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Option Trading in Practice

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1Option Trading in Practice  Empty Option Trading in Practice Tue Feb 23, 2016 6:06 pm



About the author
Colin Bennett is a Managing Director and Head of Quantitative and Derivative Strategy at Banco Santander. Previously he was Head of Delta 1 Research at Barclays Capital, and Head of Convertible and Derivative Research at Dresdner Kleinwort.Colin is a regular speaker at CBOE, Eurex, Marcus Evans, Futures and Option World, Risk Magazine and Bloomberg conferences.

This section introduces options and the history of options trading. The definition of
call and put options, and how they can be used to gain long or short equity exposure, is explained. Key definitions and terminology are given, including strike, expiry, intrinsic value, time value, ATM, OTM and ITM.

History of volatility trading

While standardised exchange traded options only started trading in 1973 when the CBOE (Chicago Board Options Exchange) opened, options were first traded in London from 1690. Pricing was made easier by the Black-Scholes-Merton formula (usually shortened to Black- Scholes), which was invented in 1970 by Fischer Black, Myron Scholes and Robert Merton.

Option trading exploded in the 1990s

The derivatives explosion in the 1990s was partly due to the increasing popularity of hedge funds, which led to volatility becoming an asset class in its own right. New volatility products such as volatility swaps and variance swaps were created, and a decade later futures on volatility indices gave investors listed instruments to trade volatility. In this chapter we shall concentrate on option trading.

Call options give right to Buy,puts right to Sell

A European call is a contract that gives the investor the right (but not the obligation) to buy a security at a certain strike price on a certain expiry date (American options can be exercised before expiry). A put is identical except it is the right to sell the security.

Call option gives long exposure, put options give short exposure

A call option profits when markets rise (as exercising the call means the investor can buy the underlying security cheaper than it is trading, and then sell it at a profit). A put option profits when markets fall (as you can buy the underlying security for less, exercise the put and sell the security for a profit). Options therefore allow investors to put on long (profit when prices rise) or short (profit when prices fall) strategies.

Selling options gives opposite exposure

As a call option gives long exposure to the underlying security, selling a call option results in short exposure to the underlying security. Similarly while a put option is a bearish (profits from decline in the underlying) strategy, selling a put option is a bullish strategy (profits from a rise in the underlying). While the direction of the underlying is the primary driver of profits and losses from buying or selling options, the volatility of the underlying is also a driver.

Options trading gives volatility exposure

If the volatility of an underlying is zero, then the price will not move and an option’s equal to the intrinsic value. Intrinsic value is the greater of zero and the ‘spot– strike price’ for a call and is the greater of zero and ‘strike price – spot’ for a put.

Assuming that stock prices can move, the value of a call and put will be greater than intrinsic due to the time value (price of option = intrinsic value + time value). If an option strike is equal to spot (or is the nearest listed strike to spot) it is called at-the-money (ATM).

As volatility increases so does the price of call and put options

If volatility is zero, an ATM option has a price of zero (as intrinsic is zero).However, if we assume a stock is €50 and has a 50% chance of falling to €40 and 50% chance of rising to €60, it has a volatility above zero.

In this example, an ATM call option with strike €50 has a 50% chance of making €10 (if the price rises to €60 the call can be exercised to buy the stock at €50, which can be sold for €10 profit). The fair value of the ATM option is therefore €5 (50% × €10); hence, as volatility rises the value of a call rises (a similar argument can be used for puts).

Options have greatest time value when strike is similar to spot (i.e. ATM)

An ATM option has the greatest time value (the amount the option price is above the intrinsic value). This can be seen in the same example by looking at an out-the-money (OTM) call option of strike €60 (an OTM option has strike far away from spot and zero intrinsic value). This OTM €60 call option would be worth zero, as the stock in this example cannot rise above €60.

ITM options trade less than OTM options as they are more expensive

An in-the-money (ITM) option is one which has a strike far away from spot and positive intrinsic value. Due to the positive intrinsic value ITM options are relatively expensive, hence tend to trade less than their cheaper OTM counterparts.

Option trading in practice

Using options to invest has many advantages over investing in cash equity. Options provide leverage and an ability to take a view on volatility as well as equity direction. However, investing in options is more complicated than investing in equity, as a strike and expiry need to be chosen.

This section explains hidden risks, (e.g. dividends) and other practical aspects of option trading such as how to choose the strike, and the difference between delta and the probability an option ends up ITM.

Choosing expiry is the most difficult decision

The biggest difference between using options and cash equities (or delta 1 products) to gain equity exposure is the fact a suitable expiry has to be chosen. Determining if an equity is cheap or expensive is often easier than determining the driver and timing of the likely increase / decrease.

Choosing a far dated expiry gives most opportunity for the expected correction, however far dated options are very expensive. Conversely if a cheaper near dated expiry is chosen, there is little time for the anticipated movement to occur. Usually key dates such as quarterly reporting or elections help determine a suitable expiry.

Expiry choice enforces investor discipline

Having to choose an expiry can be seen as a disadvantage of option trading, but some investors see it as an advantage as it enforces investor discipline. The process of choosing an expiry focuses attention on the likely dates a stock will converge with a forecast target price. If the stock performs as expected the process of expiration forces the profits on the option position to be taken, and ensures a position is not held longer than it should be.

Additionally if the anticipated return has not occurred by the expected date, the position expires worthless and forces the investor to make a decision if another position should be initiated. Using options to gain equity exposure therefore prevents “inertia” in a portfolio.

Both an equity and volatility view is needed to trade options

Option trading allows a view on equity. and volatility markets to be taken. If implied volatility is seen to be expensive then a short volatility strategy is best (short put for a bullish strategy, short call for a bearish strategy). However if implied volatility is seen to be cheap then a long volatility strategy is best (long call for a bullish strategy, long put for a bearish strategy).

The appropriate strategy for a one leg option trade is shown in Figure 1 below.
Figure 1. Option Strategy for Different Market and Volatility Views:

Long vol strategies should have expiry just after key date

Typically if a key date is likely to be volatile then a long volatility strategy (long call or long put) should have an expiry just after this date. Conversely a short volatility strategy (short call or short put) should have an expiry just before the key date.

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