Equity options: Can the tail wag the dog?
SoftBank / Bloomberg

The fact that derivatives, forwards, futures, options and swaps can be very effective in risk management is often lost


IN RECENT weeks, the financial markets were rattled by news that SoftBank Group Corp, a Japanese investment holding firm, had huge exposures in equity derivatives.

The Financial Times (FT) which broke the news identified SoftBank as the “Nasdaq Whale”, as the exposure was mainly on US tech stocks listed on Nasdaq.

What followed was a steep fall in SoftBank’s Tokyo listed stock price. Investors spooked by the news, dumped the stock causing SoftBank’s market capitalisation to fall 5.4% or US$9 billion (RM37.8 billion) on the day following the news.

The Nasdaq Composite index meanwhile is reported to have shed some US$1.9 trillion in value in just three days surrounding the news.

Note that the initial report of the FT was simply that SoftBank had exposure in equity derivatives, not that they had suffered losses. Yet, the initial market reaction was grossly negative.

When FT later reported that SoftBank may be sitting on large unrealised profits of about US$4 billion from the equity derivatives, SoftBank’s stock price which had fallen some 17% within a week, recouped almost all the losses the following week. The misstep is clear. Reports that a company was involved in derivatives were enough to not just send its investors running but also cause a near market rout.

SoftBank, it appears, had established what is known as a Bull-Call spread using equity call options on stocks of a very select group of tech companies. These were the likes of Amazon.com Inc, Microsoft Corp, Netflix Inc, Facebook Inc, Adobe Inc and such.

A spread, though speculative in nature, involves offsetting positions such that the downside is limited. Thus the risk profile is far different from naked speculative positions which can have an unlimited downside. In establishing the Bull-Call spread, SoftBank had bought out-of-the-money calls and sold call options with even higher exercise prices.

The premium received from the options sold helps to reduce the overall cost of the strategy but imposes a cap on the upside. In essence, the spread position has both a limited upside and downside effectively capping the potential gains and losses.

A Bull-Call spread is used to profit from a potential rise in the underlying stock price while simultaneously protecting against any fall in value. As the underlying stock rises in value, the call option bought makes profits but the rising profits get capped when the underlying stock position has to be assigned to the party to whom the higher-priced call was sold.

The size of the profit therefore depends on the difference between the two exercise prices. Outright losses, though limited are possible if the underlying stock price never rises above the lower of the two exercise prices.

A spread, therefore, is nothing but a speculative strategy but one with a safety net below. SoftBank’s overall strategy was relatively “safe”, except that in this case their aggregate position was reportedly large and focused on a few underlying stocks.

Note that they were using single stock options. Such large and concentrated positions can indeed move markets. The fact that derivatives have inbuilt leverage enables large positions to be taken at very low net investment.

When there is herding and similar strategies are also used by other investors, underlying asset prices can seriously deviate from fundamentals.

Changes in option values invariably impact underlying stock prices because of the need for dynamic hedging. For example, sellers of call options have to cover their short position by buying the underlying stock.

Delta hedging as the process is called requires the maintenance of a hedge ratio, by purchasing a proportion of the underlying stock as the option value increases. The proportion of stock needed to be purchased increases “exponentially” as the option becomes increasingly in-the-money.

The result is a feedback loop causing higher stock prices as shorts to chase the stock to avoid losses on the calls they sold.

Thus, large and concentrated derivative positions can move asset prices and when other retail players piggyback on the trade, markets can take a life of its own. The tail can indeed wag the dog.

The initial stock price reaction to SoftBank’s derivatives position points to deep-seated misperception about derivatives.

The fact that derivatives, forwards, futures, options and swaps can be very effective in risk management is often lost.

The long history of financial scandals involving derivatives has obviously coloured perception. It should be noted that no money has ever been lost when derivatives were used appropriately for risk management.

A well-designed hedge position cannot lose money. SoftBank’s spread position was in no way a hedge. They were trying to make quick money, albeit with limited downside.

This, however, is far different from the actions of Barings plc or Orange County which were driven by greed and a huge dose of ignorance if not stupidity.

But as another case, that of Germany’s Metallgesellschaft shows, with highly leveraged instruments like derivatives, even an intended hedge can go wrong if factors like differences in accounting regimes, disclosure requirements and liquidity mismatches arising from margin requirements are not well considered in designing the strategy.

Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.