Derivatives and Risk

Derivatives and Risk

PART A

            I have chosen to invest £100 000 in Tesco Plc equity to analyze my selected options trading strategy. The report presents the analysis as well as results from the butterfly strategy. The rationale for the choice of the spread option, also known as the butterfly option, is that it has limited or few risks. The butterfly strategy encompasses a combination of different bear and bull spreads (Sarhan, 2016). The holder integrates four options contracts constituting a similar period of expiry within a three-strike price that can lead to a perfect variation of costs as well as yield profits for the concerned holder (McMillan, 2002). The respective holder purchases two different option contracts. One option with a higher strike price while another one has a lower strike price. The holder then sells these options contracts for the strike price in the middle. The real difference in high as well as low strike prices equals the center strike price. The analysis looked at the butterfly strategy to ascertain the investment’s likelihood of yielding profit or bearing the loss.  The right strategy implemented could help understand the direction of the curve above, showing when it is likely to move downwards or upwards to help predict that option to take for payoffs to be realized in the investment. Since I never things like the standard deviation to identify some of the accurate representations in the curve, next time, I would consider using them so that I may be able to identify the direction that is likely to be taken by the fluctuations in the market places. The analysis uses the butterfly trading option to establish the viability of investing £100 000 in Tesco Plc shares.

Tesco Plc constitutes one of the UK’s leading retailers. Tesco Plc’s subsidiaries have been operating as a food retailer (Lowe & Wrigley, 2009). The company offers brick and motor supermarkets, online trading, and private-label brand products (McTaggart, 2006). It provides its services majorly throughout Europe as well as Asia (“London Stock Exchange,” n.d).  In 1947, the company initially traded but has expanded to the level of a blue-chip stock within the UK (Humby, Hunt & Phillips, 2006). Contrary to other big capitals, the company is yet to experience a split. Nonetheless, investors of Tesco Plc used to reap substantial returns on their investments before most large competitors joined the same market, thus posing stiff competition for the company.

The financial crisis of 2008 and after that worked to the detriment of this giant retailer. Before the crisis, the company trading at 500 GBX rating by 2008, which the company drove on a downward trend toward 150 GBX ratings in 2016. However, the company attained a significant improvement in April 2018 since it grew and occupied FTSE 100 first ranking. This was also supported by a 28 percent increment in its yearly profit. In April 2008, the retailer traded a 228p/share, which showed a 5.9 percent rise (Plimmer, 2010). The October 2018 financial results indicated that things were not any better for the company. The retailer’s shares fell by more than 9 percent on October 3, 2018 (Marketwatch, n.d). The events showed the company’s most deteriorated following the post-Brexit poll (“London Stock Exchange, n.d). Owing to the problems of Tesco’s Thailand and Poland divisions, investors were highly discouraged, thus making the company miss its net earnings forecast. Similarly, Barclays cuts a whole year’s net income estimates for the Plc to a margin low of £ 2.06 billion.

However, many references to the volatility of Tesco Plc stock may be referenced to the current coronavirus, as most investors are shying away from trading because of business uncertainty. With the current increase in COVID-19 infections and deaths, which have caused massive losses of jobs and business, the trading at the London Stock Exchange may be significantly interfered with.

Technical Analysis

Beta

Tesco Plc’s beta presents its overall volatility, that is, in comparison to its operating market. A Beta value shows that a firm has a strong correlation with the movement of the market. The beta with a cost lower than 1 signifies lower volatility than the market, while a beta value that is more than 1 suggests higher volatility than the market. The MarketWatch (n.d) provides Tesco Plc’s beta of 0.74. This implies that the company has more substantial fluctuations than the market.

Historical Volatility

Price volatility is interpreted to mean the fluctuation of prices. High volatility depicts more significant changes, while low volatility marks smaller changes. Table 1 presents the opening and closing share price with percentage changes.

Table 1: Tesco Plc Opening and Closing Share Price

Low volatility can be witnessed over the stated period, with averages percentage change of -2.4080 %. This has been taken into consideration in the butterfly strategy chosen.

Economic Analysis

Major Industry Events

            The current global pandemic of corona COVID-19 has negatively affected not only the share prices of the Tesco Plc share process but also other companies across the globe. There is a lot of uncertainty in the industry as the economy has significantly deteriorated. Job losses and underperforming businesses characterized by lock-downs have led to a worsening performance.

