Derivatives Trading Simulation

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Let’s learn and practice option trading… (Useful Materials for Derivatives Trading Simulation)

Basics of Option Trading Strategies Choose option trading strategies based on:

Objectives/Contexts Information Market view/prediction

Direction Magnitude Time horizon

Timing of trading Financial constraints, trading personality, etc.

Examples of option trading levels [see Jarrow and Chatterjea (2013)]: I. Level 1: the safest strategies, just covered calls. II. Level 2: all strategies in Level 1 + riskier strategies (long calls, long puts,

long straddles, long strangles, covered puts, married puts, and synthetic puts).

III. Level 3: all strategies from Levels 1 and 2 + even riskier strategies (debit spreads, credit spreads, calendar/diagonal spreads, and short puts).

IV. Level 4: the broadest flexibility including adoption of the riskiest strategies: all strategies from prior levels + short calls.

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1. Typical Trading Strategies A. Long/Short Position: Take a position in the option and the underlying. Examples: hedging, arbitrage trading strategies, etc.

B. Spread: Take a position in 2 or more options of the same type (a Spread). Example: both long and short positions in call options of the same underlying.

Spread strategies usually combine options of the same type (either both calls or both puts) on the same underlying but on different/opposite positions (i.e. long and short calls; or long and short puts). These two-sided hedges (with both long and short positions) give a small profit if the underlying moves in one direction but suffer a small loss otherwise. Three basic types of spread strategies: o (1) Vertical Spreads: options that have different strike prices but expire

on the same date (e.g. bull spread, bear spread, etc.); o (2) Horizontal Spreads: options that have the same strike but different

maturity dates (e.g. calendar spread); o (3) Diagonal Spreads: options that differ both in terms of strike price and

maturity date.

C. Combination: Take a position in a mixture of calls & puts (a combination). Example: long positions in both call and put options of the same underlying (see, e.g. straddle and strangle in this presentation).

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2. Covered Call Covered Call

Short Calls and Long Stock: one short call for every share owned. Covered Call is also constructed by Short higher Calls and Long Futures. Timing of the Covered Call matters as well: 1. Buywrite: if investors simultaneously buy the stock and short the call. 2. Overwrite: if investors short the call after buying the share.

Considerations for Covered Calls: Collecting a premium. Market demand for calls and profit for covered call. Conservative trading strategy that works well in neutral markets. Option hedging: If stock price keeps going up, the chance of exercising the call increases. The traders will consider a covered call. Important insights for option hedging and option pricing (see next class).

Applications of Covered Call: (I) Pension funds: they had started applying this strategy since 1981. (II) Trading Strategy and BuyWrite Index: Released in 2002, the CBOE’s S&P 500 BuyWrite Index (BXM) is based on the total returns from hypothetically holding the S&P 500 stock index portfolio and writing a slightly out-of-the-money, one-month maturity call option on the S&P 500 index. During 1988 2006, BXM’s return lagged slightly behind the return of S&P 500 but with only two-thirds of the risk [see Jarrow and Chatterjea (2013)]. (III) Financial Crisis: traders wrote out-of-money calls of Fannie Mae and Freddie Mac and bought the shares [see Jarrow and Chatterjea (2013)].

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3. Protective/Covered Put Protective/Covered Put

Long Puts and Long Stock: one long put for every share owned. Covered Put may also involve Short Futures and Short lower Put. Capture premium in bullish market position. Timing of the Protective/Covered Put matters as well: 1) Married Put: Long Put and Long Stock simultaneously 2) Protective Put: Long put to protect the downside risk of a previous

Long Stock position.

Considerations for Covered Put: Covered Put works like insurance policy: buying insurance by hedging a long stock with an option. Applications: Portfolio Insurance (long stock index and long put index option) – an example of financial innovations and financial engineering.

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4. Synthetic Option/Futures Positions (I) Synthetic Call: Buy Futures and Buy a Put

Profit potential: unlimited Maximum risk: (Value of future prices – Strike price) + Premium + Transaction cost (margins)

(II) Synthetic Put: Sell Futures and Buy a Call Profit potential (limited): Contract value – (Premium + Transaction costs) Maximum risk: (Value of future prices – Strike price) + Premium + Transaction cost (margins)

Deriving Synthetic Put (Hint: Apply the Put-Call Parity): p = c + S0 Ke-rT

This implies put = long call, short stock, long risk-free bond with face value K. This is a synthetic put. Why do investors use Synthetic Put when actual put exists? e.g., use synthetic puts when actual put is overpriced.

