Options typically are viewed by futures traders as a costly way to cut profit potential. It doesn't have to be that way -- in fact, here's how to get more bang for your buck, and avoid open-ended losses.

By Howard L. Simons

Many traders have used options at some point to protect profits on an underlying position, sell premium against a perceived unsustainable move in either price or volatility, or to construct a short-term position prior to key events. (See "Options: An overview" for the basics.) But few speculative traders have used options consistently over a prolonged period. Why? Most likely due to costs of being long premium, the risk of being short premium, and the manpower and computer resources required to manage an option trading program.

But options are one of the best ways for a spec trader to profit, especially since all trades are convertible into a position that has:

  • limited downside
  • unlimited upside, and
  • expected returns that can be increased over the life of trade.

Synthesized Everyone has heard of synthetic longs or shorts. These can be designed using options to create a futures contract. A series of arbitrage relationships is critical to understanding synthetics.

The most important is the relationship between the synthetic and natural futures:

  • Synthetic long future = Short put plus long call
  • Synthetic short future = Short call plus long put

In the chart "Turning options into futures" we illustrate a synthetic long future, which involves buying a call and selling a put at the same strike within the same month. The profit profiles of a long call option, which shows a gain at higher prices, and of a short put option, which shows a loss at lower prices, can be added together to reproduce the linear, 45-degree profit profile of a long futures position.

Once you understand that futures or cash forwards can be constructed through option spreads (being long/short a pair of same-strike, same-month puts and calls), the variations on this basic theme fall into place. The purpose behind the use of different strikes, different expiration months and different ratios is to get a different profit profile than a basic futures position.

The nature of these structured positions, whether they are simple options, option spreads or futures/options/cash combinations, can allow for limited downside risk and open upside potential. Of course, you can structure positions that don't limit risk.

The second major relationship is between natural and synthetic options:

  • Synthetic long call = Long future plus long put
  • Synthetic long put = Short future plus long call

A synthetic long call is designed using futures and options. The gains in the put option at lower price levels offset the losses in the long futures position. At higher prices, the combination's gain mirrors that of the future, less the initial cost of the put option.

The importance of this relationship is assets linked by an arbitrage pricing relationship at initiation will not behave identically over the life of the trade. For example, if you have a bullish outlook with a contingency that any price break will be sudden and severe, the synthetic call, with its put option component, may be the preferred instrument to own.

Which instrument to use given a market outlook now is key. Moreover, as your market outlook changes over the life of a trade, you can modify and rebalance the position.

The third major relationship is the put-call parity theorem contained in the Black-Scholes option pricing model:

  • Call - put = Present value [futures - strike]

The importance of this relationship, once again, lies in the ability to substitute positions within defined price zones for specific purposes. For example, a long call position and a short put position both constitute a long position at initiation, but their profit profiles are quite different, as shown in "Turning options into futures."

The fourth major relationship is the one between delivery months of a futures contract:

  • Back month = Front month + capital costs plus physical storage costs

The importance of this relationship once again lies in the expected behavior of a trading instrument over the life of a position. Because options on the near month are subject to more rapid time decay than those on the back month, calendar spreads can be constructed for any given outlook on price, volatility and the intermonth spread.

Managing your position Speculating with options makes use of the different rates of time decay between months and across strikes in the same month to achieve the optimal position for the desired application.

The most difficult characteristic of options is volatility, the degree of uncertainty in a market. Because volatility is inherently unpredictable and because it has a linear effect on option prices, volatility probably produces more windfall gains and frustrating losses than any other aspect of option trading. In the following examples, volatility is neither forecast nor judged "too high" or "too low." The affects of volatility on relative values are simply accounted for.

The principle of increased expected return over the life of the trade is critical to a successful options trading program. This is achieved in three general ways:

  • Selling excess delta to maintain desired exposure.
  • Adjusting strike prices to maximize the gamma of the position.
  • Restructuring the position to accommodate changes in market conditions and market outlook.

Selling excess delta comes from the equivalence relationship between options and futures. Options positions have to be constantly rebalanced as the underlying price changes, as shown in this table.

In this example, 1,376 August $17.50 crude oil puts with a delta of (0.44) were purchased to get a target exposure of 600 short crude oil futures. The cost at initiation was $742,704. Five days later, the price of crude oil drops to $17.00. The delta of the puts falls to (0.61), making the position equivalent to 844 short futures. Unless you have a pyramiding or add-on system, you are now shorter than you either need or wish to be. This can be remedied simply by selling 398 puts at a revenue of $343,894. This is equivalent to taking 57c profit on the 67c move, while remaining short the equivalent of 600 futures contracts, and reducing the maximum potential loss on the position to 65c per contract, an important consideration if the price of crude oil rebounds.

Striking out Another method of position management is strike adjustment. If, for example, in another three days the price of crude oil fell to $16.50, owning $17.50 puts would be inefficient for several reasons, including the low gamma of the position and the large amount of in-the-money premium now at risk.

In this instance, the remaining 978 $17.50 puts could be sold at $1.19 for a credit of $1,163,820 and 1,250 $16.50 puts could be purchased at 54c for a debit of $675,000. In the process, another $488,820 of the original purchase expenditure would be recouped, the gamma of the position would be improved from 0.23 to 0.28, and the exposure still would be equivalent to being short 600 crude oil futures.

The third method of position management is simple, that is, restructuring the position to accommodate changes in the market and market outlook.

Dynamic system To get the most out of options, we use the Dynamic Option Selection System (Doss), a real-time device that constructs and tailors a customized, optimal derivative position to achieve our desired goal within specified parameters. It does this with a proprietary formula designed to provide maximum return at a minimal risk and cost. The system features include:

  • Separate but consistent algorithms for selecting which strike within a month to employ for the building blocks of strategies; i.e., which call to be long in a bullish strategy, or which strike to sell a straddle against;
  • An algorithm for ranking different strategies -- 44 at present;
  • The ability to look forward and backward across different strikes in time;
  • The ability to have either price premium or volatility serve as the key variable for real-time analysis; and
  • The ability to modulate positions according to a bullish or bearish outlook, and to impose support/resistance bounds on price moves.

For example, see "Options and the S&P 500," which illustrates Doss for an S&P 500 index fund. On May 18, 1994, the fund desired $44 million long exposure to the index, which equated to 199 futures contracts with the June futures at 454.10. A Doss search recommended the implementation of a calendar straddle:

  • Buy 848 July 450 calls and 848 June 450 puts at a debit of 15.00 index points, or $6.36 million.

The delta on this straddle was 0.236, making the position equivalent to 199 futures at initiation. The long July calls will increase in value far faster than the June puts will lose value in an upwards price move; moreover, the position delta will increase, allowing the subsequent sale of excess delta in the July calls.

On May 19, the June futures increased to 456.35, a relatively modest gain of 2.25 index points. This was sufficient to bring the position delta to 285 futures equivalent. To bring the exposure back to 199 futures equivalent, 128 of the original 848 June 450 calls were sold at 13.20, or $844,000.

The new position of 720 July 450 calls and 848 June 450 puts retained the 199 futures equivalent exposure to the upside, but provided greater downside protection and a reduction in dollar exposure of 13%.

Using Doss in a speculative trading program -- or your own equivalent system -- will result in lower-risk positions, each sculpted according to more dimensions than just price, and each achieved at a lower cost than a simple option purchase program.

Howard L. Simons directs quantitative research for Fimat USA in Chicago and is a professor of finance at the Illinois Institute of Technology. E-mail: HSimons@aol.com.
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