Winning Options Trading System
Every options trader needs to be familiar with the basic features of the market. This section explores the action that takes place on the market floor and the ways in which traders away from the exchange can have their orders executed on the exchange. From its image in the popular press and television, one gets the impression that the exchange floor is the scene of wild and chaotic action. While the action may become wild, it is never chaotic. Understanding the role of the different participants on the floor helps dispel the illusion of chaos. Essentially, there are three types of people on the exchange floor traders, clerical personnel asso-
If a company has a foreign-currency receivable or a foreign-currency payable, the options market hedge can protect the company from exchange rate fluctuations. By buying a call option on the foreign currency, a US company can lock in a maximum dollar price for its foreign-currency accounts payable. By purchasing a put option on the foreign currency, the company can lock in a minimum dollar price for its foreign-currency accounts receivable. Companies understand that hedging techniques such as the forward market hedge and the money market hedge can backfire or may even be costly when an accounts payable currency depreciates or an accounts receivable currency appreciates over the hedged period. Under these circumstances, an uncovered strategy might outperform the forward market hedge or the money market hedge. The ideal type of hedge should protect the company from adverse exchange rate movements but allow the company to benefit from favorable exchange rate movements. The options market...
Many options trading desks have their own proprietary term structure models to value fixed income options. If customers want to know the volatility at which they are buying or selling options, these trading desks have a problem. Quoting the volatility inputs to their proprietary models does not really help customers because they do not know the model and have no means of generating prices given these volatility inputs. Furthermore, the trading desk may not want to reveal the workings of its models. Therefore, markets have settled on various canonical models with which to relate price and volatility. In the bond options market, Black's model, a close relative of the Black-Scholes stock option model, is used for this purpose. As discussed in Chapter 9, direct applications of stock option models to bonds may be reasonable if the time to option expiry is relatively short. Further details are not presented here other than to note that Black's model assumes that the
In this section, we consider the most important facets of the options market in the United States. We begin by considering the exchanges where options trade. We then consider an extended example to see how to read option prices as they appear in the Wall Street Journal. We conclude this section by analyzing the market activity in the different types of options that are traded on the various exchanges.
The Black-Scholes formula is useful even if one has doubts about the validity of the underlying geometric Brownian model. For as long as one accepts that this model is at least approximately valid, its use suggests the appropriate price of the option. Thus, if the actual trading option price is below the formula price then it would seem that the option is underpriced in relation to the security itself, thus leading one to consider a strategy of buying options and selling the security (with the reverse being suggested when the trading option price is above the formula price). However, one downside to the Black-Scholes formula is that its very usefulness and computational simplicity has led many to automatically assume the underlying geometric Brownian motion model as a result, relatively little effort has gone into searching for a better model. In Chapter 10 we show that real data cannot aways be fit by a geometric Brownian motion model, and that more general models may
Hynes (Appendix B) is Managing Director and cofounder of R.W. Pressprich & Co., Inc., a fixed income broker dealer located in New York City. He also serves as the firm's Chief Market Strategist. Mr. Hynes is a futures and options trader and a CTA (Commodity Trading Advisor). He has an MBA in Finance from the University of Houston.
The first formal options market was the Chicago Board Options Exchange (CBOE), begun in 1973. Soon after, several exchanges introduced options contracts to their product lines. Now options are traded on such exchanges as the CBOE, the Chicago Board of Trade (CBOT), the Pacific Stock Exchange, the Philadelphia Stock Exchange, and the American Stock Exchange. As an indicator of the growing interest in options, we note that the dollar value of options traded annually on the CBOE now exceeds the value of the stocks traded annually on the AMEX. Options are traded on both exchanges and in the over-the-counter market, with most of the recent growth in the over-the-counter market.
There are alternatives to selling short in the cash market. An investor seeking to benefit from an anticipated decline in the price of a stock, broad-based stock market index, or narrow-based stock market index (e.g., a sector or industry) may be able to do so in the futures or options markets. Selling futures has several advantages to selling short in the cash market. Buying puts and selling calls are two ways to implement a short-selling strategy in the options market. There are trade-offs between buying puts, selling calls, and borrowing the stock in the cash market in order to sell short. The relative merits of using futures and options for short selling, along with a review of futures and options and their investment characteristics, are covered by Frank Fabozzi in Chapter 3.
