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D E T A IL E D E X P L A N A T IO N O F T HE
AND ARBITRAGE CONVERSION
AN AGGRESSIVE STRATEGY
AN INVESTING NEWSLETTER
…OFFERING IMPERSONAL, GENERAL AND INDIRECT OPINION
…an investing newsletter of general, impersonal and indirect opinion
Short/Long Derivatives Hedge, an Aggressive Strategy
Copyright © 2010, 2009 Hedge Strategies, AN INVESTING NEWSLETTER
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ISBN 145376349X EAN 978-1-453-76349-0 1. Hedge-Fund 2. Hedgefund 3. Derivatives 4. Short-Long 5. Short 6. Long 7. Investing 8. Strategies 9. Trading 10. Hedged-Box 11. Short-Against-The-Box 12. Options 13. Exchange-Traded-Fund 14. ETF 15. Arbitrage 16. Conversion 17. Reversal 18. Collar
Printed in the United States of America This report is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, re-sold, hired out, posted, broadcast, or otherwise circulated without the prior consent of Hedge Strategies, An Investing Newsletter, in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser.
They derive their value from the movement of another security (referred to as the underlying 3 . but they can learn the strategies that hedge funds employ for the investment accounts of wealthy clients and apply that knowledge for their own benefit. The most important advantage is hedging an investment account against loss from falling security prices and falling markets. Boosting Long/Short Ratio Returns And Hedging With Derivatives There has never been a better time to seek help from a superhero than when the return results of a particular strategy prove to be underwhelming. impersonal and indirect opinion Short/Long Derivatives Hedge. an Aggressive Strategy STRATEGY DESCRIPTION AND EXPANATION For The Short/Long Derivatives Hedge Aggressive Strategy The mission of the Hedge Strategies newsletter is to educate the average American to the investing advantages enjoyed by the wealthy. The first report in this two-part series. structure cross-hedged derivative ratio spreads and take advantage of arbitrage opportunities to earn derivative income with zero loss of principal risk. What Are Derivatives? Derivatives are contracts or obligations that are bought or sold in trading markets.Hedge Strategies …an investing newsletter of general. increase non-linear market returns and leverage gains with margin to outperform the market benchmark. Derivatives are a leveraging tool that can boost investment position returns on ratios using primary securities as the investment vehicle. limit market exposure. Long Short Margin Ration Hedge. explains how primary securities (stocks and non-leveraged exchange traded funds (etfs)) are used to reduce loss of principal risk. This report introduces the benefits derivatives bring to investing and applies them to the long/short methodology to boost returns by factors of 10. Derivatives are that superhero. as is the case with long/short ratio strategy returns using primary securities. Average Americans may not have $5 million dollars to invest with a legitimate hedge fund.
By definition. One does not have to have a special membership card or license. but not the obligation. A put option is a contract issued by a seller to a buyer. an index is diversified possessing a low to moderate level of volatility. 4 . giving the buyer the right to sell 100 shares of a security at a contracted price (the strike price) and obligating the seller to purchase those 100 shares of the security from which the put option derives its value. Call and put options can be either sold or purchased.Hedge Strategies …an investing newsletter of general. An Index ETF is itself a derivative because its value is based on the movements of the portfolio of stocks that form the index it mimics. They expire. to buy 100 shares of a security at a contracted price (the strike price) and obligating the seller to sell to the buyer 100 shares of that security from which the call option derives its value. What Are Call And Put Options? A call option is a contract issued by a seller to a buyer. Derivatives are also referred to as securities. future contract or currency. or by having enough cash to buy 100 shares of the underlying security in the case of the sold put option--also termed hedging the short option. because options have limited lives. Buying something that disappears into thin air is an unwise investment. exchange traded fund (ETF). giving the buyer the opportunity. One only has to be able to fulfill the terms of the contract by owning 100 shares of the underlying security (obligated security) in the case of the sold call option. impersonal and indirect opinion Short/Long Derivatives Hedge. Options are derivatives. an Aggressive Strategy security) such as a stock. It is often better to sell an option than to buy one. bond. Anyone can be a seller of options. commodity.
Put and call option contracts are available at multiple strike prices along the value spectrum of a security. If the strike price is $50 and the underlying security is trading at $54.Hedge Strategies …an investing newsletter of general. an Aggressive Strategy Option Components (i) Premium is the cost of an option. the intrinsic value of the rights afforded by the put option contract are worth 5 . An option cost is composed of intrinsic value (true value) and time value (speculative value). Security Price Strike Price 56 54 50 A call option has intrinsic value only if the Intrinsic: 15 underlying security is Put Option trading above the call Underlying Security option strike price. The medium value securities have option contracts available at strike prices every $5 in value. (ii) Strike Price is the dollar amount at which the terms of the option contract obligation can be fulfilled. but not the obligation.50 in value from 0. the Underlying Security intrinsic value of a put option is $15. Any value in the premium of an option that is not intrinsic value is time value (speculative value). Securities with lower values have option contract strike prices available every $1 or $2. If a call option gives the buyer of the call option contract the opportunity. then $50 is the strike price. (iii) Intrinsic Value is the true and definable value of an option contract in relation to its strike price. If the strike price is $50 and the underlying Call Option security is trading at $35. A put option has intrinsic value Strike Price 25 Security Price 60 only if the underlying 35 50 security is trading below the put option strike price. the intrinsic value of the Intrinsic: 4 call option is $4. to buy 100 shares of the underlying security at $50. impersonal and indirect opinion Short/Long Derivatives Hedge. High value securities have option contracts available at strike prices every $10 in value. For example: If a put option contract is purchased at a strike price of $80 before the 100 shares of the already owned underlying security fall in value from $80 to $65.
The buyer of the call option contract can buy 100 shares of the underlying security from the seller of the call option contract for $150 and. if the buyer chooses. 50 For example: Referring to a prior example. For example: If a call option contract is sold at a strike price of $150. an Aggressive Strategy $15 per share to the owner of the put option contract. then only intrinsic value exists. Option contract premiums have intrinsic and time value components until the contract expires. The intrinsic value is $4.50 increase its time value and more Time: . The owner of the put option has the contracted right to be able to sell the underlying security shares to the seller of the put option for $80 per share. where more demand for an option at a particular strike price will Call Option Premium: 4. When the security price is less than the strike price the call option premium amount is time value only. and subordinately the carrying cost of money (the opportunity cost of tying up principal dollars while holding the option).50 when the security price is $54. created through the forces of supply and demand. the total premium amount the seller of the $50 strike price call option contract receives from the buyer is $4.50 is the time value of the contract.00 and $.50. Buyer Underlying Security overpayment for options is the time value portion of the option Security Price Strike Price 56 54 premium. $15 more than the current market price of $65 per share. because true value of a call option is measured as the distance between the option strike price and the higher security price (when the security price is greater than the strike price).50 Intrinsic: 4 supply of an option at a particular strike price will Call Option decrease its time value. 6 . and 100 shares of the underlying security are trading at $190. the rights afforded the buyer of the call option contract have an intrinsic value of $40 per share. The buyer of the call option contract has overpaid by $. impersonal and indirect opinion Short/Long Derivatives Hedge.Hedge Strategies …an investing newsletter of general. (iv) Time Value is indefinable or speculative value. immediately sell it in the market for the current price of $190 per share.
