Basket Options

A basket option is an exotic financial derivative that traders can use to purchase groups of assets at once, but at a predetermined time in the future. Basket options rely on the underlying asset being above or below a certain price at a given time to bring investment benefits to the holder. This guide will outline the features of basket options, how to use them, the potential benefits and drawbacks and how to get started in trading with them.

Basket Option Definition

So, what are basket options? They are a derivative where the underlying asset is a group (basket) of commodities, securities or currencies. Basket options are similar to other kinds of options in that they give the holder the right, but not the obligation to buy or sell the group of assets at a specific price on or before a predetermined date.

They are classed as exotic options because the underlying asset differs from a regular option, and the strike price is based on the total value of the items in the ‘basket’. Aside from this, however, basket options have many of the same features as standard options.

The most common and popular kind of basket is a currency basket option which is generally traded in the home currency of the option holder. Basket options also tend to be cheaper than regular options because they require only one transaction to acquire multiple assets, resulting in less spending on broker fees and commissions.

Basket option explained

How Basket Options Work

Basket options are typically formed of baskets created by the seller of the option but at the request of the buyer. They are also typically adjusted to meet the specific needs of the buyer. This kind of flexibility is possible because basket options are traded OTC (over the counter), so they can be customized to suit the needs of both parties.

For example, a currency basket is beneficial to corporations in that they can trade with multiple currencies in a single transaction, where they purchase a basket that involves several currencies at once, while only trading their home currency.

An equity index option can be considered a basket option due to the fact it is a basket of stocks, but because it is monitored and standardized by a third party, they are traded more like regular options instead, not offering the same flexibility as true basket options.

Basket options have two key benefits: firstly, they focus on one sector or investment style, and secondly, they provide traders with more diversification across a range of assets in one sector.

Basket options can also be used to hedge the risk on stock while costing less to the investor. The risk is hedged on multiple assets at once rather than hedging each individual one.

Basket Option Example

To see how basket options work in action, it is useful to look at an example…

Let’s say a trader wishes to be exposed to commodity currencies. In this case, the basket could be made up of 35% Swiss Franc, 35% Canadian Dollar, 20% New Zealand Dollar and 10% Australian Dollar.

All of these currencies can be traded in a single transaction, paid for in only the investor’s home currency.

This portfolio can be diversified and balanced using multiple currency pairs within these 4 currencies.

Key Characteristics

The main feature of the basket option is that it is effective in hedging risk across multiple assets simultaneously. Traders do not necessarily need to hedge every asset individually but can review the risk of the entire basket all at once. Since the costs that come with hedging can be significant, this can be a huge money saver for traders.

Other key characteristics include:

  • Basket options are traded over the counter so can be developed to meet the exact needs of the buyer and seller.
  • Trading fees tend to be lower with basket options because only one transaction is carried out to acquire all of the assets in the basket, rather than a new transaction for each separate item.
  • Despite their advantages, these kinds of options come with limited liquidity, so traders might need to offset them with additional transactions to exercise the option before the expiry date.
  • A basket can be made up of any sum of underlying assets, as long as the weights of the assets are all positive.
  • They can be cash-settled or physically-settled, although it is more common to settle in cash.
  • The maximum profit for basket options has no upper limit, and the maximum loss that can occur is the premium.
  • Basket options are like regular options in that they can be purchased as call options (the right to buy stock) or as put options (the right to sell stock).
  • Trading with baskets has many benefits, but such groups of assets can be limiting in terms of liquidity, making it hard to close the option before it expires. This kind of limitation can call for offsetting or partially offsetting the trader’s position.

Types Of Baskets

There are multiple kinds of baskets that you can trade with:

  • Equity baskets – made up of multiple shares in the same sector, such as small-cap technology companies, or shares that have a characteristic in common.
  • Currency baskets – using specific world currencies and deploying various strategies within the basket.
  • Commodity baskets – these can focus on an entire sector or a subsector by focusing on a type of commodity within a sector, such as gold
  • Fixed income baskets – used to diversify a portfolio and enter into a low-volatility sector to protect against dramatic price fluctuations.
  • Cryptocurrency baskets – a newer kind of basket that lowers the high volatility of the sector.
  • Cross-asset baskets – instruments from different asset classes that have a common theme.

