Of course, as an alternative, a stock owner could merely buy puts as insurance. The low interest rates will also have lowered the price of a LEAPS put. Even so, the purchase of a put will incur a debit, which presumably is not as attractive to the stock owner as a no-cost collar would have been.
In any case, it is imperative that the stock owner understand the effect that dividends, volatility, and interest rates can have on the cost of the collar. For only then can he assess it accurately to decide if it is something he wants to use at the current time.
HEDGING WITH OVER-THE-COUNTER
The ability to utilize nonstandard strikes can be advantageous.
Suppose the stock owner says, “I want to protect my portfolio if the market declines by more than 8 percent. At what strike can I sell a call that will cover the cost of a put with that protection?” The over- the-counter option dealer (typically a large trading firm such as Goldman Sachs or Morgan Stanley) will then return to him with an offer such as, “You can sell calls 10 percent out-of-the-money and buy puts 8 percent out-of-the-money for the same price on each.”
This strategy can be used for a single stock or for an entire portfolio;
the trading firm will structure the options to fit the portfolio man- ager’s wishes.
There are even more “complicated” options that are being used in the current markets in order to hedge portfolios. They fall in the category of exotic options. Exotic options are ones whose values may be dependent on a vast array of conditional parameters.
One simple type of exotic option is called a down-and-out option. This option behaves like a normal option, except that it has an additional feature: if the stock drops to a preset price at any time prior to expiration, the option automatically becomes worth- less. For example, if IBM is currently at 110, then someone might buy a Dec 110 call that is down-and-out at 100. So, if IBM drops to 100 at any time before the December expiration of the option, the call becomes worthless at that time. Otherwise, if IBM never falls that far, then the option behaves just like a normal call and has value if IBM is over 110 at expiration.
You may wonder why anyone would want to buy an option that could “disappear” like that. The main reason is that it’s cheaper than an ordinary listed IBM Dec 110 call. It’s cheaper because there’s a greater chance that the down-and-out option will be worthless. So, if the call buyer feels that IBM will not trade at 100 during the life of the call, he can buy a cheaper option initially by utilizing the exotic option as opposed to a listed option.
These exotic options can be structured in many different and imaginative ways. An entire book could probably be written just describing these exotic options. That is beyond the scope of what we are attempting to discuss here. However, there is one interest- ing exotic option that is being used today as a means of portfolio insurance: the pay-later option. This kind of exotic option is ob- tained for free, initially, and only has to be paid for if the option
finishes in-the-money at expiration. Thus, a money manger who wants downside protection might contact an over-the-counter firm and buy a pay-later put option. If the market goes up, this money manager owes no money, and his performance is the same as any of his competing money managers who did not own insurance. He only has to pay for the put if the market does indeed collapse. He doesn’t get a completely free ride, of course, for if the market drops and the put has to be paid for, it will be far more expensive than an ordinary listed put would have been. This is just one example of the many ways that exotic options are being used by sophisticated money managers.
Whenever over-the-counter options are concerned, the Option Clearing Corporation is notinvolved. This could present a problem at some time in the future. Recall that most of these options represent a transaction between a customer (institution) and a large brokerage firm, which is creating these options. Thus, the large firm acquires a position that it eventually must hedge. For example, if money man- agers are repeatedly buying put options as protection—in whatever exotic form they may be—the brokerage firm is selling those puts.
There is the possibility that eventually the brokerage firm’s position may become quite large: they could be short many puts.
The possibility that this might happen worries many regulators, for they realize that these large firms must hedge their positions. If the market falls and the firms are short a lot of puts, then they must either sell stocks or sell futures in order to hedge those short puts. Does that have a familiar ring to it? It’s exactly what happened in the crash of 1987, when there was a rush by the portfolio insurance crowd to sell futures. A similar but less dramatic event occurred in October 1998 when the market took a rather nasty nosedive in a short period of time. It wasn’t exactly a “crash,” but it was certainly panicky selling.
That decline was partly fueled by market makers who were short puts and selling futures as a hedge. Eventually, one of the larger firms removed its hedge at exorbitant prices, and that put an end to the decline. But if the decline had gone on a little longer, it could have turned even bloodier than it was because more and more naked puts would have had to be hedged. Of course, no one wants to see either scenario repeated, and the large firms do their best to find over-the- counter sellers of puts to help offset their positions. The worrisome
part of this situation is that no one knows the total extent of the expo- sure. There are no open interest figures that need to be reported and no reports that are filed. Therefore, there always exists the possibility that a dramatic down market could turn into another crash if there is a rush to hedge the over-the-counter positions.