Options, like other financial instruments, may be traded either on an organized exchange or in the over-the-counter (OTC) market. The advantages of an exchange-traded option are as follows. First, the exercise price and expiration date of the contract are standardized. Second, as in the case of futures contracts, the direct link between buyer and seller is severed after the order is executed because of the interchange-ability of exchange-traded options. The clearinghouse associated with the exchange where the option trades performs the same function in the options market that it does in the futures market. Finally, the transactions costs are lower for exchange-traded options than for OTC options. The higher cost of an OTC option reflects the cost of customizing the option for the many situations where a corporation seeking to use an option to manage risk needs to have a tailor-made option because the standardized exchange-traded option does not satisfy its objectives. Some commercial...
Because buying options can generate only profits (at worst zero) at expiration, an option contract must be a valuable asset (or at worst have zero value). This means that a payment is needed to acquire the contract. This up-front payment, which is much like an insurance premium, is called the option premium. This premium cannot be negative. An option becomes more expensive as it moves in-the-money.
When you invest in futures and options, you must be prepared for a bumpy ride. The futures and options market is not for the amateur investor. You can make a lot of money in these financial markets, but you could also lose more than your shirt. If you want to protect your investments, consider dabbling in the options market. Options, like futures, have an expiration date and can help protect your portfolio. Call options allow investors the right but not the obligation to buy the underlying security (typically stock) at a set price (the strike price) for a particular period of time. Put options, on the other hand, give you the right yet not the obligation to sell the underlying security at a set price for a particular period of time.
We can use our illustration of the producer of crude oil and the user of crude oil to explain how buying options can be used. Suppose that there are options on crude oil. Management of the producer of crude oil wants to set a minimum price it will have to pay for crude oil two months from now. It does so by buying a put option on crude oil. The exercise price for the put option is the price that management can sell crude oil. Suppose the exercise price for a put option on crude oil that expires in two months is 19. Then if two months from now crude oil falls below 19, say to 17, then management will exercise the put
WHY TRADE OPTIONS Options trading today is more popular than ever before. For the investor, options serve a number of important roles. First, many investors trade options to speculate on the price movements of the underlying stock. However, investors could merely trade the stock itself. As we will see, trading the option instead of the underlying stock can offer a number of advantages. Call options are always cheaper than the underlying stock, so it takes less money to trade calls. Generally, but not universally, put options are also cheaper than the underlying goods. In relative terms, the option price is more volatile than the price of the underlying stock, so investors can get more price action per dollar of investment by investing in options instead of investing in the stock itself. Options are extremely popular among sophisticated investors who hold large stock portfolios. Accordingly, institutional investors, such as mutual funds and pension funds, are prime users of the options...
The Chicago Mercantile Exchange (CME), known as The Merc, was founded in 1919 as a nonprofit organization to trade spot and futures commodity contracts. In 1972, the CME introduced futures trading in foreign currencies through the International Monetary Market (IMM) as an alternative to regular forward contracts offered by commercial banks. Most major exchanges around the world have added currency futures in recent years. They include the Philadelphia Board of Trade, the New York Board of Trade, the Deutsche Termin Borse in Frankfurt, the Hong Kong Futures Exchange, the London International Financial Futures Exchange, the New Zealand Futures Exchange, the Singapore International Monetary Exchange, the Stockholm Options Market, the Tokyo International Financial Futures Exchange, the Mer Der Exchange in Mexico, the BM&F Exchange in Brazil, the Budapest Commodity Exchange, and the Korean Futures Exchange.
Hedging in the call options market MNCs with open positions in foreign currencies can utilize currency call options. Suppose that an American firm orders industrial equipment from a German company, and its payment is to be made in euros upon delivery. A euro call option locks in the rate at which the US company can purchase euros for dollars. Such an exchange between these two currencies at the specified strike price can take place before the settlement date. Thus, the call option specifies the maximum price that the US company must pay to obtain euros. If the spot rate falls below the strike price by the delivery date, the American firm can buy euros at the prevailing spot rate to pay for its equipment and can simply let its call option expire.