In the recent past and during this time of my options strategy implementation, Tesco is undergoing two key things that could help in improving its business in the market due to the continuously changing times in the company in the industry. Starting from last year, Tesco has been eliminating so many household brands and substituting it with privately-labeled products in the UK stores. This is intending to improve efficiency so that they can compete with low-cost rivals in the industry. This has seen several suppliers slashed off in a bid to simplify the structure of the supply chain. Secondly, Tesco did team up with Starship Technologies so that they can deliver services through the use of robots. This app was launched in 2019 and currently undergoing testing in the market. If this succeeds and proves viable, the delivery of services would be better and convenient, and hence by the time the strategy will be picking up, and it could be of help. This could see the business grow significantly in the coming years.

PART B

Butterfly Trading Strategy

With the proposed strategy of butterfly options, the analyzed has focused on the Tesco Plc share prices. Despite the existence of COVID-19 pandemic, I have remained silent on the hypothesis of Tesco’s share prices, hoping all the time of an increase and stability in the share prices since things may change for the better in years to come, probably by next year. For this reason, I have decided to invest the £100 000 in Tesco Plc shares (London Stock Exchange), for it appears feasible.  This will enable sustainability and will be environmentally friendly, an initiative that is currently being campaigned for in every part of the world (Sharpe, 1970). This new initiative would probably pay off as campaigns are on the top gear to mobilize the members of the community so that change can be realized by shoppers buying the new packaging bag as they shop in the retail shops across different parts of the world.

This investment will pay off, thus increasing the share prices of the company in the long-run as opposed to the short run. The short-term gains and hence the current situation has been adversely affected by the COVID-19 pandemic as people have reduced their spending tremendously as a way of cushioning themselves against the looming tough times. The share prices have and will continue to fall drastically, and so I will make use of the Euro-dollar futures to replicate the swap’s ”pay floating” side. In this case, the investment will be due to its long-term influences as opposed to the short-term as dictated by the current situation. Otherwise, it would have paid in the short-term (Nasdaq, 2019b). Since the euro-dollar futures are based on a three-month maturity, two consecutive euro-dollar prospects would be used, bringing the total duration to be six months. Thus coupon payments would be semi-annually.

The investor has been provided with 100,000 euros to invest. Leveraging on the butterfly strategy, I have made this investment appropriately, and the analysis is as shown below in the table, and in each case, the shares to be invested in is 1000. However, the data provided by Yahoo Finance (n.d) shows that the previous price of Tesco Plc is £ 235.80, while the opening is £ 239.90. It can be deduced from this analysis that it is profitable to invest in the company, despite the current global pandemic of COVID-19.

The analysis has been guided by the chosen butterfly trading strategy, correctly using a long call butterfly trading strategy. Being in mind that the COVID-19 has negatively impacted trade globally, the London Stock Exchange may not be spared either. Tesco Plc shares which are currently trading at £ 239.90 will not move significantly in several months to come because of the devastating effects of the coronavirus on businesses. In this regard, I would select to adopt a long call butterfly strategy as a means of spreading profit, assuming that the price of PLC shares stays at the current level.

Using the PLC data from Yahoo Finance, £235.80 (previous closing), and £ 239.90 (opening), the following table shows the share prices and 5% premium.

Table 2: PLc shares at 5% Premium

Table 2 depicts that when the PLC share is trading at a 5% premium, they will be trading above the current market price.

PART C

Report on the Actual Profit or Loss using the Butterfly Trading Strategy

            By using the butterfly trading strategy, precisely the long call butterfly trading option, I write two different call options about Tesco Plc within the strike price of £ 239.90 as well as purchase two more calls at £ 235.80 and £ 240.80 respectively. The current scenario demonstrates that I would earn the maximum profit if the Tesco Plc stock is trading for £ 239.90 at the expiration. However, when the price of Tesco Plc stock falls below £235.80 at the termination or above the cost of 240.80, I would suffer a maximum loss in this investment. The damage would be as the result of purchasing the two different wing call options, which is higher as well as lower strikes. This will be lowered by proceeds reaped from the sale of these two middle-strike options. The reduction of the price of stocks would be detrimental to my (investor’s) investment. Likewise, the increment above the £240.80 is not likely to yield any profit on the investment taken.

When the underlying stock is priced within the range of £235.80 and 240.80, either benefit or a loss is likely to be witnessed. The amount of premium that has been used to enter this position is crucial. Bearing in mind that the 5% premium (£12) is the cost paid to be in this position. As a result of the 5% premium, if Tesco Plc’s stock has been priced at £239.90 minus £12, the occupied area is likely to yield a loss. The same observation is also valid if the underlying stock of Tesco Plc was priced at £239.90 plus £12 at termination. The scenario would only be profitable if the underlying Tesco Plc stock is priced within the range of £227.90 and £251.90 at termination. Notably, the underlying situation analyzed does not involve commission costs that increase the value of trading in stocks, especially under multiple options.