Recall that each option contract controls or obligates 100 shares of the underlying security at a particular strike price. because it requires a net outflow of principal monies.500. Sellers of options can realize profits when the underlying security makes zero or very little movement. 7 . impersonal and indirect opinion Short/Long Derivatives Hedge. The market price of the underlying security is equidistant and between the strike prices of the call and put options. These are extrinsic or out-of-the-money options. which controls 100 shares of the underlying security.31.00. It is an investment. down or flat. depending on one’s ownership interest or position obligation in an option contract. (vi) Multiplier for option contracts is 100. The Long Strangle.Hedge Strategies …an investing newsletter of general. 100 shares each at $85 will have to be sold to the contract owner to cover the option contract’s obligation for a transaction amount of $85 × 100 = $8. an Aggressive Strategy (v) Option Valuation is a function of the price movements of an option’s underlying security plus its option premium. The put option is purchased at a strike price to the left of the underlying security market price. Buyers of call options and sellers of put options realize profits when the underlying security rises in value.00. with call and put options purchased at strike prices providing only time value as the component of option premium. If the underlying security is priced above the call option’s 85 strike price at $89. Compare it to a long straddle strategy. It is the amount the quoted price of an option must be multiplied by to calculate the transaction amount of the option contract. The first is called the out-of-the-money strangle. composed of an equal number of call and put options purchased at the same strike price at or near the current market price of the underlying security. The call options represent the long. The call option is purchased at a strike price to the right of the underlying security market price. the transaction amount will be $6. The put options represent the short. A Neutral Long/Short Derivatives Strategy The long strangle is a strategy composed of an equal number of purchased call and put options. sellers of call options and buyers of put options realize profits when the underlying security falls in value.31 × 100 = $631.28. For example: If the quoted price of a sold call option contract is $6. Since option contracts can be purchased or sold. (vii) Option Profits are realized when the underlying security trades up. as well as when the underlying security moves in a direction that will make the sold option’s premium value fall. There are two ways to build the long strangle.
MARKET PRICE AT ONSET (BEGINNING) OF TRADE PUT OPTION CALL OPTION 8 7 6 5 4 3 2 101 2 3 4 5 6 7 0 1 2 3 4 5 6 787 6 5 4 3 2 1 OUT-OF-THE-MONEY PUT 6 STRIKES OUT WITH ZERO INTRINSIC VALUE AND 2 UNITS OF TIME VALUE OUT-OF-THE-MONEY CALL 6 STRIKES OUT WITH ZERO INTRINSIC VALUE AND 2 UNITS OF TIME VALUE The put and call options of an out-ofOUT-OF-THE-MONEY LONG STRANGLE STRATEGY the-money strangle will expire worthless (undesirable for the purchaser of options) if the market price of the underlying security does not move from its onset location beyond either option’s strike price by option expiration. Time value onset amounts (in purple) are provided below the value range. an Aggressive Strategy The diagram to the right illustrates the out-of-the-money strangle. and end of trade intrinsic or in-the money option values in black below the value range. THE CALL HAS 4 UNITS OF INTRINSIC VALUE THE PUT HAS NO VALUE AT EXPIRATION 8 .Hedge Strategies …an investing newsletter of general. To reach a breakeven. AT EXPIRATION (ENDING OF TRADE). Additionally. It identifies out-of-the-money strike units from the security market price (in blue) color coded for the call (in green) and put (in red) options. THE MARKET PRICE MUST MOVE PUT OPTION 11 10 9 8 7 6 5 4 3 2 1 0 1 0 0 1 2 3 4 5 6 7 8 9 10 11 AT EXPIRATION. THE PUT HAS 4 UNITS OF INTRINSIC VALUE THE CALL HAS NO VALUE AT EXPIRATION CALL OPTION 1 0 1 2 3 4 5 6 7 8 9 10 11 11 10 9 8 7 6 5 4 3 2 1 0 0 0 AT EXPIRATION. The diagram below displays strike units (green for the call option and red for the put option). $2 each) to prevent loss of principal investment dollars at option expiration. the underlying security value movement beyond either option strike price (shown as the blue arrow line in the diagram below) must be at least as much as the total value of both option onset prices (the sum of the options’ time value amounts. the underlying security’s market price must move 4 value units beyond either put or call option strike price to the 10 value unit mark (orange). The initial trade cost was 4 value units. impersonal and indirect opinion Short/Long Derivatives Hedge. This movement will make either the put or call option an in-the-money option with an intrinsic value that will not evaporate at option expiration (the third Friday of every month).
25. the underlying security market price must move down to $38. because the trader is buying intrinsic value. composed of an in-the-money call option and an in-themoney put option. The Out-Of-The-Money Long Strangle and the In-The-Money Long Strangle are profitable when the underlying security market price moves beyond the strike price of either option a distance equal to at least the sum of the time value portions in the premiums of both options at the onset of the trade. the chance for total loss of investment principal is zero. The ideal price action for profitability of the in-the-money strangle is for the underlying security market price to make its move early in the life of the trade. and the current market price of the underlying security is $39.20 to break even and even lower to profit. The out-of-themoney long strangle strategy works best as a short term trade in directional market conditions with rising volatility. in addition to time value.Hedge Strategies …an investing newsletter of general. Holding it until its component options expire will likely result in a total loss of investment principal. also in strong bull or crashing markets.18. The maximum loss is limited to the amount of time value in the call and put option premiums. It does not work when the market is calm. If the underlying security market price moves up to $40. The breakeven point is roughly 2. while there is still a time value component to each options’ premium values in addition to the intrinsic value component. the first out-ofthe-money strike call option costs $.6% from the current market price. 9 .30. the trade will break even.87. an Aggressive Strategy For example: If the first out-of-the-money strike put option costs $. If held until expiration. MARKET PRICE AT ONSET (BEGINNING) OF TRADE CALL OPTION PUT OPTION 8 7 6 5 4 3 2 101 2 3 4 5 6 7 8 7 6 5 4 3 2 101 2 3 4 5 6 7 THE CALL IS 6 STRIKES IN-THE-MONEY WITH 6 UNITS OF INTRINSIC VALUE THE PUT IS 6 STRIKES IN-THE-MONEY WITH 6 UNITS OF INTRINSIC VALUE IN-THE-MONEY LONG STRANGLE STRATEGY The cost to enter an in-the-money strangle strategy is higher than an out-of-the-money strangle strategy. The second long strangle strategy is the in-the-money strangle. It must move higher to profit. because at least one of the component options (the call or the put) will have intrinsic value at the end of the trade. impersonal and indirect opinion Short/Long Derivatives Hedge.
In an absolute sense the deltas are equal at that point. theta (Θ) and lambda (Λ). 10 . Another way to explain this interpretation of delta is that the call and put options with absolute deltas of . impersonal and indirect opinion Short/Long Derivatives Hedge. Velocity is measured by the Greek symbol gamma (Γ).85 and the delta of a call option is . For example: If each price point on a delta’s value range is a linear representation. These at that point changes are the velocity component in a delta calculation. The option delta also can be interpreted as the probability that the option will expire inthe-money (with some amount of intrinsic value in its option premium). as created in the Hedged Box long/short strategy using only primary securities). These variables apply to the options of primary securities and are identified with the Greek letters delta (Δ). changes in option value from one underlying security price point to the next are the same amount. kappa-vega (Κ). The absolute (practical) value for delta is between 0 and 1. Deltas change with varying degrees in response to movements in the market price of the underlying security. in the case of a put option. Δ For example: The delta of a put option is −. the put and call option values will change $. The delta value is interpreted as suggesting that for every dollar change in the market price of the underlying security. an Aggressive Strategy Option Greeks: Delta (Δ). gamma (Γ). Kappa-Vega (Κ). Gamma (Γ). the underlying security market price will be below the option strike price. in the case of a call option. visualized by the same green slope of the tangent lines along the linear value range (see page 11).85.85 have an 85% chance of expiring in-the-money with some amount of intrinsic value in their closing option value. This creates a state of constant delta neutrality (an equilibrium. When applied to the strangle strategy’s component options. The numeric value for delta is between −1 and 0 for put options or 0 and 1 for call options. This is true. Theta (Θ) & Lambda (Λ) The possibility for achieving greater success from a derivatives strategy (in addition to targeted price movements that should occur sooner rather than later in the life of the investment) is found in a set of predictive variables created from statistical price data of the underlying security and its options. the underlying security market price will be above the option strike price.Hedge Strategies …an investing newsletter of general. delta indicates the amount the price of the option will change for every 1 dollar change in the market price of its underlying security.85 in opposite directions. At that point implies that deltas are not constant. Delta provides information as either a probability or a measure.