Now we will take the exact same trades, only, using the Black-Scholes stock option pricing model from Chapter 5, we will convert the entry prices to theoretical option prices. The inputs into the pricing model are the historical volatility determined on a 20-day basis (the calculation for historical volatility is also given in Chapter 5), a risk-free rate of 6 , and a 260.8875-day year (this is the average number of weekdays in a year). Further, we will assume that we are buying options with exactly .5 of a year left till expiration (6 months) and that they are at-the-money. In other words, that there is a strike price corresponding to the exact entry price. Buying long a call when
Many attribute the rise in gold prices from 2004 to 2007 to the demand for the metal resulting from these funds. Previous to the GLD launch gold investing for investors was confined to futures and options trading the leverage and continuous contract rollover was off-putting to most individual investors , precious metals stocks which also could be dissatisfying due to the unreliability of various company prospects , and numismatic coin collections marked by heavy sales expenses and little liquidity . A liquid ETF tracking the price movement of gold overcame previous gold investing deficiencies. It shouldn't be too surprising that subsequently the more speculative and volatile silver issue, SLV iShares Silver ETF was launched in April 2006.
Our coverage of open interest has concentrated on the futures markets. Open interest plays an important role in options trading as well. Open interest figures are published each day for put and call options on futures markets, stock averages, industry indexes, and individual stocks. While open interest in options may not be interpreted in exactly the same way as in futures, it tells us essentially the same thing where the interest is and the liquidity. Some option traders compare call open interest (bulls) to put open interest (bears) in order to measure market sentiment. Others use option volume.
You can buy or sell options retail on specialized options exchanges, or you can trade them with wholesalers, that is, the dealers. Options dealers make markets in options they accomodate clients by buying options from those who want to sell them and selling options to those who want to acquire them. How, then, do dealers handle the risk they are forced to assume
This is where using options in a trading strategy is so useful. Either buying a put or call outright in opposition to the underlying position to limit the loss to the strike price of the options, or simply buying options outright in lieu of the underlying, gives you a floor, an absolute maximum loss. Knowing this is extremely handy from a money-management, particularly an optimal f, standpoint. Further, you know what your maximum possible loss is in advance (e.g., a day trade), then you can always determine what the f is in dollars perfectly for any trade by the relation dollars at risk per unit optimal f, For example, suppose a day trader knew her optimal f was .4. Her stop today, on a l-unit basis, is going to be 900. She will therefore optimally trade 1 unit for every 2,250 ( 900 .4) in account equity.
Estimating the standard deviation of the stock's returns is more difficult and more important than estimating the risk-free rate. The Black-Scholes model takes as its input the current, instantaneous standard deviation of the stock. In other words, the immediate volatility of the stock is the riskiness of the stock that affects the options price. The Black-Scholes model also assumes that the volatility is constant over the life of the option.7 There are two basic ways to estimate the volatility. The first method uses historical data, while the second technique employs fresh data from the options market itself. This second method uses options prices to find the options market's estimate of the stock's standard deviation. An estimate of the stock's standard deviation that is drawn from the options market is called an implied volatility. We consider each method in turn.8
The currency options market shares its origins with the new markets in derivative products, which have blossomed in recent years. They were developed to cope with the rise in volatility in the financial markets world wide. In the foreign exchange markets, the dramatic rise (1983-1985) and the subsequent fall (1985-1987) in the dollar caused major problems for central banks, corporate treasurers, and international investors alike. Windfall foreign exchange losses became enormous for the treasurer who failed to hedge, or who hedged too soon, or who borrowed money in the wrong currency. The investors in the international bond market soon discovered that the risk on their bond positions could appear insignificant relative to their currency exposure. Therefore, currency options were developed, not as another interesting off-balance-sheet trading vehicle but as an alternative risk management tool to the spot and forward foreign exchange markets. They are a product of currency market...
As pointed out above, we will analyze the Bund future options market. Our data set of daily closing prices for the Bund future starts at the beginning of 1988 and runs through August 1995. We follow standard procedures and take futures prices for those series only for which the time to maturity is larger than one month. This gives us a consistent series, that is, however, not stationary. Hence, instead of using the prices we employ returns series.
