Home Forums Main Forum Basic Options Maneuvers

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  • Curve Advisor
    Keymaster
    Post count: 612
    #2827 |

    It seems to me that some people are not very familiar with some of the more basic maneuvers you can do in options. Put-call parity says that if you are long a call plus short a put (same strikes), you have the equivalent positioning as being long the underlying future. Conversely, being long a put and short a call is equivalent to being short the future. If you take a step back and think about it, we have three items we can trade (call, put, underlying future), and each item can be defined a combination of the other two. This means that for many options views, you can structure them in several equivalent ways. I want to discuss some of the more common structures and their equivalent structures, because sometimes, it may be possible to get filled easier (or better) knowing all your alternatives. It may also give you a different perspective on the risk/reward of your structure.

    Note: I’m going to ignore “exercise risk” in these discussions. On the day of expiry, it may get uncomfortable if you are short an option, the contracts is right at the strike and you are uncertain if the other party will or will not exercise their option. Because it can take many hours before you are notified whether you need to deliver, you may not know what you exact positioning is. This is not a big deal when the markets are quiet, but can be a risk if the markets are volatile. Sometimes, you may get a situation where someone exercises and option, even if it is OTM on at the close of trading.

  • Curve Advisor
    Keymaster
    Post count: 612

    APPLICATION OF PUT-CALL PARITY

    When you look at the options markets, you will generally find that the bid-ask on the out-of-money (“OTM”) options will be tighter than the in-the-money (“ITM”) options. This is understandable, since the OTM options have less delta, and are less affected by moves in the underlying future. Say you were long the EDU6 99.375 put (aka “EDU6 93 put”). The market is 13.5 bid and 14.5 offer. This isn’t so terrible – you can work the middle, and I suppose you really *had to* get out, you could cross the bid/offer spread and pay the half bp. So if you are fortunate, you can get out at 14 mid, and in the worst case, you can get out at 13.5.

    Let’s assume: (1) your brokerage per contract is negligible, and (2) your cost to carry a position is negligible. For some of you, one or more of these will not be the case, but humor me – maybe you will switch jobs at some point. Or maybe my point will still come in handy. You could definitely just try and sell the put, as per the above. But selling the EDU6 93 put is the same as buying EDU6 future and selling the EDU6 93 CALL. So you can synthetically exit your position by sitting on the 99.25 bid in EDU6 future. If you get it, you can work to sell the EDU6 93 calls @ 2. This would be the equivalent of selling 14.5s in the puts alone. Even if you had to hit the 1.75 bid in the U6 93 calls, you are still doing a quarter tic better than trying to work the mid in the U6 93 puts. My point isn’t that this is how you should trade all your options. But you should always know what all your alternatives are. You also created some additional liquidity for yourself. A quarter bp may not sound like much, but you would be surprised how quickly a quarter bp a day adds up in a year.

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  • Curve Advisor
    Keymaster
    Post count: 612

    I was originally thinking I would write these out in some building-block order, but it would be much easier for me to give you some real-life examples.

    Let’s say you were short the EDU6 92 straddle (short EDU6 99.25 put and short EDU6 99.25 call). If you wanted some protection on a selloff, you could buy the EDU6 99.125 put. The structure we have now is exactly equivalent to an EDU6 91-92 call 1×2 (long EDU6 99.125 call and short 2x EDU6 99.25 call). It may be surprising to options novices, since it looks like most of the component contracts are different. But you can prove it to yourself by: (1) drawing a payout picture, or (2) using put-call-parity to prove it using formulas. Try it and see [teach a man to fish].

    Why would you need to be able to convert from one to another? There are times when it is easier to think about (1) what you have on, or (2) it may help you think about what you need to do to adjust your positioning, if you could think about a position in multiple ways. I generally prefer to look at the prices of structures as numbers closer to 0. So saying that the call 1×2 is 2.5 tells me more about the risk than saying the straddle plus put is 10. If we get a massive selloff, the call 1×2 would go to 0. So on a big selloff, we are risking the 2.5bps. On the straddle structure, it’s not as “natural” to think of the structure going from 10 to 12.5 on a big selloff, even though my risk is the same 2.5bps.

    [to be continued]

  • Curve Advisor
    Keymaster
    Post count: 612

    The topic of risk reversals recently came up in a chat. So I thought I would share some thoughts on this option structure. A bullish risk reversal would be where you purchase a call and sell a put. You are selling the put to finance the cost of the call. Typically, a risk reversal will be close to “zero” cost. A bearish risk reversal would be where you buy a put and sell a call.

    One of my former managers would say “if you want to buy a risk reversal, you might as well just go long” (or vice versa). To some extent this is true. Your mark-to-market on the options structure is going to be somewhat close to just owning a smaller amount of the underlying futures on a small move. But there are cases where doing a risk reversal could make sense. I’m sure there are chapters of books devoted to the topic of risk reversals, but I just wanted to give you a few applications where I think a risk reversal makes sense:

    * You plan to hold the option structure to expiry and are more comfortable at certain terminal levels of EDs than the short-term directional moves. For example, if you are certain the Fed won’t hike more than 2.5 times by the end of the June meeting, but think an ease is likely. You could sell the EDM 98.375 put and buy the EDM 99.125 call. If you are right, you make a ton of money. If you are wrong, you are “happy” to eventually make back any mark-to-market losses on the decay. Keep in mind though that you could take as much (or more) mark-to-market pain as having a smaller amount of the underlying future. And if enough people get stopped out (or you are dead wrong), you can take even more pain.

    * You think one tail is much more likely than the other. Again, this would be a leveraged play on the this tail view. Keep in mind that there is ALWAYS tail risk. We saw that on the upside with 9/11 (i.e. a dirty bomb in NY can happen, as can a bunch of other things) and we saw this on the downside with the libor blowout. Caution needs to be exercised that you are weighing the risks appropriately. In addition, on a tail event, volatility could blow out, increasing your losses.

    * You want a leveraged view on a massive move. As you get closer to expiry, the delta on the options structure will start increasing much faster on a large move than a smaller amount of the underlying.

    * You think the put:call skews are wrong. For example, the markets are pricing in a bigger tail on more hikes by the Fed, rather than the crisis risks from causes X, Y, Z. You can buy an OTM call and sell and OTM put. You can leave the structure as-is to express a directional view, or (partially) hedge the delta to take more of a view on the skew.

    This is not a structure I do that often so I don’t spend a lot of time thinking about this. So I’ll add to the above list as I think of other uses. The main thing to note is that it is a leveraged structure on a large move (as compared to taking a smaller position on the underlying), and while there can be large gains, there can be large losses. If you are right, you will be long gamma, but conversely if you are wrong, you will be short gamma. So you need to pick good strikes and you need to understand there could be notable mark-to-market losses.

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