11 . dynamic delta velocity allows a call option to increase in value faster than the put option decreases in value. Higher gamma values translate into faster delta changes. When its underlying security is rising in value. This is proven by the different slope coefficients of the green tangent lines along the parabolic option value range. impersonal and indirect opinion Short/Long Derivatives Hedge. Changes in option value through dynamic delta velocity are what enable derivative-based long/short strategies to achieve profit from underlying security price movements after they are established in a perfectly hedged state (identified by matching deltas of its component put and call options). Many variables (represented by Greek letters) can influence the value of options. All must diverge toward their optimal state for a derivative strategy like the strangle to become profitable. Study the diagram on the following page. Some variables influence the behavior of other variables. Gamma values modify the changes in delta velocity. because their net investment position values do not experience unequal (parabolic) changes in price velocity. changes in option value represented by the slope of each price point’s tangent line are not the same as the option value change at other price points along the delta value line. or from O2 to vp2 and vc2 when the underlying security price rises. Perfectly hedged primary securities do not provide a profit opportunity from changes in price.Hedge Strategies …an investing newsletter of general. where a state of delta neutrality existed. in which the call value line is represented by green and the put value line is represented by red. this creates a velocity change in option values as the underlying security moves away from the trade’s onset point. lower gamma values into slower changes. an Aggressive Strategy In a parabolic (dynamic) representation considering an option delta’s velocity. Transversely. A strangle strategy produces profit for an investor in the sum of an amount equal to the difference of the initial call and put prices from O1 to vp1 and vc1 when the underlying security price falls. PARABOLIC DELTA LINEAR DELTA This means that there is a differential between the velocity change of the deltas for call options and put options.
…an investing newsletter of general, impersonal and indirect opinion
Short/Long Derivatives Hedge, an Aggressive Strategy
Put Value Line
Option Value / Delta Value
Call Value Line vp1 vc2
THETA (Θ) Influence: Call and Put value lines shift down. KAPPA-VEGA (Κ) Influence: Low value - Put shifts to left, Call shifts to right; High value - the reverse for Call and Put. GAMMA (Γ) Influence: Low value - compresses (broken lines) the option value lines; High value - expands (solid lines) the option value lines.
rising value option line
onset/entry line falling value option line
Underlying Security Price / Time
Changes to an option’s gamma (Γ) (orange) compress or expand the option value lines to represent new option value behavior through the option’s delta. A decrease in gamma expands the value lines (solid lines). When there is an increase in gamma the value lines (broken lines) compress. As the life of an option progresses toward its expiration date, the time value decay amount identified by the Greek variable theta (Θ) increases, shifting the option value lines down. Changes in option kappa-vega (Κ) (purple) shift the option value lines left or right. An increase in kappa-vega shifts the put option to the right and the call option to the left. A decrease in kappa-vega causes the opposite. The delta variable exerts the most influence on option values. Delta is influenced by price movements of the underlying security, and changes in kappa-vega and gamma. Theta is influenced by gamma (see page 14).
OF AN EQUITY OPTION
Θ Δ Κ Γ Λ
cALL or put CONTRACT
as downward for the losing option. As an option’s life comes to an end. The preferred condition of the gamma variable at the trade onset is low in the component options of the long strangle strategy. except at the underlying security price point. compared to the shorter falling values in red. Securities with larger daily percentage price movements have higher volatility. 13 . Equalized price changes in the option components of an out-of-the-money strangle will ensure that there is minimal loss in value of investment principal while the market price of the underlying security moves to the strategy breakeven points. by how much is a function of kappa-vega (K). Higher price volatility is identified by wider trading ranges over a measured period of time.Hedge Strategies …an investing newsletter of general. This causes put option and call option deltas to change approximately as fast upward for the winning option. labeled with a blue ‘×’). A low gamma maintains derivative strategy neutrality over a wider range of price movements. an Aggressive Strategy Γ Gamma is the measure of the velocity of change in the delta. Note in the diagram on the following page the length of the rising values represented by green. When price volatility of the underlying security falls. impersonal and indirect opinion Short/Long Derivatives Hedge. Lower gamma values reflect lower velocity. causing faster delta changes. Higher gamma values reflect higher velocity. because price stability is key to maintaining option investment principal over time. in turn causing the rate of change in delta to increase. the gamma coefficient falls at all points along the value line. Kappa-Vega defines price volatility. Volatility increases when security prices fall because prices fall faster (as measured by distance over time) than they rise. Κ Increases in underlying security volatility influence the behavior of the option delta through gamma in the following ways: high kappa-vega causes gamma to increase. Kappa-vega is a statistical measure for the sensitivity of the option value through the option’s gamma and delta to the underlying security’s price volatility. The ideal location for the long out-of-the-money strangle strategy to experience a break from neutrality sooner in the life of the trade is at the lower gamma state inflection points (see page 15. causing slower delta changes. the gamma coefficient falls. It can be interpreted as a measure for option price stability (also viewed through option delta changes).
Theta exists because options have limited lives. (c)2010 Yahoo! Inc. Inc. The ideal state of long strangle strategy Greek option variables at trade onset and close is: ONSET/ENTRY POINT CALL AND PUT OPTIONS . Drops in volatility influence the values of all options to fall. Inc. an Aggressive Strategy Rises in volatility maintain the losing option price value and increase the winning option price value. creating a positive and profitable deviation from delta neutrality. as a function of price decay.50 TO . YAHOO and the YAHOO logo are registered trademarks of Yahoo. which raises the kappa-vega coefficient. The only way a buyer of options (including strangle and straddle strategy traders) temporarily overcomes the negative effects of theta on option value is for the volatility of the underlying security to rise. Reproduced with permission of Yahoo. the gamma coefficient and the theta coefficient. Kappa-vega is a measure for the rate of change in option value through an influence on delta through gamma for a change in the volatility of the underlying security. represented as a negative number.Hedge Strategies …an investing newsletter of general.65 (absolute) LOWER LOWER LOWER LOWER 14 CLOSING/ENDING POINT FALLING VALUE RISING VALUE OPTION OPTION LOWER HIGHER LOWER LOWER HIGHER HIGHER HIGHER HIGHER HIGHER HIGHER DELTA (Δ) THETA (Θ) GAMMA (Γ) KAPPA-VEGA (Κ) VOLATILITY . Anything with a limited life is generally a poor investment. is the measure of the rate of time value decay in the time value component of an option’s premium. impersonal and indirect opinion Short/Long Derivatives Hedge. Higher thetas indicate that an option’s time (speculative) value component falls faster over time. Θ Theta.
compared to smaller changes in the outlying zones beyond the inflection point labeled with a blue ‘×’. Low gamma translates into more price stability in long (purchased) derivatives due to smaller velocity-based changes in the delta coefficient and more linear (slower). an Aggressive Strategy How Changes In Gamma Create Faster Price Gains In Derivative Strategies Because options have a limited life. impersonal and indirect opinion Short/Long Derivatives Hedge. A low gamma state produces a peaking histogram at the current market price of the underlying security. Figure a on page 16 places a long out-of-the-money strangle strategy on the value range diagram of its underlying security and the gamma behavior diagram of its component 15 . When a long out-of-the-money strangle strategy with low gamma values at strike prices near the inflection points of the gamma histogram is applied with the options of an underlying security. The underlying security is provided with more time to move beyond the strategy breakeven points and into profit zones before nearing expiration when the theta variable will rise to affect greater daily value declines to zero in the time value component of option value. illustrated by the green tangent lines with similar slope coefficients. they have a higher probability of becoming worthless if held for a longer rather than a shorter time (except for in-the-money option strategies that lose only the time value portion of their option premium). rather than parabolic (faster) changes in the theta variable. CURRENT MARKET PRICE LOW GAMMA STATE HIGH GAMMA STATE GAMMA VALUES DELTA VELOCITY SECURITY VALUE RANGE By comparison. a high gamma state is elevated across a larger underlying security value range. creating a value imbalance that is profitable if the value differential is positive.Hedge Strategies …an investing newsletter of general. The preferred gamma state of a long derivative strategy is lower gamma. This creates faster changes in option value through the delta variable. and more reliably than a long straddle strategy (discussed on page 17) applied in either gamma state. It indicates that the difference in delta values will be greater in this area. Consider the gamma behavior diagram to the right. indicating that the change in delta from one point to the next is small. This encourages a deneutralization of the component option values. the strategy will realize profitability sooner than in a high gamma state. Recall that the measure of profit in derivative neutral strategies is the condition when one of the strategy option values rises faster than the other option value falls.
