Just as we did with futures, we’ll go through the market participants and then cover how each participant uses these products and why. It’s always good to draw a quick table, separate types of users and see how they use the product. Understanding the logic behind each use of a product will allow analysts to design solutions based on specific decisions which fit their goals and objectives.
Single options: buying calls, buying puts, selling calls or selling puts are the four first profiles we viewed. We learning to calculate breakeven points profit potential and risk. Now we will look at those same options to list the specific participant and their chosen strategies.
Source: MH Derivative Solutions, LLC
The participants who use options are the same four participants as Futures & Swaps.
We’ll detail the strategies they use and their goals and objective for using these strategies.
Keep in mind the note from the above graphic:
Corporations use Equity options on their own stock as well as those they own or are interested in purchasing. For example:
Yield Enhancement is the term used by unleveraged fund managers to describe selling options to receive the premium. Managers also purchase options, called Portfolio Insurance
Many participants fall into this quadrant. Let’s list what all speculators have in common: They tend to take short term positions (one day to two weeks) They tend to trade directionally (based on technical indicators or an algorithmic signal
Market Makers & Specialist use options in a similar way but for a totally different reason. In either case, here we’re speaking of a user transferring risk. They use one of several ways to manage this.
N.B.: Gamma Scalping & Skew Trading are covered in detail in the advanced portion of the site.
These payoff profiles also called Hockey sticks are an easy visual for the risk & reward of each strategy.
Yield Enhancement strategies generate income through the sale of options. Investors who own stocks may choose to sell calls on those long shares.
At expiration either:
Below is the graph for the buy-write described above. Notice the dotted line shows the long stock position alone. If you add the short call to the position, the buy-write lowers your cost basis on the stock.
A pension plan, mutual fund or even a small retail account can sell puts (usually out-of-the-money) with the goal being to
Below is the graph for the put-write described above. Notice the dotted line shows a long stock position (if we already had one). Instead, we sell an OTM put.
Long Stock @ $65 Long 65 Put @ 3.00 Current price of stock = $65 per share MAXIMUM PROFIT POTENTIAL = Unlimited (upside)
Portfolio Insurance is used very differently today than it was back in the 1980s. Nowadays, managers purchase lots of out of the money puts when they’re cheap. Especially when their index requires them to hold a certain amount of stock. They’ll buy the protection for a shorter period of time.
Stock Index Futures & Portfolio Insurance: Shorting futures against portfolio’s of stock was widely used before October 1987’s. Particularly portfolio’s with performance compared to the S&P 500, it seemed logical to sell S&P 500 futures as a hedge.
Options & Portfolio Insurance: Investment Managers that had permission from clients to purchase options bought puts against their long stock, creating a synthetic long call payoff profile.
Vertical spreads are spreads between two strike prices, both with the same expiration. To draw the payoff profile, using the intrinsic table is a memory tool and make the graph easier to draw.
EXAMPLE: LONG VERTICAL CALL SPREAD
Long 65 call @ $3.40 Short 70 call @ $1.40 = NET PREMIUM PAID $2.00
Following with your finger from left to right, with the stock at 66, the 65 call is worth $1 on expiration night.
Please notice the title of the intrinsic matrix: BULL SPREAD USING CALL OR LONG CALL SPREAD. Both titles are correct and describe the payoff profile correctly. But different authors use different terms so instead of making confusion I allowed you to pick the term with which you’re more comfortable. This Is the intrinsic table for a long call spread
This is the payoff graph for the long call spread (long bull call spread)
This is the intrinsic Matrix for short call spread
This is the Payoff graph for the short call spread
This is the intrinsic table for the long put spread A.k.a. the bear spread using puts or long 65 puts and short 60 puts
Payoff profile of the long 60-65 put spread
intrinsic value of the 60-65 put spread at expiration
This is the payoff graph for the short 60-65 put spread
Volatility spreads are not the same as trading volatility. Volatility spreads get their name because the trader is either looking for the market to move big in either direction or not move at all. Because you can make (lose) money in either direction, they were dubbed volatility spreads. Collectively, they’re straddles, strangles or butterflies. Speculators use volatility spreads when they have a view as to how wide the market will swing. Investment managers use volatility spreads by selling calls and puts against long stock. If the stock goes down, they buy more stock at the put strike. If the stock goes up, they sell the stock (or some of the stock) they already own. This is the intrinsic table for a long straddle position: long 65 calls & puts
Payoff profile of the long straddle described above
Below is the intrinsic matrix for the short 65 straddle
Payoff graph for the short straddle described above
PAYOFF GRAPH – SHORT STRADDLE 60p – 70c Intrinsic matrix long strangle (60 put & 70 call)
The payoff profile for the long 60p + 70c strangle
Intrinsic matrix for short 60-70 strangle
Payoff graph of the short 60p-70c strangle
Butterflies have three legs. We talked about being long the straddle or strangle. When we were long we would make money is the asset moved BIG. With butterflies, it’s the opposite. Long a 60-65-70 butterfly makes the most money when the stock doesn’t move from the ATM strike. But if it does move, you lose small. This payoff can be seen in the payoff graph below.
With a short butterfly you want the stock to trade in a wide range up or down. A butterfly’s payoff profile is the opposite of the straddle or strangle. Recall with the straddle & strangle, the short position is when we wanted the stock to stay still. With the short butterfly, we want a wide range in order to make money.
This brief overview is meant to give you a glance at the normal strategies people use and why they’re using them. As you saw some of their strategic choices are limited by regulation, but for the most part, once the portfolio managers were on board, it was easier to speak to their client.
Arb’s or Market Makers, trading options is how they earn their living. They’re waiting patiently for their salespeople to get clients interested. They respond to client interest by making a market (a bid & offer) to the client. While they wait, they buy coffee for the sales team and treat them to lunch at noon. (caught ya… were you napping? Didjya believe it? Don’t)
In the 1980’s I was an options market maker, the only reasonable way to manage our risk was to trade volatility (Gamma Scalping or Skew Capture). As the market grew and became more efficient, I headed to the bond markets and left the floor.
“we pick up nickels in front of bulldozers. When the nickels turn to pennies, we find another game to play.” For me, that was a move up to our government securities and swaps sales team as the derivative specialist supporting the bond salespeople. I’d like to show a simple example of a gamma scalping setup.