Writing options on exchanges tends to be simpler as the credit risks are controlled by a margin system. The margin is a small percentage of the value of the contract, which must be deposited to cover losses up to a certain limit. The margin is usually adjusted on each trading day and, on occasions, more frequently to take account of market movements. However, the greater flexibility available in the OTC market allows some of the credit difficulties to be pursued and overcome. Participants in the foreign exchange currency options market include
What we mean by highly leveraged is that on equal dollar investments, an option investor has the potential to make significantly higher profits on the options than on the underlying asset. This applies to losses as well, except that the loss on an option is limited to the premium paid. (You will be able to see all of this clearly using some of the models we will develop.)
Most short sellers over the past two decades have found that the options market has offered more opportunity to prosper from both long and short positions. Options eliminated many of the drawbacks of actually shorting an individual stock, but they introduced even more risks. Option premiums and expirations have become too complex for average investors, and most individuals dealing in options have lost money, and continue to lose.
Several exchanges trade options on stock indices. Some of the indices used track the movement of the U.S. stock market as a whole. Some are based on the performance of a particular sector (e.g., mining, computer technology, and utilities). Some are designed to track the performance of a foreign stock market.
In his 1995 book, Point & Figure Charting (John Wiley & Sons), Thomas J. Dorsey espouses the Chartcraft method of 3 point reversal charting of stocks. He also discusses point and figure application to commodity and options trading. In addition to explaining how to construct and read the charts, Dorsey also shows how the P&F technique can be applied to relative strength analysis, sector analysis, and in the construction of an NYSE Bullish Percent Index. He shows how p&f charts can be constructed for the NYSE advance decline line, the NYSE High-Low Index, and the percentage of stocks over their 10 and 30 week averages. Dorsey credits Michael Burke, the publisher of Chartcraft, (Chartcraft, Inc., Investors Intelligence, 30 Church Street, New Rochelle, N.Y. 10801) with the actual development of these innovative p&f indicators which are available in that chart service.
The question then is, how does a trader characterize an option using these hedging gains First of all, in liquid option markets the order flow determines the price and the trader does not have to go through a pricing exercise. But still, can we use these trading gains to represent the frame of mind of an options trader
Options trading by trend followers reinforces the behavior of market timers. When the market is trading within a channel, traders will sell put and call options at strike prices that represent the lower and upper bounds of the channel. As long as the market remains within the channel, these speculators collect premiums as the options expire worthless.
We now explore the application of the Merton model to pricing options on a foreign currency. We assume that we are looking at the issues from the point of view of a U.S. options trader. In terms of the Merton model, the dollar value of the foreign currency takes the role of the stock price, S and the foreign interest rate takes the role of the continuous dividend
Well, there is an entire market called the options market that helps these transactions go through. For every option holder there must be an option seller. This seller is often referred to as the writer of the option. So selling a put option is called writing a put. Anyone who owns the underlying asset, such as an individual or a mutual fund can write options.
Using your favorite mathematics computer program, enter the Black-Scholes options pricing model. Enter the parameters for a recently traded, active option to solve for the price. Then vary the five parameters that affect the price. How much does the options price vary as each parameter is varied How would this affect your options trading system, if you had one
When options were first traded, contracts were arranged between pairs of investors and customized to meet specific needs. These customized contracts could vary according to exercise price, expiration date, and underlying asset. Because of these infinite possibilities, it was nearly impossible for a secondary options trading market to exist. Investors would enter into customized agreements according to their investment needs if their needs changed, it was difficult to find another investor to buy the option contract. Another important event occurring with the establishment of standardized option contracts was the creation of the Option Clearing Corporation (OCC). The OCC is the clearinghouse for options trading. It is the single guarantor of all the options listed on the options exchange. With the OCC in place, an option buyer need not be concerned with counterparty risk (lack of performance, for example).