When Are They Used?

There are different uses for basket options, and while they can be used by multinational corporations to hedge against the risks of foreign exchange rates, that is not the only way they can be used effectively. Independent traders can also benefit from using basket options, particularly those who are looking to protect their investments. Index options are another popular choice for investors, but they do not offer the same exposure to specific economies or emerging markets in other countries.

Basket options are arguably more beneficial to independent investors than individual stock options as well, as individual options are more expensive with added transaction costs and higher prices due to the higher volatility that comes from the increased risk of individual options.

As an investor, buying a basket of shares is a great way to take advantage of appreciation in a certain sector of the stock market without major participation. It is also good for investors who want to participate in a sector while still protecting their capital.

You may also want to purchase a basket option if you think the average basket option correlation in certain shares is going to increase, so that you can still hedge against any changes in volatility.

When Basket Options Can’t be Exercised

Due to the limited liquidity of basket options, there is a chance that the investor won’t be able to close on it before it expires. However, some things can be done if the equity investor, for example, is worried that this is going to happen.

If you own a call on a basket of currencies, but do not want to buy them or won’t be able to before the expiry, then a put option could be bought on a similar basket to either entirely or partially net out the effects of the first one.

See more on how to hedge your options in the strategy section below.

Valuation Of Basket Options

To understand how to price these derivatives, it is important to analyze pricing methods for basket options. Payoffs are determined by the weighted average prices of the underlying assets in the basket. This differs from European and American options where the payoff of the option is only dependent on the price of one underlying asset, and therefore basket option payoffs can be larger in comparison to the costs of the transactions.

Basket option pricing can be solved in several different ways. Aside from pricing basket options with skew, there are other techniques too, such as moment matching, geometric basket options conditioning or pricing basket options using Monte Carlo simulation. For the analytical approach, the basket price is approximated through lognormal distribution with moments matched to the distribution of the weighted sum of individual stock prices. Alternatively, it can also be used to price basket options by using an averaging mechanism, which covers calls and puts.

Basket option calculators can also be found online and used to price products.

Advantages Of Basket Options

Trading with basket options offers multiple advantages for traders…

Firstly, having a single option on a portfolio of assets is cheaper for the investor than it would be to purchase an option on each asset individually. The cost-saving will be greater the lower the correlation between the assets included in the basket. Furthermore, basket options tend to be traded over the counter which means they are highly customizable to the needs of the investor.

There is also a huge range of different baskets available, so as an investor you are going to be able to choose what kind of basket will suit you, for example, interest rates, FX, equity or commodity.

Finally, baskets give the investor more exposure and are less volatile. They create a more balanced and personalized investment portfolio, allowing you to gain more exposure to other sectors and industries, without taking huge risks.

Disadvantages Of Basket Options

While basket options may offer protection to the investor, the drawback of trading with them is that they come with somewhat limited liquidity.

This may require offsetting the option to save capital, but it is worth noting that this can come with additional transaction costs, and avoiding these may have been one of the temptations of using basket options in the first place.

Strategy: Basket Option Hedging

To protect yourself when using basket options, it is important to incorporate an airtight strategy into your trading so that you aren’t exposed to excessive risks. To protect your stock buy basket put options that correlate to a broad index, for example, the S&P 500 or Nasdaq 100, at a cost of between 3% and 5% of the value of the securities in the basket, at regular intervals over the lifespan of the option. This is where trading with basket options can become more costly, even negating the cost-effective benefits that drew you to them in the first place.

However, strategies can be used to minimize the cost of protecting your basket as well. Firstly, it is important to find an index that is similar to the variety of assets that are in your portfolio, known as a ‘correlating’ index. If your basket has assets that span across multiple sectors, then the S7P 500 (SPX) or S&P 100 (OEX) may be the best options for you, whereas if it’s centred in one sector then something more specific is best, such as tech-heavy baskets, which may be better suited to indices such as Nasdaq 100 (NDX).