and rising value options gain value through changes in delta at faster rates. A large value change will produce strategy profitability by virtue of the underlying security’s price move (less likely to occur) instead of a delta-based positive differential resulting from a low gamma state. an Aggressive Strategy option. 16 . The gamma differential is the source of positive deviations from neutrality that creates a positive profit differential in the component options of the strangle strategy.Hedge Strategies …an investing newsletter of general. A low gamma state produces faster option value changes than the high gamma state for the rising value option through changes in its delta velocity. The turquoise dots represent the put and call option delta contact points for a low gamma state and the green dots represent the put and call option delta contact points for a high gamma state. not a large change in excess of the combined component option time values. Diagrams a and b below and c and d on pages 17 and 19 represent a small value (price) change scenario of an underlying security. which is more likely to be the source of long strangle strategy profitability. The differences in the slope coefficients between the onset and end contact points for the falling value option and the rising value option create the gamma differential that translates into more varied delta velocity values through points along the security value range. CURRENT MARKET PRICE CURRENT MARKET PRICE GAMMA / DELTA GAMMA / DELTA t1 t2 a Falling Value Option t1 b t2 Rising Value Option SECURITY VALUE RANGE SECURITY VALUE RANGE Note how figure b demonstrate that the change between the low gamma state contact points (the turquoise line) of the rising value option (green post) is greater than the change between the high gamma state contact points (the green line) when the underlying security market value moves from its onset location. identified by the difference in slope coefficients of the high gamma state green line and low gamma state turquoise line at the onset and end contact points. The falling value option (red post) experiences slower value changes through delta in a low gamma state than in a high gamma state. because falling value options lose value through changes in delta at slower rates. A low gamma state is best for strangle strategies. impersonal and indirect opinion Short/Long Derivatives Hedge.
which is fixed to underlying security price action. not its intrinsic value component. However. Delta influences on option premium occur through the time value component only. Therefore. then through an increase in delta and finally through an increase in the time value component of option premiums. the rising value option is composed of both intrinsic and time valuing components and the falling value option is composed of time value only. Theta is the second option valuing variable that gamma affects. creating a positive value differential. there is no gamma-based break in neutrality. what gamma does to theta is 17 . an Aggressive Strategy In other words. impersonal and indirect opinion Short/Long Derivatives Hedge. The only difference is that one is falling in value and the other is rising in value. The Long Straddle. Long straddle strategies rely on time value-based positive deviation from neutrality to become profitable in the small value change scenario. next through an increase in gamma. Gamma’s effects on theta are not as significant as its effects on delta. If this differential occurs sooner in the life of the trade. When a straddle strategy moves from its onset location at the current market price of the underlying security. Price volatility of the underlying security influences option values first through the kappa-vega variable. CURRENT MARKET PRICE GAMMA / DELTA SECURITY VALUE RANGE GAMMA / DELTA t1 t2 c CURRENT MARKET PRICE t1 t2 d SECURITY VALUE RANGE The call and the put options are experiencing theoretical changes in delta velocity through gamma by the same amount because their contracts are written at the same strike price.Hedge Strategies …an investing newsletter of general. A Neutral Long/Short Derivatives Strategy Figure c is the onset diagram for a long straddle strategy with both component options (an equal number of calls to puts) purchased at the same strike price identified by the purple post. Figure d demonstrates that there is no difference in gamma contact points for the component options of the long straddle strategy (no green dots and no turquoise dots). the strategy will likely beat the negative effects of time value decay (through the theta variable) on option values. as the market price of the underlying security moves closer to one of the component options. the closer option gains value faster than the farther option loses value.
5 . impersonal and indirect opinion Short/Long Derivatives Hedge. Volatility can increase in the market as a whole and not cause a change in the prices of underlying securities. and (ii) the time value component of the winning option rises sufficiently in conjunction with its intrinsic value gains to increase its value in excess of losing option losses occurring through declines in its time value component. an Aggressive Strategy adjust the rate of time decay for the time value component of the option premium. kappa-vega responses to price volatility are reflected through gamma in the time value component of an option’s premium. In the small value change scenario. and the average speed of time value depreciation on the falling value option is 1 point down. For example: If the average daily speed of intrinsic value appreciation in a long straddle strategy on the rising value option is 3 points up.Hedge Strategies …an investing newsletter of general. Rising Value Option Up 3 Units Rising Value Option Time Value Decay Down 1.5 points down for every one unit of time. The large value change scenario shows that a positive deneutralization in the straddle strategy is dependent upon the distance over time that the price of the underlying security changes in relation to the decay coefficient of the theta variable. the average daily speed of time value depreciation on the rising value option is 1.5 Falling Value Option Down 1 Unit 18 −1 = . Therefore. achieved when the intrinsic value component of the rising value option appreciates faster than the time value component of both options decays. then this long straddle strategy is positively deneutralization by one half point per day.5 Units +3 − 1. breaks from neutrality for the straddle strategy in relation to price volatility and the kappa-vega variable occur in one of two ways: (i) the time value components of its options’ premiums rise to exceed the loss incurred by both options through time value decay.
an Aggressive Strategy The speed of option time value decay is governed by the theta variable coefficient. A low gamma state causes the speed that the option time value component decays to follow the expected or theoretical path (solid blue line from point A). Countdown to Option Expiration (tx-1. Because the time to expiration for an option is fixed. tx) CURRENT MARKET PRICE GAMMA / DELTA SECURITY VALUE RANGE GAMMA / DELTA t1 t2 c CURRENT MARKET PRICE t1 t2 d SECURITY VALUE RANGE Notice in figure d how the pink line representing the contact points of a low gamma state for the straddle strategy component options has a higher slope coefficient than the red 19 . The gamma variable governs the speed with which the theta variable increases the time value decay coefficient to cause faster time value decay as the option approaches its expiration. added to the current theoretical theta coefficient. This causes a shift in the time decay line to the left. causing a fall in time value to zero sooner than at the theoretical point that coincides with the option expiration date. If the intrinsic value of the rising value option does not appreciate by an amount greater than the sum of the value decay from the time value components of both options in the straddle strategy. an increase in option time value resulting from a rise in the gamma coefficient will necessitate a rise in the theta coefficient (a shift down from point A to point B in the diagram above) by an amount equal to the rise in time value divided by days remaining until option expiration. The velocity of change in theta’s time value decay challenges the intrinsic value appreciation of the rising value option. A B Option Expiration GAMMA (Γ) Influence: High gamma value coefficients shift the time value decay curve away from the expiration date. the strategy will not achieve a positive deneutralization.Hedge Strategies …an investing newsletter of general. Time Value Component of Option Value A high gamma state causes the speed that the option time value component decays to increase (dashed blue line) from any past point tx-1 to any present point tx. impersonal and indirect opinion Short/Long Derivatives Hedge.
page 19) to the slower theta-based time value decay of in-the-money or out-of-the-money options (point A. This can cause a condition of negative deneutralization. Time values deplete at different points for low gamma state and high gamma state conditions. A similar adjustment occurs when an option’s gamma state changes from low to high.Hedge Strategies …an investing newsletter of general. The structure of the long straddle strategy allows it to potentially profit more than the long strangle strategy from rises in volatility. impersonal and indirect opinion Short/Long Derivatives Hedge. because the appreciation rate of the option’s intrinsic value component cannot keep up with the high gamma state decay of time value components in an option’s premium. page 19). the volatility of the market and underlying security is currently at or below average historic volatility measures and volatility is expected to rise. in the area between t1 and t2. Low gamma is the expected theoretical state of an option’s gamma variable coefficient. 20 . the component options of the strangle strategy reside at outlying locations where the gamma coefficient is lowest. However. tx) A theta with a higher rate of change (high gamma state) will depreciate the full amount of option time value in advance of the low gamma state’s theoretical zero point at option expiration. This sudden low gamma state coefficient change reflects a sudden adjustment from a condition of faster theta-based time value decay typically experienced by at-the-money options (point B. Time Value Component of Option Value SECURITY VALUE RANGE Option Expiration HIGH GAMMA STATE LOW GAMMA STATE Countdown to Option Expiration (tx-1. If one were to establish a short straddle strategy. The ‘×s’ in the diagram to the right represent depletion points for low gamma state (the green ‘×’) and high gamma state (the black ‘×’) time value amounts of an option premium. This is normal theta coefficient behavior in a low gamma state. the ideal condition is a low gamma state with contracts written on strike prices at the market price of the underlying security no further out than the inflection point of the histogram representing the low gamma value range. an Aggressive Strategy line representing the contact points of a high gamma state. The best time to use a long straddle strategy is when the time horizon of the holding period is short. Rises in volatility have the same affect on the component options of the strangle strategy as they do for the straddle strategy. where time value decay through the gamma influenced velocity change in theta is highest.