Even though the volatility of Tesco Plc in terms of the share prices from the historical data is very low, it does not eliminate the possibility of risks coming my way in the course of investments. To begin with, with the financial report of the first quarter of operation being released by the end of April, any case of underperformance could lead to no payments of shareholders and hence losses on their sides (Nasdaq, 2019a). Again, there is the risk of people shopping around in the Tesco outlets in different countries failing to embrace change, failing to shift to the new environmentally friendly packaging bags that would see the total investment not being able to pay off. This kind of risk is unlikely, though, in business, anything can happen, and thus we must look into such so that adequate preparation be made just in case it occurs.

The contract options proposed were from March of 2019 to April 2020, with the figures below showing the share movement during the entire period. This data was sourced from Yahoo Finance (2020).

Figure 1

Figure 1

Since the option is a UK one, I have the liberty to exercise any opportunity at any given point in time before the expiry date. During the period stated in the analysis above, the price of the share per pence rose to 159. This means that the long-term investment was redundant since it would not pay off if invested on and instead would result in losses of the premiums invested on the long-term option of investments (Yahoo Finance 2020).

Conclusion

The adoption of the butterfly trading strategy shows that it is profitable to invest the £1000 in Tesco Plc stock. However, at a 5% (£ 12) premium, if Tesco Plc’s stock is priced at £239.90 less £12, the position is likely to bear a loss. The same observation is also actual if the underlying stock of Tesco Plc was priced at £239.90 plus £12 at expiration. Further, because of the nature and the type of investments, if I were to be allowed again to conduct the same investment, I would be keen to ensure that I strictly follow the Brownian motion and the market factors so that losses, like the ones experienced in this case, could be minimized. Another option is given a second chance would also be to look around for a company that can increase much higher volatility, like in the agricultural industry. This kind of production is more volatile as it booms during particular times of the year, and thus at such times, profits on the investments made would be tremendous and realized by all the shareholders.

References

Humby, C., Hunt, T., & Phillips, T. (2006). Scoring Points: How Tesco continues to win customer loyalty. London & Philadelphia: Kogan Page.

London Stock Exchange (n.d). TESCO share fundamentals (TSCO). Home – London Stock             Exchange. https://www.londonstockexchange.com/exchange/prices/stocks/summary/fund            amentals.html?fourWayKey=GB0008847096GBGBXSET1

Lowe, M, & Wrigley, N. (2009). Innovation in retail internationalization: Tesco in the  USA. The International Review of Retail, Distribution and Consumer             Research, 19(4), 331.

Market Watch (n.d). Tesco Plc. Retrieved from           https://www.marketwatch.com/investing/stock/tsco?countrycode=uk

McMillan, L.  G. (2002). Options as a Strategic Investment (4th Ed.). New York, NY: New York    Institute of Finance

McTaggart, J. (2006). Industry awaits Tesco’s invasion. Progressive Grocer, 85 (4),  8-10.

Nasdaq. (2019a). Counterparty Risk Management. Retrieved April 6, 2020, from             https://business.nasdaq.com/trade/clearing/nasdaq-    clearing/riskmanagement/counterparty-risk-management/index.html

Nasdaq. (2019b). Options Defined. Retrieved April 6, 2020, from             https://www.nasdaq.com/investing/options-guide/definition-of-options.aspx

Plimmer, G., (20100. Scoring Points: How Tesco continues to win customer loyalty. Journal          of Revenue and Pricing Management: Special Issue: AGIFORS 2009     Conference, 9(4), 377-378

Sarhan, A. (2016). Markets 101: Volatility Explained. Retrieved April 6, 2020, from             https://www.forbes.com/sites/adamsarhan/2016/08/01/markets-101- volatilityexplained/#3b783a5e4d19

Sharpe, W. (1970). Portfolio theory and capital markets. New York: McGraw-Hill.

Simms, A.  (2007). Tescopoly: How one shop came out on top and why it matters. London:            Constable

Yahoo Finance (2020). Tesco Plc. Retrieved from https://au.finance.yahoo.com/quote/TSCO.L/

Appendices

Appendix 1: Tesco Streaming Chart Indices

Appendix 2:

(Ref: Cboe UK 100)