls and dealing delegations, we suspect the options category would be a more frequently favored category, more in balance with fixed hedges than is currently the case.