the trader has a remaining equity balance of 25% the initial 160/40 value amount. rather than later into the life of the trade. allowed 25 % margin Potential Leverage 2 times 4 times 40 times 14 times 12 times 9 times The amount of potential loss on a long derivative such as a purchased call or put option. 45 . It is composed of 160 long shares and 40 short shares of an equity security. 45 days or less) Option Contract (mid-term expiration. If the value of an equity security used in this 160/40 ratio example falls to zero (ignoring minimum margin requirements). a net investment position of 120 and a positive bias. 2) A gamma state that remains low. This provides a 25% downside hedge. Derivative-based Leverage Boosting For The Long/Short Margin Ratio Strategy The benefits of derivative leverage and derivative loss limits make equity option contracts a fantastic substitute for primary equity securities in Long/Short Margin Ratio strategies.270 days) Option Contract LEAPS (Long-term Equity Anticipation Security) 9 months or more. which is a fraction of the cost of outright ownership of the equity security itself.Hedge Strategies …an investing newsletter of general. Non-specific and general examples of leverage factors for index ETF options are: Instrument Retail Trading Margin Account Day-Trading Margin Account Option Contract (near-term expiration. 180 . Considering margin. impersonal and indirect opinion Short/Long Derivatives Hedge. For example: The 160/40 long/short ratio is one that utilizes the maximum allowable margin in a brokerage account (assuming 100 shares is the maximum quantity that all of the account equity can purchase prior to using margin for leverage). the overall net result as a worst case scenario is that the 21 . an Aggressive Strategy The conditions for positive deviation from neutrality in long straddle strategies are: 1) A theta value that remains low. Derivatives experience the price movements of equity securities at a fraction of the costs of outright ownership for the security. 3) A kappa/vega that remains low if the volatility of the underlying security is high at the onset of the trade. 4) A directional change of value in the underlying security sooner into the life of the trade. is limited to the cost of the option contract. Derivates such as equity call and put options provide leverage many times in excess of that which can be gained from an equity security in a brokerage margin account.180 days) Option Contract (long-term expiration.
Inc.846.23 Close of Trade Day 8 SPY at 102. the call option expiring the Next June is selected to replace 100 shares of the long side SPY 22 . an Aggressive Strategy trader owes the brokerage 75% of the value amount borrowed at the onset of the trade (an amount equal to 75 shares at their onset trade price). The number of option contracts used to replace long or short shares is based on option delta values. The value of the trader’s equity will be zero. Applying maximum leverage for the 160/40 trade at this value amount controls a total of 200 shares valued at $21. (c)2010 Yahoo! Inc.20.20 Reproduced with permission of Yahoo. The 8 day SPY value range reaches a high of 109. Those call option contracts have expiration dates in December and the following June. Two call option contracts in a quantity based on option deltas that approximately equal 100 security shares are selected for use as a substitute for security shares of the long side investment. the equity security proxy of the S&P 500 Index. Each security share has a delta of 1. Call option contracts can be used in place of long shares or a put option contract can be used in place of the short shares. Choosing for which side of the strategy to leverage with derivatives should be based on the options (the call options or the put options) that are experiencing lower kappa/vega levels when compared to the historic average. Based on a conservative criteria. Inc.Hedge Strategies …an investing newsletter of general. the value of 100 shares (at the onset) is $10. The trade is held for 8 days. impersonal and indirect opinion Short/Long Derivatives Hedge.23 and a low of 102. Applying this example to actual values from the index ETF with ticker symbol SPY. The choice is 100 option deltas equalling 100 long shares or 40 option deltas equalling 40 short shares. Onset of Trade Day 1 SPY at 109.923. YAHOO and the YAHOO logo are registered trademarks of Yahoo. The best option substitute for the 100 long shares is determined by weighing price to leverage and optimal Greek coefficient values.
461. +8% . divided by Hedged Equivalent Shares). theta.273.50 * $10.923/$5. The reasons for its selection include the fact that its gamma value is lowest and its strike price is to the right of the underlying security market price. 3% 6. Expiration Date Call Option Strike Price Bid/Ask Price Spread at Trade Onset Preferred State December Next June Theoretical Option Value vs.50 $10. If the advantages of using call options outweigh those of dividend paying equity security shares.5073 2 101 $813.50 50% Cost is $5. The SPY does distribute dividends quarterly. which is desired when options are purchased.219.0223 .248. divided into 1. the theoretical option value differential to the current option market price) at this 23 .00 each 25% − $203. Actual Gamma (Γ) Kappa-Vega (Κ) Theta (Θ) Theta (Θ) Coverage Lower Lower Higher Lower Lower Lower Higher 111 6. which means that this option is the most under-priced.21.24 = . $1.0159. ETF Dividend Pirating. 1% 113 7.736.143.3034 -. Expiration Date Days to Expiration Delta Value Number of Contracts Hedged Equivalent Shares Cost of Call Contract Margin Available to be borrowed 100 Primary Shares December Next June NA 1. **Cost of margin not considered. Refer to the Hedge Strategies report. proceed with the example as outlined.5067 2 101 $624.0223 22 days 9. +1.248 × 100 ÷ 101.50=2 Shares cost Total Cost of Calls Leverage Factor 177 . an Aggressive Strategy equity security from the 160/40 Long/Short Margin Ratio Hedge strategy.496.Hedge Strategies …an investing newsletter of general. the lowest of the choices. A third reason can be the investment value that one places on dividend distributions.8.0159 71 days A second reason is because the Next June market price is 14% below the theoretical option value.92 .25 each $1.00 each NA $1. for instruction on how to strip ETFs of their dividends.923/$1.923/$1. impersonal and indirect opinion Short/Long Derivatives Hedge.235=8.6.00 NA NA $5.0156 . +.461. +14% .00 * $10.8 359 . equal to 71 days (calculated .4321 -.15 .09.461. The Next June call option has the greatest theta coverage.207=9 *Leverage Factor takes into account any differences in delta values between primary shares to be replaced and option contracts by adjusting the leverage values based on equalized deltas (calculated as Total Cost of Calls multiplied by the quantity of shares to be replaced by option contract(s). suggesting price stability during adverse price action.13 = . A fourth reason is its theta variable.143.
Option theta values can vary over time.297 less when using the derivative-based ratio.27% less when using the derivative-based ratio. divided by absolute theta value. The results indicate that the loss for every dollar utilized in the trade is less for the 160/40 all equity long/short margined ratio than for the derivative-based ratio. and (iii) portfolio dollars are unapplied and available to correct an unprofitable trade by adjusting the bias and weight of its long and short elements. As a point of comparison. The affect that the kappa/vega variable has on the gamma variable is actual. (ii) the quantity of actual dollars lost in this exercise is 20. giving the low kappa/vega state on the December call option priority over the higher kappa-vega state on the call option expiring next June. the 160/40 all equity security long/short margined ratio provides a yield of −7. Theta coverage represents the amount of beneficial value measured in days found in the price discount of actual versus theoretical option values.07%. Covering the option value price decay that theta represents is very important.846 is $9. the yield based on the amount of equity applied to this trade provided by the Next June call options chosen to replace 100 SPY security shares in the 160/40 is −10. This calculation result equals the number of days that the beneficial price discount covers the theta-based option time value price decay. impersonal and indirect opinion Short/Long Derivatives Hedge. Theta is the only variable with an affect on option values that can not be stopped or reversed by external factors. Many benefits still remain with the derivative-based ratio: (i) the maximum potential loss (MPL) of $21.72%.Hedge Strategies …an investing newsletter of general. The theta coverage calculation is determined by the following formula: positive price difference of actual from theoretical option value. unavoidable in an out-of-the-money option. because a rise in volatility is only a possibility. not a possibility. When theoretical value > actual option ask price: Theta (Θ) Coverage = (Theoretical Option Value – Actual Option Ask Price) ÷ Absolute Theta Value A low kappa/vega coefficient is preferred at the onset of a long derivatives trade. an Aggressive Strategy point. 24 . This means that a portion (an amount not more than 71 days) of the price decay. can be covered by the discount at which this call option is purchased from the market. The chart on page 22 shows that over the course of 8 days.