(III) Synthetic Short Futures: Sell Call Option and Buy Put Option Profit potential: limited (see Class #2) Maximum risk: unlimited (see Class #2)

(IV) Synthetic Long Futures : Buy Call Option and Sell Put Option Profit potential: unlimited (see Class #2) Maximum risk: limited (see Class #2)

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5. Bull Call Spread

K1 K2

Profit

ST

A spread is a two-sided hedge that combines two options of the same type (e.g., Calls or Puts) but with opposite trading positions (Long and Short positions). To construct a Bull Call Spread – in the same contract month: (1) Long Call of a lower strike price (2) Short Call of a higher strike price Profit = Profit from (Long Call + Short Call) – Net Premium – Transaction Cost

Bull Call Spread is useful when the price is expected to increase; features are: (a) Lower cost: Receive premium for writing call option; lower premium cost. (b) Limited risk: maximum loss = net premium + transaction costs (c) Limited gain: maximum profit = (K2 K1) net premium transaction costs (d) Neutralize time decay in options. (e) Debit spread: costs money to create the spread. (f) Others: exchanges allow spreads to have lower margins than uncovered trades.

Bull Call Spread

Short Call at K2

Long Call at K1

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5.1. Bull Put Spread

K1 K2

Profit

ST

Bull Put Spread is useful when the price is expected to increase; features are: (a) Limited risk: maximum loss = (K2 K1) net premium + transaction costs (b) Limited gain: maximum profit = net premium transaction costs (c) Neutralize time decay in options. (d) Credit spread: receive money (credit) for creating the spread and writing put.

To construct a Bull Call Spread – in the same contract month: (1) Short Put of a higher strike price; (2) Long Put of a lower strike price. Profit = Profit from (Short Put + Long Put) – Net Premium – Transaction Cost

Bull Put Spread

Long Put at K1

Short Put at K2

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6. Bear Put Spread

K1 K2

Profit

ST

To construct a Bear Put Spread – in the same contract month: (1) Long Put of a higher strike price; (2) Short Put of a lower strike price. Profit = Profit from (Long Put + Short Put) – Net Premium – Transaction Cost

Bear Put Spread is useful when the price is expected to decrease; features are: (a) Lower cost of carry (hedging option). (b) Limited risk: maximum loss = net premium + transaction costs (c) Limited gain: maximum profit = (K2 K1) net premium transaction costs (d) Neutralize time decay in options. (e) Debit spread: costs money to create the spread.

Bear Put Spread

Short Put at K1

Long Put at K2

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6.1. Bear Call Spread

K1 K2

Profit

ST

To construct a Bear Call Spread – in the same contract month: (1) Short Call of a lower strike price; (2) Long Call of a higher strike price.

• Profit: (Short Call + Long Call) – Net Premium – Transaction Cost

Bear Call Spread is useful when the price is expected to decrease; features are: (a) Limited risk: maximum loss = (K2 K1) net premium + transaction costs (b) Limited gain: maximum profit = net premium transaction costs (c) Neutralize time decay in options. (d) Credit spread: receive money (credit) when creating the spread and writing call.

Bear Call Spread

Long Call at K2

Short Call at K1

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7. Butterfly Spread Using Calls

K1 K3

Profit

ST K2

Long Butterfly Spread is a two-sided volatility hedge (small profit if volatility is low but limited loss otherwise):

(1) Long 2 Calls with high K1 and low K3; and

(2) Short 2 Calls with K2 where K1 > K2 > K3.

Butterfly Call Spread

Long Call at K1

Long Call at K3

Short 2 Calls at K2

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7.1. Butterfly Spread Using Puts

K1 K3

Profit

STK2

Long Butterfly Spread (can also be created with puts):

(1) Long 2 Puts with high K1 and low K3; and

(2) Short 2 Puts with K2 where K1 > K2 > K3.

Butterfly Put Spread Long Put at K1 Long Put at K3

Short 2 Puts at K2

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7.2. Condor Spread

K1 K3

Profit

STK2

Condor Spread

K4

Long Condor Spread: option portfolio created by four options of the same type (all calls or all puts) with four different strike prices: (1) Long two options with extreme strike prices (K1 and K4); and (2) Short two options with middle strike prices (K2 and K3).

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8. Long Strangle or Straddle Combination strategies combine options of different types (Calls and Puts) on the same underlying stock, where Calls and Puts are either both long or both short. Examples of combination strategies include the following: Straddles and Strangles are volatility plays – volatility trades that speculate on events that can have positive or negative outcomes. Long Straddle:

Long at-the-money Call and Long at-the-money Put.

Long Strangle: Long out-of-money Call and Long out-of-money Put.