The diagram on the right side of Figure 10.1 is the payoff profile for the call option writer. In this case, the writer receives the price of the call option up front. Essentially, the writer is making a bet that the price of the underlying stock will not rise above the exercise price. If the bet is correct, the holder of the option will never exercise the option and the writer has the premium as profit. Options trading is a zero-sum transaction any profits gained by one counterparty are exactly matched by losses incurred by the other counterparty. Option transactions take place electronically through the OCC and its member brokers. The clearinghouse processes all transactions and acts as the counterparty on both sides of an option contract to ensure performance. If an option holder exercises an option, the OCC randomly assigns an exercise notice to a broker's account that reflects the writing of the same option. The broker then assigns the notice to one of its clients (option...
12 No Arbitrage Warm-up and a Joke The reader might argue that no arbitrage is nonsense. If one cannot do better than buying treasuries that produce a risk-free rate, why would people go to the trouble of buying options and dynamically hedging them with stock Why should we assume that time-averaged stock returns are equal to the risk-free rate, when we all know that stock is riskier than debt, so the stockholder deserves a greater return than the bondholder (who because of corporate credit risk, already receives a coupon above the risk-free rate). Nonetheless, options are priced using no arbitrage. The answers to the questions are what you need to understand to become a quant or a trader. In practice, the option volatility is backed out from interpolating values of the volatility needed to obtain agreement with options trading in the market this defines the implied volatility. Only a small fraction of possible options actually trade - and your option may not trade at all - so the...
You can see that by buying options Petrochemical protects itself against increases in the oil price while continuing to benefit from oil price decreases. If prices fall, it can discard its call option and buy its oil at the market price. If oil prices rise, however, it can exercise its call option to purchase oil for 20 a barrel. Therefore, options create an attractive asymmetry. Of course, this asymmetry comes at a price the 500 cost of the options.
The average investor has no interest in putting on large leveraged positions. For most this type of trading was too stressful and overwhelming. The only avenue for retail investors to raise the risk level of their investment activity was investing in futures and options trading directly or through an investment in a managed futures fund. But even these ventures were too risky for most.
Ogtions on stocks were first traded on an organized exchange in 1973. Since then, there has been a dramatic growth in options markets. Options are now traded on many different exchanges throughout the world. Huge volumes of options are also traded over the counter by banks and other financial institutions. The underlying assets include stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts. r w j 'Note that the terms American and European do not refer to the location of the option or the exchange. Some options trading on North American exchanges are European.
If an options trader fails to perform as promised, the OCC absorbs the loss and proceeds against the defaulting trader. Because the OCC is a buyer to every seller and a seller to every buyer, it has a zero net position in the market. It holds the same number of short and long positions. Therefore, the OCC has very little risk exposure from fluctuating prices.
Even though the commission per dollar of options traded may be higher than for stocks, there can be significant commission savings in trading options. In our example, the option price is 6.50 per share of stock. The share price might well be 100 or more. If it were 100, trading 500 shares would involve a transaction value of 50,000. Commissions on a stock transaction of 50,000 would be much higher than commissions on our option transaction. Trading the option on a stock and trading the stock itself can give positions with very similar price actions. Therefore, options trading can provide commission savings over stock trading. This principle holds, even though options commissions tend to be higher than stock commissions for a given dollar transaction.
Disposition of an option, either through sale, exercise, or expiration gives rise to a profit or loss. Profits and losses on options trading are treated as capital gains and losses. Therefore, options profits and losses are subject to all the regular rules that pertain to all capital gains and losses. Capital gains may be classified as long-term or short-term capital gains. A capital gain is a long-term gain if the instrument generating the gain has been held longer than one year, otherwise the gain or loss is short-term. In general, long-term capital gains qualify for favorable tax treatment. There are other special and more complicated rules for taxing options transactions, so the account here is not definitive. Additional complications arise for some options on stock indexes, for example. Also, there are special tax rules designed to prevent options trading merely to manipulate taxes.
This chapter has introduced the options market. In the short time since options started trading on the Chicago Board Options Exchange, they have helped to revolutionize finance. They permeate the world of speculative investing and portfolio management. Corporations use them in their financing decisions to control risk. Beyond their uses as trading vehicles, options provide a new way to analyze many financial transactions. The chapters that follow build an understanding of the options revolution on several levels. Foremost, we seek to build an understanding of options trading and speculating as a topic that is interesting in its own right. However, by following the argument of this book, the reader will develop skills in financial thinking that will apply to many problem areas. After completing the book, the careful reader should even be able to analyze many financial problems using an options framework. At that point, the reader has become part of the options revolution.