20 subtracted from onset value of $109.00 −11.Hedge Strategies …an investing newsletter of general. plus 40 short shares valued at the onset price of $109. $6.923. ***ROM is return on margin. $5. The comparison results follow for both 160/40 long/short strategy iterations from June 23 to July 2: 160/40 all equity long/short ratio (160 long.60 End result of 60 long shares at $102.07% Loss of -$672. ****Cost of margin is not factored into these results The derivative-based long/short ratio return denominator is calculated as 60 long shares valued at the onset price of $109.23.23.00 *MPL is maximum potential loss. The variable responsible for this lower loss of equity in the derivative-based ratio is the call option’s low gamma.549 $9.15% of its value (calculated as ending price of $336 from onset price of $624. expiring 6 months sooner than the Next June call option.23. plus ¾ of 2 long call options valued at the onset price of $813.72% for 25 . $12.549. $10.23. plus end result of 40 short shares at $102. multiplied by 2 call options) compared to a value loss of 32.86% −7.00 −10.00 Loss of -$843. plus ½ of 40 short shares valued at the onset price of $109. The derivative-based long/short ratio return on margin denominator is calculated as ½ of 60 long shares valued at the onset price of $109. plus 2 long call options valued at the onset price of $813. plus ¼ of 2 long call options valued at the onset price of $813.36% Loss of -$672. plus end result of 40 short shares at $102. 40 short) $12.60 divided by trade equity.20 from onset value of $109.23.868.00 MPL* RM** P/L Return Yield ROM*** −3. an Aggressive Strategy Use of the call options in place of 100 security shares abated the overall trade dollar loss by $171.00 (margin of 25% is available for options with time to expiration periods greater than 9 months). plus ½ of 40 short shares valued at the onset price of $109.297 more 0 −$843.927 −$672. plus end result of 2 Next June call option contracts at $547 subtracted from onset value of $813 −5. divided by its onset price.72% Loss of -$843. Gamma stabilized the option price by slowing the loss of option value through the rate of change in the delta for each one dollar drop in the underlying primary security price.23. **RM is remaining margin.60 divided by total trading liability. The derivative-based long/short ratio yield denominator is calculated as ½ of 60 long shares valued at the onset price of $109.60 divided by total trading liability.681. $21.60 divided by margin. 40 short) $21.00 (margin of 25% is available for options with time to expiration periods greater than 9 months).60 End result of 160 long shares at $102.923.23 Derivative-based long/short ratio (2 calls.72% −7.846. lost 46.23. 60 long.23.00 Loss of -$843.23.20 subtracted from onset value of $109.60 divided by margin.297 less $9.00.45% Loss of -$672. Was the Next June call option the best derivative choice for this exercise? The December call options.60 divided by trade equity. $10. impersonal and indirect opinion Short/Long Derivatives Hedge.20 from onset value of $109.846 $9.
430. This equals a call-based derivative imbalance of 14 deltas short (calculated as . fractional delta discarded). multiplied by 2 call options). The calls produce an insufficient delta match for the 100 long primary securities that they replaced at the onset of the trade on June 23 for the 160/40 ratio. Onset of Trade Day 1 SPY at 102.Hedge Strategies …an investing newsletter of general.20.66 This trade example is rebalanced on July 2 to match the onset long short ratio of 160/40. divided by its onset price. The criteria used to select the Next June call options over the December call options are valid.22 Close of Trade Day 11 SPY at 109. The delta value of the Next June call option has become .4347 from .80 to return the trade currently at a ratio of 146/60 to its onset ratio of 160/40. The ratio is deficient 14 deltas. Two benefits derivatives provide are high leverage and low loss exposure. The final day of the trading example incorporating two options in place of 100 primary security shares of the ETF SPY marked the bottom of the short term bear cycle. Additional delta in the form of long primary securities must be purchased to boost the total delta value to the onset ratio amount of 100.0726 deltas per opotion contract. Derivative-based trading strategies with a positive bias experience greater declines in value during falling markets and experience greater appreciations in value during rising markets when compared to primary security shares alone. an Aggressive Strategy the Next June call option (calculated as ending price of $547 from onset price of $813.5073 on July 2.0726 × 100 (multiplier) × 2 (options). The market trend reversed and climbed consistently over the next 11 days from July 2 to July 13. a drop of . At the market price of 102. experiencing price decay unless the underlying security moves in the desired direction by an amount greater than its daily theta decay value. it will cost 1. This rebalancing cost can be reduced by stripping the 26 . The drawback for derivatives used in their long capacity is that they are limited life securities. impersonal and indirect opinion Short/Long Derivatives Hedge. all other variables remaining constant.
00 options value rebalance long value rebalance short value $8.656.64 = $9. carried forward gains/losses.562.80 shares value 72 @ $547.66 = $4.66 = $8. which is the price at which the market is willing to sell a security.43 × 100 × 2) 02 @ −$532.656.114.386.722. The bid is lower than the ask.20 = $4.20 short shares −40 deltas from 40 short shares 02 @ −$672.656. impersonal and indirect opinion Short/Long Derivatives Hedge.00 = $1.20 = $7.094.60 rebalance July 2 to July 13: +$767. trade closing dollar values and profit/loss results follow: 160 deltas from 60 long shares profit/loss from June 23 to July 2: 114 deltas from 14 newly purchased shares 60 @ −$421.40 final result: +$95. trade onset dollar values.60 loss to carry forward at 140 short deltas 160/40 close of trade on July 13 Bid is the price at which the market is willing to buy a security.20 profit from the 40 short shares.088.00 long options (valued on bid) 160 long deltas 40 @ +$281. an Aggressive Strategy 281.84 − $8.84 shares value 72 @ $804.386.80 long shares 186 deltas from 2 options (.Hedge Strategies …an investing newsletter of general.80 + $4.80 $4.04 27 .722.80 40 @ $102. trade onset dollar values 74 @ $102.00 = $1.84 $4.386.00 short value trade closing dollar values 74 @ $109.40 40 @ $109.80 − $4.00 options value closing long value closing short value $9. The newly rebalanced trade delta values.40 short value trade profit/loss from June 23 to July 13: June 23 to July 2: −$672.608.656.
20. minus end result of 40 short shares at $109.80 $7. plus ½ of 14 long shares valued at the rebalance price of $102.66 subtracted from onset value of $109. ***ROM is return on margin.20 more 0 $51.00 subtracted from onset value of $813.66 from rebalance value of $102. The derivative-based long/short ratio return denominator is calculated as 60 long shares valued at the onset price of $109. plus rebalance result of 40 short shares at $102. +14 long) ★ $13. plus ¾ of 2 long call options valued at the onset price of $813. ****AY is annualized yield. plus rebalance result of 40 short shares at $102. The derivative-based long/short ratio yield denominator is calculated as ½ of 60 long shares valued at the onset price of $109. plus 40 short shares valued at the rebalance price of $102. $10. $7. 60 long.20.00 (margin of 25% is available for options with time to expiration periods greater than 9 months). plus ½ of 40 short shares valued at the rebalance price of $102.13% End result of 60 long shares at $109.00 Profit of $51. minus end result of 40 short shares at $109. 40 short) $21. plus 14 addition shares at $109.00 Profit of $51. an Aggressive Strategy The comparison results follow for both 160/40 long/short strategy iterations from July 2 to July13.20.93% *MPL is maximum potential loss.583.20% . 40 short. plus 2 long call options valued at the onset price of $813.80 Profit of $95.28% 1.47% 8. $10.00 (margin of 25% is available for options with time to expiration periods greater than 9 months). plus end result of 2 Next June call option contracts at $804.60 divided by trade equity of $10. plus 14 long shares valued at the rebalance price of $102.20.396.979. impersonal and indirect opinion Short/Long Derivatives Hedge.846.396.Hedge Strategies …an investing newsletter of general.23.923.846 $7.47% .20 from onset value of $109.60 End result of 160 long shares at $109.04 Return Yield ROM*** AY***** .20 from onset value of $109.866.979. plus ¼ of 2 long call options valued at the onset price of $813.23.9184.108.40.206. $21. ★ Result adjusted for rebalance of 14 additional long shares Profit of $51.20 ★ $95. $6.20 Derivative-based long/short ratio (2 calls.23.68% 1.34 Profit of $95.40 plus 1.23. 28 .20 plus ½ of 14 long shares valued at the rebalance price of 102.20.866. MPL* RM** P/L 160/40 all equity long/short ratio (160 long.60 divided by margin. $13.866. **RM is remaining margin.04 divided by trade equity. minus 1 *****Cost of margin is not factored into these results.00 Profit of $51.04 divided by margin.40 Profit of $95. minus 1 .66 subtracted from rebalance value of $102. to the power 365 divided by 20 days. to the power 365 divided by 20 days.23.923.00 plus 1.66 subtracted from onset value of $109. plus ½ of 40 short shares valued at the rebalance price of $102.00 Profit of $95.20 less $7.60 divided by trade equity.20.00.60 divided by total trading liability.66 from rebalance value of $102. The derivative-based long/short ratio return on margin denominator is calculated as ½ of 60 long shares valued at the onset price of $109.44% 26.04 divided by total trading liability.04 divided by trade equity of $7.