After working out which index is best for your portfolio, it’s time to calculate how many puts you need to buy to protect the assets so that you can create a hedge for your basket. Below are the steps you can take to do this:

  • Calculate the cash value of the index you have chosen. This can be found out by checking with the index in question.
  • Work out how much of a hedge you are going to need. This can be done by dividing your prospective portfolio value by the cash value of the index, to get the number of puts that are needed.
  • Calculate final hedge cost. This is done by working out how far into the future you want the protection to last, and where you want to protect most.

Strategy: Covering

Hedging basket options is an effective strategy for protecting your stock, but the costs that it can incur can be unattainable for some investors, and selling parts of your portfolio to raise the capital is not always optimal either. This is where the strategy of covering comes in, which can help you to pay for the hedge.

Covering calls is the process of selling a basket call option against each of your stock holdings, which is possible when you own 100 or more shares of stock for each call that you sell. The money you make from the sold calls can then reduce the cost of your put hedge, making it more affordable.

As with most strategies, this can come with its risks. If the stock price moves above the short-call strikes, then your stock can get ‘called away’ meaning it will be sold at the strike price, which can result in taxable income if you have made a gain. It is also important to consider the cost of the transactions that need to be carried out to sell covered calls.

An analysis of pricing methods and formulas for basket options

Special Considerations: Basket Options & Tax Avoidance

Something to take into consideration if you are looking to start trading with basket options is that hedge funds have recently been under tighter scrutiny due to some accounts using basket options to avoid paying the high tax that can come with capital gains. This concern tends to come when the taxpayer begins a contract with a financial institution so that their return is on the performance the institution holds, but is managed by a hedge fund. When this happens, hedge funds can claim on tax returns that the profits came from exercising options and do not count as capital gains from trading.

As a result, basket option contracts must now be listed on tax returns. Consult a local tax advisor for guidance.

How To Trade With Basket Options

Here are steps that you can take to be prepared for beginning to trade with basket options:

First, it is advisable to find a brokerage and open a trading account. A broker’s job is to help facilitate your trades and liaise with the other party or institution. However, it is important that you choose a broker who is suited to your specific needs. This means taking into account costs and premiums, including making sure there aren’t any hidden fees. Also consider whether you need a cash account or a margin account and that a high-quality platform is available.

It is worth noting when it comes to brokers that not all providers support basket orders for options, and when they do they can come with minimum requirements for trading. When the assets have been placed into the basket, the purchase goes through as one order, but all of the assets are listed individually within the portfolio so you can still control them.

It is also important to study the market before you get into trading. This means immersing yourself in the relevant literature and seeking out resources about the market that you are looking to invest in. There is a wealth of resources out there from ebooks to podcasts to videos to PDFs, all of which can give you invaluable information that will help you to make effective investments.

Furthermore, use indicators so that you can assemble charts for trading basket options. These are going to show you what the market is likely to do, and therefore will give you a better chance of investing wisely.

Finally, it is important to remember that trading with basket options takes time to learn, especially if you are new to investing. Taking the time to work on a chart that paints an accurate picture of your chosen market and sector goes a long way in ensuring that you can make lucrative decisions.

Final Word On Trading Basket Options

Basket options are a great investment tool if you are looking to diversify your portfolio and purchase several assets together at a cheaper rate than if the same portfolio was purchased in vanilla options. Furthermore, since they are traded over the counter, they are customizable and flexible to your needs in comparison with vanilla options. The issues with such options lie within the limited liquidity, which means they can be hard to close before they expire, but with a well-researched strategy, the risks can be minimized.

FAQ

What Is A Basket Fund?

A basket fund is a collection of over a dozen securities that share a common theme such as their sector, industry or metric. This could be a collection of currencies or commodities, for example.

What Are Basket Derivatives?

Basket derivatives are contracts that come with basket funds, and tend to be ETFs or ETNs. This is what gives a trader exposure to a market but does not oblige them to purchase or sell.

How Are Basket Options Priced?

Baskets are priced using a mathematical formula that is used by the issuer of the option. See our guide above for more details.

What Assets Can Be In A Basket Option?

Various assets can be included in a basket option, including equity, currency, commodity, cryptocurrency, fixed income, and cross-asset.

Why Should I Choose Basket Options Over Regular Options?

Basket options offer investors benefits that other kinds of options cannot, with the main benefit being that they are cheaper to purchase. This is because they minimize the transactions it would take to buy all of the assets separately.