A critical evaluation of exchange traded option 'Delta' as a risk management tool for self-managed superannuation funds
Creators: name: Enticott, Steven J.
Publisher: name: Swinburne
Year: 2024

description: This research discusses the use of Delta in regulating the investment behaviour of the Trustees of Self-Managed Superannuation Funds (SMSFs) who use Exchange Traded Options (ETOs) in their investment strategies. An ETO represents a contract between two parties, giving the taker (the buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price, on or before a predetermined date, to or from the writer (the seller). It is acceptable for SMSF Trustees to use ETO investments as part of their overall investment strategy, providing that leverage or mere speculation are not the reasons behind that investment. It is important to note that neither the Regulator, the Australian Taxation Office (ATO), nor its predecessor, the Australian Prudential Regulatory Authority (APRA), actually state what constitutes 'speculation', or what the allowable uses for derivatives are. There are no practical guidelines. This is a key issue for this research, which aims, as practically as possible, to fill these crucial gaps. A Trustee must abide by their superannuation fund's overriding covenants and investment strategy, and inform its members, through Risk Management Statements, of the trust's derivative strategy. While ETOs can be used to manage risk, they also carry a level of risk themselves. Delta measures an ETO's value movement in correlation with a movement in the option's underlying share price. An ETO carrying a low Delta generally means a cheaper price (premium) per contract than an option carrying a higher Delta. The lower the Delta, however, the lower the chance there is of a positive result for the buyer. This research shows that an ETO Delta of less than 0.2 gives results in favour of buyers in only 11 out of 100 occurrences. This figure rises to 42 out of 100 when Delta is greater than 0.8. From the sampled data, there is an overall financial loss to the buyer of -1.91%, with the financial return results being mixed at all levels of Delta. The overall return results have been compiled without preference to market direction, and clearly highlight the natural premium bias (which the buyer pays) to the seller. What this data does is reenforce the need for Trustees to have a solid view of market directions, or a set strategy in place, as buyers of ETOs. The conclusions drawn from the findings show that the chance of loss (when buying), or gain (when selling) ETOs with a Delta of; - less than 0.20 is 89%; - less than 0.40 is 74%; - less than 0.60 is 66%; - less than 0.80 is 57%; - greater than 0.80 is 58%; For example, a Trustee buying an ETO with a Delta of less than 0.20, faces an 89% chance of loss; a Trustee selling an ETO with a Delta of less than 0.20, faces an 89% chance of gain. The findings on overall financial returns (profit or loss) offer additional support to this critical review of Delta as a risk measurement tool. Whist it is impossible to know the motives or actual positions of portfolio managers of SMSF at any time, the aim of the thesis is to provide a measurement tool that can be used to assist the trustee at any given time by measuring the option risk element alone. When interpreting the findings, the reader must remember that ETO strategies are numerous, and a high-risk profile for one strategy may represent a low risk for another. Further to this, an ETO strategy's risk profile may change with the overlaying of another ETO. For example, where a Call option is bought, the risk involved in that purchase is represented by the premium paid. However, another Call option can then be sold against that position, with a later (or earlier) date to expiry, and with a higher strike price. This 'overlay' reduces the initial risk, but impacts on the maximum gain. It is vital that Trustees have a solid understanding of the basics of ETO strategies before considering using Delta as a measure of risk. The research proposes some guidelines Trustees can use when assessing an ETO strategy against their derivative/investment risk profile. For example, a Trustee buying an ETO with a Delta of less than 0.20, faces an 89% chance of loss; a Trustee selling an ETO with a Delta of less than 0.20, faces an 89% chance of gain. The findings on overall financial returns (profit or loss) offer additional support to this critical review of Delta as a risk measurement tool. Whist it is impossible to know the motives or actual positions of portfolio managers of SMSF at any time, the aim of the thesis is to provide a measurement tool that can be used to assist the trustee at any given time by measuring the option risk element alone. When interpreting the findings, the reader must remember that ETO strategies are numerous, and a high-risk profile for one strategy may represent a low risk for another. Further to this, an ETO strategy's risk profile may change with the overlaying of another ETO. For example, where a Call option is bought, the risk involved in that purchase is represented by the premium paid. However, another Call option can then be sold against that position, with a later (or earlier) date to expiry, and with a higher strike price. This 'overlay' reduces the initial risk, but impacts on the maximum gain. It is vital that Trustees have a solid understanding of the basics of ETO strategies before considering using Delta as a measure of risk. The research proposes some guidelines Trustees can use when assessing an ETO strategy against their derivative/investment risk profile. The findings from 2400 data samples show strong trends in support of the underlying premise (see Figure: Positive Results Versus Delta (ETO Buyers)). Given these findings, the research concludes that Delta can be used as a measure of risk by SMSF Trustees. Delta may not be suitable, however, for measuring multiple layers of combined ETO positions, a type of derivative strategy not suited to or usual in the context of measuring risk within a SMSF. There is a major difference between simple and simplistic solutions offering practical answers in an environment of increasing complexity. Often, simple solutions offer far more value to the less experienced, when compared to complex ones, especially given the growing number of SMSFs, and the increasing lack of expertise in the areas of superannuation and risk management that this growth implies.