Kappa/Vega (Κ) . delta and theta. they no longer hedge or substitute for an investment or position as intended. A buyer of options dreads declines in volatility over the holding period of the derivative. When the deltas of an option contract change over time. It is the degree of change in lambda from the onset of the trade that identifies the success or failure of an option contract to maintain the hedge intended. Zero to small variances in lambda identify a maintained and successful hedge.Lambda Derivative delta values are a dynamic non-constant measure for determining which option contracts are used as a substitute for primary equity security shares.Hedge Strategies …an investing newsletter of general. Kappa/vega’s influence on option values is modified by the implied volatility coefficient of the underlying security. Lambda measures the elasticity of a hedge in relation to the value movements of the underlying investment or position. Collapsing Volatility . There is no established scale for the interpretation of the lambda coefficient. investment position or portfolio that is being hedged). Λ Lambda is the Greek variable providing a measure for the relational fit of a hedge between an option (as measured by its delta coefficient) and the shares of an equity security. When entering into a derivatives based long/short hedge strategy like the long strangle or long straddle. the optimal time to enter the trade is when market volatility is low. impersonal and indirect opinion Short/Long Derivatives Hedge. If 29 . Elasticity is the ability of a hedge to maintain its hedge ratio in dollars lost to dollars gained for the value movements of the target (the underlying investment. an Aggressive Strategy The Measure For The Derivative Hedge . in which rises in underlying security price volatility increase option values and decreases in underlying security price volatility lower option values.A Thief In The Night There is a parallel relationship between the Greek variable kappa/vega and option prices. position. Higher kappa/vega values cause greater changes to option prices through its influence on gamma. Large variances identify a failed hedge because adverse changes in the underlying security are not being countered by desired changes in the derivative.
an Aggressive Strategy volatility increases at any time during the holding period of this trade. translating into more option value stability. the volatility in a market and a security can fall dramatically. Traders who are long derivatives can wake to discover that their investments have fallen in value overnight. resulting in a boost in profitability for the trade. 30 . The options of the in-the-money strangles have low gamma coefficients. Strangle and straddle strategies that had positive hedge differentials the day before. the short or both sides. This drawback is solved by using synthetic securities for either the long. The issue with the hedged box strategy is that profit can be made only if the bias moves from its perfectly hedged state of zero to either positive (long) or negative (short). over a weekend or over a 5 to 10 day period. its short call option and its long put option. The Equity Conversion. impersonal and indirect opinion Short/Long Derivatives Hedge. The result is a perfectly hedged trade with zero principal loss risk and defined rewards prior to trade onset. after an anticipated news event. News and sentiment shifts change the volatility of an underlying security. The objective of the Equity Conversion strategy is to profit from a collapse in the volatility-inflated time values in the short call option premium. The effect of volatility can be limited by trading in-the-money strangles. A synthetic investment or position mimics the value movements and payoffs of a long or short underlying primary security. Between closing bell and opening bell the next morning. The short call and long put configuration creates a synthetic short equity position. The options must be written at the same strike price. as both the call option and the put option lost a significant portion of their premium’s time value overnight. The collapse in volatility may occur in as short a time as overnight. Derivative Arbitrage Recall how the same primary security held long and sold short creates the hedged box strategy. Perfectly hedged equity securities cannot make a profit. No harm comes from holding the trade until the options expire the third Friday of the month. The basic components of an Equity Conversion are a long underlying equity security. now have negative hedge differentials.Hedge Strategies …an investing newsletter of general. the deneutralized differential can increase.
Put Strike (Long Put Option) Short Call + Long Put = Synthetic Short Equity SHARES LONG Sold Call OPTION CONTRACT OF AN SECURITY EQUITY CS PS Purchased Put OPTION CONTRACT EMV The advantages a synthetic short security provides when combined with its long underlying equity security are the perfect hedge characteristics of a Hedged Box long/short ratio and the profit potential of time enhanced option premiums. a proxy for the NASDAQ 100.Call Strike (Short Call Option) PS . A second benefit is that adverse price moves (underlying security moves up in value) affecting the short call are hedged by the long equity. 31 .Hedge Strategies …an investing newsletter of general. The total profit from this trade is determined by the formula: Strike Price of Put + Premium of Call − Cost of Put − Equity Security Market Price The result of this calculation must be greater than zero. an Aggressive Strategy Equity Conversion Strategy Components EMV . resulting from environmental conditions creating high underlying security volatility and high option kappa/vega coefficients.Equity Market Value (Long Equity Security) CS . A real-life example of the Equity Conversion trade is applied to the index ETF QQQQ. Loss in value of the long put option is covered by the premium proceeds from the sale of the short call option. Loss of value in the long equity security is hedged by the long put. In this instance a collapse in volatility works in the strategy trader’s favor. Apply this calculation to the following call and put option pairs near the current market price of the underlying security to determine the optimal option pair for use in this strategy. impersonal and indirect opinion Short/Long Derivatives Hedge.
04 0.36% 0.91 2. which defines margin leverage opportunities in offsetting trades.59 = Profit 0.19 0. an Aggressive Strategy *CMV is Current Market Value of Underlying Equity Security QQQQ Call Options Bid (Sell) Ask (Buy) 2.59 42.84 0.41 0.59 42.03 0. the minimum amount of margin equity [collateral] which must be maintained for the underlying component [the security] shall be 10% of the exercise price.47 1. the strike price immediately below the current market value of the underlying security produces the largest profit for this trade.11 2.45 0.59 42.91 2.50 2.67 1.07 0. The resulting 17 day yield is 14.60 0.84 0.02 0.94 2.15 1.18 − Put Ask (Buy) 0.59 42.Hedge Strategies …an investing newsletter of general.29 0. 32 . NYSE Rule 431(g)(v) .64 0.47 0.43 .59 Strike Prices 40 41 42 43 44 45 QQQQ Put Options Bid (Sell) Ask (Buy) 0. NYSE Rule 431(g)(v) allows a 10 to 1 boost in leverage for this trade.22 0.50 2.08 17 Day Return 0.80% 0.21 CMV* = $42.43 0.06% 1. impersonal and indirect opinion Short/Long Derivatives Hedge.3 2.51 **MP is Market Price + Strike Prices 40 41 42 43 44 45 + Call Bid (Sell) 2. Margin leverage can be applied to the Equity Conversion in two ways: (i) as two times long security equity margin in a retail trading account.03 0.11 1.41 1.59 42.67 1. The time horizon until option expiration is 17 days.When a call…carried in a short position is covered by a long position [an investment] in equivalent units of the underlying component [the security] and there is also carried with a long put…specifying equivalent units of the same underlying component [the security] and having the same exercise price and expiration date as the short call….34 0. and (ii) through NYSE Rule 431(g)(v).68% 1.09% (exclusive of trading and margin fees).41% 1.22 0.45 0.18 .58 0.19% Typically.07 0.88 0.51 − Equity MP** 42.
