Derivatives can be used to generate additional alpha within an investment portfolio. Alpha (from the Greek letter α) is the measure of an investment's excess return compared to a benchmark. This excess return metric is important for evaluating the performance of securities and fund managers.
The term "derivatives" originates from the Latin "derivare" (to derive). Derivatives are based on an underlying financial instrument or a physical product and can be traded on or off-exchange.
The characteristics of derivative products are contractually defined (selection):
- Underlying asset
What underlying asset is the derivative based on? - Strike price
At what price can the derivative be bought or sold? - Maturity
What is the maturity date of the derivative?
Calls
A call option gives the buyer the right, but not the obligation, to buy an agreed-upon underlying asset at the strike price on a specific date, in exchange for an option premium (option price).
- "Covered call writing" (writing covered call options or generating additional income by selling calls)
The "covered call writing" strategy is used by investors seeking above-average returns and willing to accept the risk of falling prices. The investor anticipates stable or slightly rising prices and can generate additional income equal to the option premium by writing call options.
Puts
A put option gives the buyer the right, but not the obligation, to sell an agreed-upon underlying asset at the strike price on a specific date, in exchange for an option premium (option price).
- "Long put" (buying puts as a substitute for short selling)
The investor buys puts when speculating on falling prices. - "Protective put" (buying puts to hedge existing positions)
Here, an underlying asset in the portfolio is hedged by buying a put option on the same underlying. The main motivation is to reduce the risk of loss, also known as hedging. The investor has the right to deliver at a predetermined price (strike price) and thus limit the potential loss. The option premium paid represents the hedging cost. - "Short put" (selling puts to open new positions)
When selling puts, the seller commits to buying the underlying asset at a specific strike price. This strategy is used to open a new stock position when the underlying asset is trading above the desired price level. The seller of a put is interested in stable or slightly rising prices. Due to the high potential for loss, this strategy is only recommended for investors who understand the exact risk and have analyzed the underlying asset in detail.
Certificates
Optimization strategies can also be implemented using certificates.
The following types are suitable for this purpose:
Discount certificates
Equity-linked bonds
Bonus certificates
Author
Günther Kornfellner, CFA, CAIA
Derivate Trader, Bybit EU