Derivative Products

Market Participants & Option Strategies

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 OPTION STRATEGIES

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

MARKET PARTICIPANTS & THEIR USE OF OPTIONS

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:

• unleveraged users of derivatives, use all of the products to hedge risk,
  • Leveraged users use them to generate profits.
  • Leveraged user’s profit rates look very large, distorted by the leverage-factor of all derivative products.

CORPORATIONS

Corporations use Equity options on their own stock as well as those they own or are interested in purchasing. For example:

1. Issue Convertible Bonds: Low rated corporations will add an equity ‘kicker’.
2. Issue warrants (typically I conjunction with stocks (called units)
3. They purchase calls when they have a share repurchase program.
4. Executive Stock Options can also be hedged with respect to the price of the common stock.
5. Buy calls on stocks in which they’d like to purchase a minority stake. Trading desks called this a “starter kit”.
6. Industrial hedges (i.e. Energy): hedging volatile businesses or products, writing a forward contract with another side of the business.
7. Financial hedges: (i.e. Energy) hedging volatile businesses using futures.
8. Here we’ve described the way they use equity options which is not a large % of their total interest in option products.
9. Today, they are seen as the participant to use most asset classes to hedge their risk.

INVESTMENT MANAGERS

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

1. To gain a little income by selling options (yield enhancement):
   1. Sell calls versus long stock positions – with a systematically defined strategic way: Buy-Write, Put-Write, etc.
   2. Sell OTM puts – used when the manager likes the stock and wants to continue buying as it trades lower

1. To protect long positions (portfolio insurance)
   1. Buy out of the money puts vs. Long stock
   2. long Put graph + Long Stock = the payoff profile looks like the Synthetic Long call
   3. Buy at or in the money calls instead of long stock
   4. Called an “anticipatory hedge”; managers purchase calls in advance of receiving more money to invest.

SPECULATORS

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

1. Make money on a directional move:
   1. Buying options

1. Vertical Spreads: limited risk, limited reward
   1. Buy a call spread:
   2. Buy a put spread
   3. Sell a call spread
   4. Sell a put spread
2. Volatility Spreads: Straddles and Strangles
   1. Long straddle
   2. Short straddle
   3. Long strangle
   4. Short strangle
3. Volatility Spreads: Butterflies & Iron Condors
   1. Long Butterfly
   2. Short Butterfly
   3. Long Iron Condor
   4. Short Iron Condor

ARBITRAGEURS

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.

1. To extract price risk and profit from long or short volatility
   1. Gamma scalping
   2. Skew trading

N.B.: Gamma Scalping & Skew Trading are covered in detail in the advanced portion of the site.

PART TWO: PAYOFF GRAPHS FOR EACH STRATEGIC USE

• We illustrate each strategy at expiration with an intrinsic table
• We also draw a graph of the same intrinsic results.

These payoff profiles also called Hockey sticks are an easy visual for the risk & reward of each strategy.

INVESTMENT MANAGERS: YIELD ENHANCEMENT STRATEGIES

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:

1. the option is in the money and the call seller needs to deliver the stock, generating the premium income.
2. The option is out of the money and the call seller keeps the premium.  The Investment Manager is long stock and the price is lower.
   1. But the cost basis of the stock has gone down due to the options premium received.

BUY-WRITE

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.

1. At expiration, if the call is in the money, the short call will be assigned, and the long stock will be delivered against the short call.
2. At expiration, if the call is out of the money, the short call will expire worthless. The premium received directly reduces the cost basis and continue to own the stock.

CASH SECURED PUT WRITE

A pension plan, mutual fund or even a small retail account can sell puts (usually out-of-the-money) with the goal being to

1. buy the stock at the strike price if the stock is below the strike on expiration day.
2. keep the premium if the stock close above the strike price at expiration. The downside is you don’t buy the stock if the stock goes up a lot more than the premium you received after expiration.

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.

1. At expiration, if the put is in the money, short will be assigned and long stock will be delivered when the strike price is paid.
2. At expiration, if the put is out of the money, the short will expire worthless. The premium received will enhance the performance of the short’s portfolio.

INVESTMENT MANAGERS: OPTION STRATEGIES – PROTECTIVE STRATEGIES

PORTFOLIO INSURANCE

Long Stock @ $65 Long 65 Put @ 3.00 Current price of stock = $65 per share MAXIMUM PROFIT POTENTIAL = Unlimited (upside)

• MAXIMUM RISK = Limited (strike – stock purchase price) + premium paid
• MAXIMUM RISK = (65 – 65) + 3.00 = $68.00
• BREAKEVEN POINT = Strike price + premium Paid for Put
• BREAKEVEN POINT = 65 + 3.00 = 68.00

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.

INVESTMENT MANAGERS & SPECULATORS USE VERTICAL SPREADS:

VERTICAL SPREADS

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.

• Purchasing or selling the vertical spread depends on whether the net premium is paid or received.
• If the net premium is paid = Long Vertical Spread; If the net premium is received = Short Vertical Spread.
• Vertical spreads use both puts and calls.

EXAMPLE: LONG VERTICAL CALL SPREAD

Long 65 call @ $3.40 Short 70 call @ $1.40 = NET PREMIUM PAID $2.00

• Note the long 65 call has positive numbers when the option is in the money at expiration.
• Note the short 70 call has negative numbers when the option in in the money at expiration.
• The last column on the right has two important figures
• On top of the last column is the net premium paid or receive for the spread.
• Then the intrinsic value of the spread is adjusted for the premium paid or receive.

Following with your finger from left to right, with the stock at 66, the 65 call is worth $1 on expiration night.

• The 70 call is worth zero.
• The net premium for the spread is +1.
• The net premium we paid for the spread was -2, leaving a P/(L) of $1.00 as you look up at the higher price, you’ll not you make money as the stock goes up $1 for $1.
• Note the net premiums with the stock at 75: 65 call is worth $10; the 70 call is worth $5.
• The net spread is $5.00.
• That’s as much as this spread can ever be worth: the difference between the strikes (+/-) the net premium on the spread.

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

SPECULATORS & INVESTMENT MANAGERS

VOLATILITY SPREADS

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

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.

OPTION STRATEGIES – SUMMARY & CONCLUSION

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.

• Corporations must provide details of all their derivatives positions in the 10Q- & 10K respectively. Corporations took the longest time to complete their documentation. Because they needed to receive approval from each portfolio manager and then from each client whose strategy was right for the use of options, it was a long process from sending docs out and receiving them back.
• Investment managers are required to get approval from the client to use options in their account.  If the vehicle is a fund the use of options is in the prospectus.  Investment managers tend to use options for yield enhancement (buy-writes & OTM put writes) and buying protective puts.
• Speculators use of options can be defined by the KYC (Know Your Customer) process approving the client for a level of options usage consistent with their experience and knowledge of options, their overall goals as well as their capital. Presuming the client can use all strategies, speculators like to trade options around earnings announcements; sell vertical spreads (or Iron condors).  For speculators, the range of uses is wide and varied.  Using the charts above give you the basic strategies.

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.