Equity Market Value (Short Equity Security) CS . an Aggressive Strategy Kappa/vega and volatility coefficients influence option price action. Other ways to capitalize on this differential are explained further in the Hedge Strategies report. The preferred condition of the underlying security and the market as a whole is bullish. The Short Reversal. The components of the trade are: (i) short equity security. dividend x-dates or any market condition creating a volatility-based differential between call to put option premiums. Derivative Arbitrage T R A D IN G ST R A T E G IE S D E T A IL E D E X P L A N A T IO N O F HE D G E F U N D EVENT DRIVEN VOLATILITY CAPTURING HEDGED PROFIT SPREADS AN INVESTING NEWSLETTER AN AGGRESSIVE STRATEGY ™ …OFFERING IMPERSONAL. (ii) long call option.Hedge Strategies …an investing newsletter of general. The condition 33 .Call Strike (Purchased Call Option) PS .hedgestrategies.Put Strike (Sold Put Option) Long Call + Short Put = Synthetic Long Equity OF AN SECURITY EQUITY Purchased Call OPTION CONTRACT CS EMV PS Sold Put OPTION CONTRACT The Long Conversion can be flipped to create a Short Reversal.info). GENERAL AND INDIRECT OPINION Short Reversal Strategy Components SHORT SHARES EMV . This creates an over-valued state in the premium of the call option. and (iii) short put option. Event Driven Volatility Capturing Hedged Profit Spreads (also available at www. The best call and put options for this strategy have high kappa/vega and high volatility coefficients. This is useful when the values of the equity security put options are inflated through increasing fear-based demand-driven option price inflation (created by professional traders anticipating a burst in an asset valuation bubble) at the market cycle’s peak. This is a useful strategy prior to market-affecting news. impersonal and indirect opinion Short/Long Derivatives Hedge. earnings releases.
06.65).33 ÷ 112.When a call…carried in a short position is covered by a long position [an investment] in equivalent units of the underlying component [the security] and is also carried with a long put…specifying equivalent units of the same underlying component [the security] and having a lower exercise price and the same expiration date as the short call. (ii) through NYSE Rule 431(g)(v).65. which nets this 3 day trade a return of 2. call options are overpriced and the underlying security is expected to remain static (unchanged) at its present market price or rise.74 and a call ask value of 1. Some money can be lost in this trade. − Equity Security Market Price − Equity Gap short reversal is perfectly Call − Cost of Put Coverage ice example: of Put − Cost of Call − Strike Price of Put + Premium The closing value on September 14 For (3 days before option expiration) for the Standard & Poor’s 500 Index mimicking etf SPY was 112. The Collar The Collar Strategy is not a perfect hedge as is a conversion and reversal. NYSE Rule 431(g)(v) . an Aggressive Strategy of the underlying security and the market as a whole is neutral to bearish with high levels of volatility.9% before trading fees and cost of margin.33) The return is .33 (calculated as 112. the minimum amount of margin [equity collateral] which must be maintained for the underlying component [the security] shall be the lesser of 10% of 34 . The total profit for this trade is .06 − 112 = . Though its components resemble those of a conversion and reversal. The 112 strike put and call options closed with a put bid value of . NYSE Rule 431(g)(v) allows leverage of 10 times. If the underlying security falls in value. Margin leverage for the Short Reversal is applied in the same way as the leverage opportunity of the Equity Conversion to yield a 10 to 1 leverage boost. Margin leverage is applied to the Collar in two ways: (i) as two times long security equity margin in a retail trading account. its call option and put option are not written at the same strike price. which defines margin leverage opportunities in offsetting trades. there will be a loss equal to the amount of equity gap coverage.74 − 1. The reason for this is to take advantage of the condition when put options are under-priced. impersonal and indirect opinion Short/Long Derivatives Hedge. The total profit from this trade is determined by the formula: Equity Security Market Price + Premium of Put − Cost of Call − Strike Price of Put The Strike Price of Put +aPremium of hedged trade.0029% (calculated as .Hedge Strategies …an investing newsletter of general.65 + .
The total profit from this trade is determined by the formula: PRELIMINARY CALCULATION Onset Market Value of Underlying Security − Strike Price of Put Option = Equity Gap Coverage CALCULATION Strike Price of Put + Premium of Call − Cost of Put − Equity Security Market Price − Equity Gap Coverage The components of the Collar strategy are: Collar Strategy Components EMV .Call Strike (Short Call Option) PS .Put Strike (Long Put Option) Sold Call OPTION CONTRACT EGC PS EMV Purchased Put OPTION CONTRACT 35 CS LONG SHARES OF AN EQUITY SECURITY . there will not be enough premium from the call option to hedge the difference between the onset market price of the underlying security and the lower strike price of the put option. minus the lower strike price of the put option). impersonal and indirect opinion Short/Long Derivatives Hedge. an Aggressive Strategy the exercise price of the put plus the put "out-of-the-money" amount or 25% of the call exercise price. The dollar amount referred to as the “out-of-the-money” amount is equity gap coverage. If the call option is not written at a strike price at or below that of the put option.Equity Market Value (Long Equity Security) EGC . the additional cash covering the maximum potential loss (calculated as the difference between the onset market value of the underlying security. Recall that put options cover security loss amounts below the put option strike price.Hedge Strategies …an investing newsletter of general.Equity Gap Coverage (Cash) CS .
Not knowing what can happen with investment principal in a trade’s future is the riskiest of all situations. GENERAL AND INDIRECT OPINION …OFFERING IMPERSONAL. Using derivatives as a substitute for one side of a hedged long/short primary security strategy trade safely boosts strategy return (yield) through the inherent leverage found in derivatives. Clearly define the risks and rewards prior to entering every trade. Other Hedge Strategy Investment Reports: T R A D IN G ST R A T E G IE S D E T A IL E D E X P L A N A T IO N O F T HE HEDGE FUND T R A D IN G ST R A T E G IE S D E T A IL E D E X P L A N A T IO N O F HEDGE FUND MARGIN RATIO DERIVATIVES HEDGE HEDGE A MODERATE AN AGGRESIVE STRATEGY STRATEGY AN INVESTING NEWSLETTER ™ AN INVESTING NEWSLETTER ™ …OFFERING IMPERSONAL.Hedge Strategies …an investing newsletter of general. an Aggressive Strategy Conclusion A hedged trade maintains the safety of account principal. impersonal and indirect opinion Short/Long Derivatives Hedge. GENERAL AND INDIRECT OPINION 36 .
the risk may be reduced.Hedge Strategies …an investing newsletter of general. You can ask the firm with which you deal for details in this respect. models or strategies discussed. you will be exposed to risks associated with the system including the failure of hardware and software. impersonal and indirect opinion Short/Long Derivatives Hedge. 37 . If you undertake transactions on an electronic trading system. execution. but also from trading on other electronic trading systems. Trading on an electronic trading system may differ not only from trading in an open-outcry market. will always be profitable or will equal the performance of the strategy as explained in this report. an Aggressive Strategy RISK DISCLOSURE STATEMENT It should not be assumed that concepts. As with all facilities and systems. presently or in the future. Your ability to recover certain losses may be subject to limits on liability imposed by the system provider. The result of any system failure may be that your order is either not executed according to your instructions or is not executed at all. If the option is not covered. Most open-outcry and electronic trading facilities are supported by computer-based component systems for the order routing. registration or clearing of trades. they are vulnerable to temporary disruption or failure. the risk of loss can be unlimited. matching. the market. If the option is "covered" by the seller holding a corresponding position in the underlying security or a future contract or another option. Transactions in options carry a high degree of risk. the clearing house and/or member firms. Such limits may vary.
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Hedge Strategies is not engaged in rendering any legal.Hedge Strategies …an investing newsletter of general. at lectures and within other media. in oral lecture or on its website are provided as general market commentary. you should carefully consider your investment objectives. warrant or guarantee the merchantability. personal or specific investment advice or any other legal or tax professional advice. impersonal and indirect opinion Short/Long Derivatives Hedge. research. before deciding to participate in derivative trading. or indirectly.jsp prior to trading derivatives.
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