Therefore the promoted benefit is not being realized thoroughly by retail investors. When we presented this problem repeatedly to exchanges and sponsors they pointed to the brokers as the problems. So did the specialists. And so the buck-passing continued. In fact the exchanges just suggested that retail investors finding difficulty shorting should just turn to the options market. In my opinion, most options strategies available were never satisfactory and here I speak as an options principal. Besides options strategies were more lucrative financially to the exchange than if they had to work at helping fulfill the promoted shorting benefit.
A more subtle issue is that it is not the past volatility that matters. It is the volatility that occurs during the life of the option which will cause hedging costs and the option should be priced thereby. The trader therefore has to estimate the future volatility. This could be based on market prices, past performance and anticipation of future news. It is important to realize that often announcements are expected in advance, and the information they contain will either push the asset up or down. The market knows that the asset price will move but cannot discount the information as it does not know whether it is good or bad. The options trader on the other hand does not care whether the information is good or bad, all he cares about is whether the asset price will move. Thus the anticipation of an announcement will drive estimated vols up. The trading of options is therefore really about the trading of vol, and the options trader is taking views on the future behaviour of volatility...
There are two alternatives available to the US company do not hedge, or hedge in the options market. If the US company does not want to cover its open position, it would wait for 4 months, buy francs at the prevailing exchange rate in the spot market, and use these francs to pay for its imports. If the bank's forecast is accurate, the US company will spend 375,000 to purchase SFr625,000 at the spot rate of 0.6000. The price of 10 franc call options is 187.50 (0.03 cents x 10 options x 62,500 units per contract). If the US company decides to hedge its position in the options market, on June 1 it would exercise its right to buy SFr625,000 for 312,500 ( 0.500 x SFr625,000). Consequently, the US firm would spend a total of 312,687.50 ( 187.50 + 312,500) to purchase SFr625,000. By doing so, the American firm would avoid the risk of a 62,312.50 loss ( 375,000 - 312,687.50). Still, if the future spot rate for francs remains below the strike price of 0.5000, the US company can let its options...
The quoted price is the price of an option to buy or sell 1 share. As mentioned earlier, one contract is for the purchase or sale of 100 shares. A contract therefore costs 100 times the price shown. Since most options are priced at less than 10 and some are priced at less than 1, individuals do not have to be extremely wealthy to trade options.
The big potential profit from these trades is from gamma, in other words, large moves in the underlying, rather than changes in implied vol. One promising name announced in mid-February that manufacturing process and control issues have led to reduced sales of certain products in the U.S., which it expected to influence its first quarter and full-year sales and earnings. On Friday, options maturing in August had a mid-market implied vol of around 43 , which implies a 2.75 move in the stock per trading day. Over the last month, the stock has been moving on average 3 a day, which means that by buying options on the company, you're getting vol cheap. (Derivatives Week, April 1, 2001)
Options trading is in many respects similar to futures trading (see Chapter 2). An exchange has a number of members (individuals and firms) who are referred to as having seats on the exchange. Membership of an exchange entitles one to go on the floor of the exchange and trade with other members.
Created by buying options with strike prices Xi and X3 and selling two options with strike price X2 where Xi X2 X3 and X3 X2 X2 X . Figure 8.13 shows the payoff from a butterfly spread. This could be described as a spike. As Xi and X3 become closer together, the spike becomes smaller. By judiciously combining together a large number of very small spikes, any payoff function can be approximated.
In this paper we employ volatility forecasts to evaluate the profitability of option trading strategies. We first present several volatility models theoretically and then use these specifications to empirically evaluate the efficiency of the Bund future options market. It turns out that volatility forecasts based on historical returns are capable of adding value when used together with simple trading rules. We derive profits for several different variations of the trading rule and find in all cases abnormal returns.