Advantages: Long Straddle or Long Strangle provides limited risk and unlimited profit potential. Long Straddle or Long Strangle generates profits if the price of the underlying is volatile in either direction. Insights: Straddles and strangles are volatility trading strategies. Options traders use these strategies when they predict a risky future events that can significantly impact the value of the underlying asset in either a positive or negative direction.

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8.1. (Long) Straddle Combination Profit

STK

Long Straddle: (1) Long at-the-money Call (at K); and (2) Long at-the-money Put (at K).

Straddle

Long Put at K

Long Call at K

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8.2. Strip and Strap

Profit

K

ST

Profit

K

ST

Strip

Strap

(1) Strip (see left above): Long 1 Call and 2 Puts with same K and T (profitable if price is volatile and decrease is more likely). (2) Strap (see right above): Long 2 Calls and 1 Put with same K and T (profitable if price is volatile and increase is more likely).

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8.3. (Long) Strangle Combination

K1 K2

Profit

ST

Long Strangle: (1) Long out-of-money Call (at K2); and (2) Long out-of-money Put (at K1).

Strangle

Long Call at K2

Long Put at K1

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9. Short Strangle or Straddle Short Straddle:

Short at-the-money Call and Short at-the-money Put.

Short Strangle: Short out-of-money Call and Short out-of-money Put.

Advantages: Applied in expectation of neutral markets. Short Strangle or Short Straddle generates profits with a neutral market with low volatility: when the price of the underlying remains stable or the price of the underlying remains within a trading range until option expires (low volatility).

Case Study of Derivative Disaster using Straddle: Barings Bank Barings Bank lost more than $2 billion in Nikkei index futures and options. Nick Leeson: Short Straddle positions to recoup the losses he made from Nikkei stock index futures. Leeson believed that the Nikkei would stabilize but his bet failed and losses escalated to $1.4 billion, causing the bankruptcy of Barings.

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10. Examples of Other Option Trading Strategies [Advanced; optional]

Box Spread: a combination of a Bull Call Spread and a Bear Put Spread – speculating on different values of spreads.

Arbitrage strategy (attempts to generate a risk-free gross profit), which combines Bull Call Spread with Bear Put Spread, with same strike prices and expiration dates. Financing tool – e.g., collateralized lending and borrowing. The long box spread is useful when the spreads are underpriced. Another application of the Put-Call Parity (European options).

Iron Condor: a combination of 4 different options with different strike prices: (1) Short an out-of-the-money put with a lower strike price, (2) Long an out-of-the-money put with an even lower strike price, (3) Short an out-of-the-money call with a higher strike price, and (4) Long an out-of-the-money call with an even higher strike price. Low volatility strategies – Limited risk and limited profit trading strategy for larger probability of smaller profit (this strategy is useful when the underlying has low volatility).

Iron Butterflies: a combination of options with different strike prices to formulate a directional-neutral, low volatility strategies (similar to Iron Condor above).

Low volatility strategies – with limited profit potential and limited risk.

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10.1. Box Spread

K1 K2

Profit

ST

Box Spread can be used for Arbitrage or Financing Tool and viewed as: (a) Combination of Bull Call Spread with Bear Put Spread (with same strike prices and expiration dates). (b) Combination of synthetic long futures and synthetic short futures. (c) Combination of long strangle and short strangle.

Bull Call Spread

Bear Put Spread

Box SpreadRisk-Free Return

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Summary: Basic Option Trading Strategies Covered call:

Long stock and Short call

Straddle: With Same Exercise Prices:

Long Call Long Put

OR Short call Short Put

Strangle: At Different Exercise Price: Long strangle:

Long call Long put

Short strangle: Short call Short put

Bull spread: Long call @ Low Exercise Price Short call @ higher exercise price

OR Long a put @ low exercise price Short a put @ higher exercise price

Bear spread: Short call @ Low Exercise Price Long call @ higher exercise price

OR Short a put @ low exercise price Long a put @ higher exercise price

Butterfly spread:

Long butterfly: ONE Long call at (K – a) strike TWO short calls at K strike ONE Long call at (K + a) strike

OR Long 1 put at (K – a) strike Short 2 puts at K strike Long 1 put at (K + a) strike

Short butterfly: ONE Short call at (K – a) strike TWO Long calls at K strike ONE Short call at (K + a) strike

OR Short 1 put at (K – a) strike Long 2 puts at K strike Short 1 put at (K + a) strike

Condor spread: Four options of the same type (all calls or all puts) with four different strike prices. Low volatility strategies.

Box spread: Any combination of options that has a constant payoff at expiration.

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