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smartman
smartman
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Number of messages : 167
Points : 1872
Date of Entry : 2015-08-04
Year : 49
Residence Country : Mexico

ma1 Choosing Strike of Strategy

on Tue Feb 23, 2016 6:23 pm
While choosing the strike of a strategy is not as difficult as choosing the expiry, it is not trivial. Investors could choose ATM to benefit from greatest liquidity. Alternatively, they could look at the highest expected return (option payout less the premium paid, as a percentage of the premium paid).
Figure 2. Profit of 12 Month Options if Markets Rise 10% by Expiry:
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ITM options have highest return for “normal” market moves

While choosing a cheap OTM option might be thought of as giving the highest return, the Figure below shows that, in fact, the highest returns come from in-the-money (ITM) options (ITM options have a strike far away from spot and have intrinsic value). This is because an ITM option has a high delta (sensitivity to equity price);hence, if an investor is relatively confident of a specific return, an ITM option has the highest return for relatively “normal” market moves (as trading an ITM option is similar to trading a forward).

Forwards are better than options for pure directional plays

A forward is a contract that obliges the investor to buy a security on a certain expiry date at a certain strike price. A forward has a delta of 100%. An ITM call option has many similarities with being long a forward, as it has a relatively small time value (compared to ATM) and a delta close to 100%. While the intrinsic value does make the option more expensive, this intrinsic value is returned at expiry.

However, for an ATM option, the time value purchased is deducted from the returns. For pure directional plays, forwards (or futures, their listed equivalent) are more profitable than options. The advantage of options is in offering convexity: if markets move against the investor the only loss is the premium paid, whereas a forward has a virtually unlimited loss.

OTM options have highest return for “abnormal” moves

Only if the expected return is relatively high (or abnormal) do ATM or OTM options have the highest return. This is because for exceptional returns their low cost and high leverage more than compensates for their lower delta.

Liquiditi can be factor in choosing strike

If an underlying is relatively illiquid, or if the size of the trade is large, an investor should take into account the liquidity of the maturity and strike of the option. Typically, OTM options are more liquid than ITM options as ITM options tie up a lot of capital. This means that for strikes less than spot, puts are more liquid than calls and vice versa.

Low strike puts are usually more liquid than high strike calls

We note that as low-strike puts have a higher implied than high-strike calls, their value is greater and, hence, traders are more willing to use them. Low strike put options are therefore usually more liquid than high-strike call options. In addition, demand for protection lifts liquidity for low strikes compared with high strikes.

Single stock liquidity is limited for maturities up to two years

For single stock options, liquidity starts to fade after one year and options rarely trade over two years. For indices, longer maturities are liquid, partly due to the demand for long-dated hedges and their use in structured products.

While structured products can have a maturity of five to ten years, investors typically lose interest after a few years and sell the product back. The hedging of a structured product, therefore, tends to be focused on more liquid maturities of around three years.

Hedge funds and structured product flow can overlap

Hedge funds tend to focus around the one-year maturity, with two to three years being the longest maturity they will consider. The two-to-three year maturity is where there is greatest overlap between hedge funds and structured desks.

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