With options trading on an exchange, Galai had access to daily price quotations. Therefore, he was able to compute the rate of return on the hedged option-stock portfolio for each option for each day. He also adjusted the hedge ratio each day to maintain the neutral hedge neutral in the sense that a change in the stock price would not change the overall value of the combined optionstock position. Comparing market prices to Black-Scholes model prices, Galai assumed that he sold overpriced options and bought underpriced options each day.
Since the price of an option depends on several variables, it will change with changes in the value of any of those variables. Option investors and traders as well as those who use options to hedge their portfolios need to understand and measure the impact of changes in the different variables on the price of options. At the simplest level, the holder of an option wants to know how much the value of his option will change if the stock price changes by one dollar or how fast the value of his option will deteriorate with the passage of time. At more complex levels, these sensitivities are used to measure and control the risks of large portfolios with respect to the different variables. For example, financial institutions who hold large portfolios that include enormous positions in derivatives need to estimate how the values of their portfolios would change if volatility went up or down sharply and decide how much of that risk they should hedge and how they should do so.
A kurtosis trading strategy is supposed to exploit differences in kurtosis of two distributions by buying options in the range of strike prices where they are underpriced and selling options in the range of strike prices where they are overpriced. More specifically, if the implied SPD f * has more kurtosis than the time series SPD g*, i.e. kurt(f*) kurt(g*), we sell the whole range of strikes of FOTM puts, buy the whole range of strikes of NOTM puts, sell the whole range of strikes of ATM puts and calls, buy the whole range of strikes of NOTM calls and sell the whole range of strikes of FOTM calls (K1 trade). Conversely, if the implied SPD has less kurtosis than the time series density g*, i.e. kurt(f*) kurt(g*), we initiate the K2 trade by buying the whole range of strikes of FOTM puts, selling the whole range of strikes of NOTM puts, buying the whole range of strikes of ATM puts and calls, selling the whole range of strikes of NOTM calls and buying the whole range of strikes of FOTM...
Although ETFs and index futures are very important to investment professionals and institutions, the options market has caught the fancy of many investors. And this is not surprising. The beauty of an option is embedded in its very name you have the option, but not the obligation, to buy or sell stocks or indexes at a given price by a given time. For the option buyer, this option, in contrast to the futures, automatically limits your maximum liability to the amount you invested.
There are many recorded examples of fantastic gains in puts and calls. But for every option that gains so spectacularly in value, there are thousands of options that expire worthless. Some market professionals estimate that 85 percent of individual investors who play the options market lose money. Not only do options buyers have to be right about
It has been argued that implied bias will persist only if it is difficult to perform arbitrage trades that are needed to remove the mispricing. This is more likely in the case of stock index options and less likely for futures options. Stocks and stock options are traded in different markets. Since trading of a basket of stocks is cumbersome, arbitrage trades in relation to a mispriced stock index option may have to be done indirectly via index futures. On the other hand, futures and futures options are traded alongside each other. Trading in these two contracts are highly liquid. Despite these differences in trading friction, implied biasedness is reported in both the S&P100 OEX market (Canina and Figlewski, 1993 Christensen and Prabhala, 1998 Fleming, Ostdiek and Whaley, 1995 Fleming, 1998) and the S&P500 futures options market (Feinstein, 1989b Ederington and Guan, 1999, 2002). Unbiasedness of implied forecast was not rejected in the Swedish market (Frennberg and Hansson, 1996)....
Black and Scholes and Galai have tested whether it is possible to make excess returns above the risk-free rate of interest by buying options that are undervalued by the market (relative to the theoretical price) and selling options that are overvalued by the market (relative to the theoretical price).16 A riskless delta-neutral portfolio is assumed to be maintained at all times by trading the underlying stocks on a regular basis as described in Section 13.5. Black and Scholes used data from the over-the-counter options market where options are dividend protected. Galai used data from the Chicago Board Options Exchange (CBOE) where options are not protected against the effects of cash dividends. Galai used Black's approximation as described in Section 10.14 to incorporate the effect of anticipated dividends into the option price. Both of the studies showed that, in the absence of transactions costs, significant excess returns over the risk-free rate could be obtained by buying...
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