STRATEGIES USING EQUITY FUTURES AND EQUITY OPTIONS
Futures Contracts for Hedging, Speculation, and Arbitrage
Calendar Spread Arbitrage
- Definition: A trading strategy that involves taking opposite positions in two futures contracts with different expiry dates to profit from the mispricing of the spread between the two contracts.
- Details: The arbitrageur goes short the near-month futures contract and long the mid-month futures contract, expecting the spread to return to its fair value, allowing for a profit when the positions are unwound.
Key Characteristics of Calendar Spread Arbitrage
- Low Risk: The strategy involves taking opposite positions, protecting the arbitrageur from large losses regardless of the stock price movement.
- Low Return: The return is low because the arbitrageur is capturing a small mispricing in the futures contracts, with no directional bet involved.
- Difficulty in Finding Opportunities: Calendar spread arbitrage opportunities are difficult to find due to the high liquidity of index and stock futures contracts, which allows for quick exploitation of mispricing by arbitrageurs.
Important Considerations
- Simultaneous Execution: To make a profit, it is essential to enter and square up the long and short positions simultaneously, as any delay can reduce profitability or lead to losses.
- Fair Spread: The arbitrageur profits when the actual spread returns to the fair spread, which is the expected difference in prices between the two futures contracts.
Use of Options for Trading and Hedging
The following are key concepts related to the use of options for trading and hedging:
- Trading Strategies: The most common trading strategies using options include spreads, straddles, and strangles.
- Spreads: Spreads involve combining options on the same underlying and of the same type (call/put) but with different strikes and maturities. These are limited profit and limited loss positions.
- Vertical Spreads: Vertical spreads are created by using options having the same expiry date but different strike prices.
- Horizontal Spreads: Horizontal spreads involve options of the same type, having the same strike price, but different expiry dates.
- Diagonal Spreads: Diagonal spreads involve a combination of options on the same underlying but different expiry dates as well as different strikes.
- Straddles: A straddle involves two different types of options (call and put) with the same strike prices and same maturity.
- Strangles: A strangle involves two different types of options (call and put) with different strike prices and same maturity.
- Covered Call: A covered call is a strategy used to generate extra income from existing holdings in the cash market.
- Collar: A collar strategy is an extension of the covered call strategy, which involves buying a put option to limit the downside risk.
- Butterfly Spread: A butterfly spread is a limited profit and limited loss strategy that involves buying and selling options with different strike prices.
- Hedging with Options: Options can be used to hedge against unexpected movements in the underlying price.
- Protective Put: A protective put is a hedged position that involves buying a put option to protect against a fall in prices.
Arbitrage using options: Put-call parity
- Definition: Arbitrage is possible whenever the traded price of an option deviates from its fair price, based on the principle of put-call parity.
- Details: The put-call parity formula is given by: π + π β π βππ‘ = π + π0, where:
- π: premium for the call option
- π: premium for the put option
- π: strike price of the options
- π0: spot price of the underlying
- π: rate of interest
- π‘: time to expiry of the options
Key Concepts
- The put-call parity principle is only applicable to European options.
- If the traded price of the put option is different from the derived fair price, there is an arbitrage opportunity to make a risk-free profit.
- The arbitrageur will buy the put and the stock, and short the call option to capture the arbitrage gain.
- The strategy involves simultaneous buying and selling of the stock, the put, and the call, which can be difficult to execute and may expose the arbitrageur to large losses if not done correctly.
Delta-hedging
- Definition: Delta-hedging is a technique used by option traders to manage the risk of their short option positions by taking a long or short position in the underlying asset.
- Details: It involves calculating the delta of the option position, which measures the sensitivity of the option value to a given small change in the price of the underlying asset.
Key Concepts
- Delta: The delta of an option measures the change in the option value for a one rupee change in the underlying stock price.
- Delta-Neutral Position: A position where the combined delta of the option and the underlying asset is equal to zero, making it unaffected by small changes in the stock price.
- Hedging: The process of reducing or managing risk by taking a position in a security that offsets the risk of another position.
Advertisement
Delta-Hedging Process
- Calculate the delta of the option position to determine the size of the long or short position in the underlying asset needed to hedge the risk.
- Take a long or short position in the underlying asset to offset the risk of the short option position.
- Continuously monitor and adjust the position in the underlying asset to maintain a delta-neutral position as the delta of the option changes with changes in the underlying stock price.
Important Points
- Delta changes with changes in the price of the underlying stock, so the hedging position must be continuously adjusted.
- Delta-hedging is used to manage the risk of short option positions, but it does not eliminate the risk entirely.
- The process of delta-hedging involves buying or selling futures contracts to maintain a delta-neutral position.
Interpreting Open Interest and Put-Call Ratio for Trading Strategies
- Open Interest (OI): Refers to the number of positions that have been opened by market participants and not yet closed.
- New Formulation of Open Interest: Measured at a portfolio level by computing the net Delta-adjusted open positions across futures and options for an underlying.
- Delta Value: Indicates the sensitivity of a derivativeβs price movement relative to its underlying asset.
- Delta Value Interpretation:
- Long Futures: +1, gains βΉ 1 for every βΉ 1 rise in underlying asset
- Short Futures: -1, loses βΉ 1 for every βΉ 1 rise in underlying asset
- Long Call: 0 to +1, partial gain when underlying asset rises
- Short Call: 0 to -1, partial loss when underlying asset rises
- Long Put: 0 to -1, partial gain when underlying asset falls
- Short Put: 0 to +1, partial loss when underlying asset falls
Key Concepts for Trading Strategies
- Future Equivalent Open Interest (FutEq OI): Calculated by multiplying the delta value with the long position in call or put options.
- Put-Call Ratio (PCR): The ratio of trading volume of put options to call options, calculated either on the basis of options trading volumes or on the basis of their open interest.
- Trading Strategies Based on Open Interest and Futures Price:
- Rising futures price and increasing open interest: Bullish trend, go long on futures.
- Rising futures price and declining open interest: Short-covering, existing short positions being squared up.
- Declining futures price and increasing open interest: Bearish trend, go short on futures.
- Declining futures price and declining open interest: Existing long positions being squared up.
- Trading Strategies Based on Put-Call Ratio:
- PCR less than one: Bearish trend, option sellers do not expect the index to rise.
- PCR greater than one: Bullish trend, option sellers do not expect a fall in the market.