Question

A (HF) hedge fund, “BigBets” currently holds a well diversified (passive) portfolio of stocks worth V_p = $10m with β_p =1.2 (with respect to the market index the S&P500, which currently is at S=1000).

In addition, the HF holds V_B =$1m in Boeing stock, with a current price of S_B = $100 and a beta β_B = 2. The risk-free interest rate = 1% pa (continuously compounded). The volatility of Boeing stock is currently 30% pa.

Derivatives contracts available include a 1-year futures contract on Boeing stock, a 1-year stock index futures contract and calls and puts on Boeing stock, with 1 month to maturity. (Assume Boeing stock pays no dividends).

The HF believes that over the next month, the market index (S&P500) will decrease by 2% (due to a slowdown in the world economy). The HF also believes that there will be a clear announcement about the grounded Boeing 737-800 jet in 1 months time, which will result either in the plane not coming into service (for the foreseeable future) or, it is announced that all the technical problems have been solved. The HF therefore forecasts either a 20% rise or a 20% fall (with equal probability) in Boeing’s stock price, depending on the outcome.

The boss of the HF states that you cannot change the composition of your stocks’ portfolio but you can use futures and options contracts to achieve the best outcome possible, for the HF over the next month, given the above scenario.  

Explain ONE strategy you might use (with futures and/or options) and the potential outcomes from your strategy. Explain any costs and risks in your strategy.

You may use illustrative data, tables and diagrams in your analysis.

(Max 400 word limit)

Answer 1

As a swing trader in the futures and futures options markets, most of my trades are directional in nature, based on price action and time cycles. As such, I generally use 1 of these 3 different option strategies:

If implied volatility rank or percentile is high, selling OTM or ATM options is a very attractive strategy, one that I really like to use. On top of being a directional trade, you also get the benefit of time decay and volatility reversion to the mean. I generally sell options that are 30–50 delta, and 30–45 days out.

If implied volatility rank or percentile is low, then selling OTM or ATM options has a much lower risk/reward ratio, and is far less attractive. In those cases, I would look to sell ATM credit spreads, looking for directional movement as well as time decay. I generally look for spreads where I can collect 40–50% of the width of the strikes, with an objective of 50% of max profit.

But most often, for straight directional trades, I look at buying ITM options as a substitute for an outright futures position. This is dependent on the options liquidity and a comparison of the option cost to the futures margin. I buy options with an approximate delta of 70, and in most cases, the options are a better choice then the futures. I generally buy 3 of the 70 delta options instead of a 2 futures contract position. This gives me essentially the same profit exposure to an outright futures position, but with reduced risk.

Futures and options both are individually different and belong to the derivatives segment which means they derive their value from an underlying asset or instrument.An option contract provides the contract buyer the right, but not the obligation, to buy or sell an asset or financial instrument at a fixed price on or before a predetermined future month. That means the maximum risk to the buyer of an option is limited to the premium paid. Below are the five advantages of futures:(1). Futures are great for trading certain investments.(2. )Fixed upfront trading costs (3). No time decay (4). Liquidity (5). Pricing is easier to understand. However suitability of futures or options depends upon the risk taking ability of the individual.

The complexity of trading in ththe financial markets grows in the following order spot< futures< options. Spot is also 100% cash and for both the futures and options you can leverage in the increasing order (i.e. more leverage for options than futures). To answer your question it is easiest to understand and trade in spot, then in futures and then in options. If you understand all three products and have the risk apetite with deep understanding of technicals then I would suggest you go ahead with options as returns vs risk is better. Or better trade in futures and hehe with options. If you don’t understand the product then I would suggest a slow approach, start with spot understand the technicals and your risk apetite and then move on from there. Covered call is all about buying naked call options by basic covered call or buying-write.

· In case of Covered put, the underlying assets are shorted along with selling a put option on the same number of shares.

· Covered call and Covered put is both useful in F&O (Future and Options) segment traders.

· Recommended for both positional traders and intraday traders.

· Shall be used consistently and in a disciplined way.

· Applicable for stock and F&O index.

· Covered call if expected to move up, traders shall take a long position in stock future and to protect that, the nearest call option shall be short or written.

· Call Premium rises when a stock moves up.

· In any case, after the stock meets the target, a long position in future along with the call option is to be covered.

· The amount of resulting profit in future gets reduced to the extent of the premium covered in shorting of call and the difference obtained in them is the actual profit earned.