- 1997: Volume 6, No. 1 When Is An Option Overvalued?

In the CTA world, everyone recognizes the opportunity for big returns through the use of highly leveraged futures trading. Unfortunately, most professionals also know that along with the opportunity for big gains there is the chance of large losses. More and more asset allocators are looking at the risk/return relationship and many may find a trading strategy which uses long options is a welcome addition to their portfolios.

Options Minimize Downside Exposure

One of the most basic uses of a long option trading strategy is to minimize the chance of incurring big losses. While options have limitless upside potential, losses are limited to the premium paid. Even futures with stop loss orders cannot fully cap losses to predefined levels because of daily market trading limits and periods of low market liquidity. Options trading however, ensures that downside risk is limited to the premium paid. This can be especially useful when trading in volatile markets.

Payoff Chart for a Long Call

Market Price at Expiration Assumes purchase
of a $3 call with a strike of 60

Options Impart Discipline

Options can be particularly useful for ensuring trading discipline with discretionary traders. Discretionary traders can determine what they are willing to accept as a maximum loss for a given investment, and commit funds toward those options with absolute precision. Discretionary traders who use futures, even those who use stop-loss orders, must be extremely disciplined in setting and sticking to those stop loss orders. Futures traders who get psychologically attached to a trade may override pre-determined stop levels if they believe the market is experiencing a minor adjustment. Even worse, traders may believe they can recoup losses by staying in a market beyond a pre-determined level. A long options program can help prevent the "rogue" trader syndrome.

Options Allow Traders to Commit to a Direction

Options allow a discretionary trader to commit to a market direction without having to worry about being taken out of the market too early. When an options trader believes the market is heading in a particular direction, the trader can ride out periods in which there is a lot of price noise. With futures, the trader may get taken out of the market automatically with a stop-loss order. The futures trader is forced to make a re-entry decision if the market rebounds or else lose the opportunity to participate in the trade. Options can again be particularly useful in volatile markets.

Options Can Reduce Capital Requirements

In many markets, options provide the only way of trading smaller accounts effectively. Margin requirements in futures markets can be substantial for the smaller trader. S&P futures, for example, require almost $15,000 in margin for one contract. An options trader can take a position in an option on a futures contract often for as little as a $1,000. This means that someone who wants a 5% equity exposure to the S&P futures contract need invest no more than $20,000 in a managed options account. A managed futures account with the same equity exposure would require a minimum account size of $300,000.

Options Adjust Leverage Automatically

One of the unique aspects of options is that the amount of leverage increases automatically as a trade moves in the trader's favor and decreases as it moves against him. The reason for this is that options have "gamma." Gamma is the term used to describe the rate of change of the delta of the option with respect to the underlying future's price. Delta is the rate of change of the price of the option with respect to the underlying future price. Gamma, in effect, regulates the option's exposure to movements in the futures price. Gamma causes the delta of the option to rise or fall, depending on whether the price of the underlying future is moving in a favorable or unfavorable direction for the option. This means that an at-the-money call, for example, with a delta of 0.50 on purchase, can see its delta rise to 1.0 in a rallying market or drop to .25 in a declining market. Every one point move in the underlying future that used to account for a 0.50 change in the option price would now yield 1.00 for every one point rise and only .25 for every one point drop.

Of course, trading long options has its own requirements for success.

Options Have Time Decay

Unlike futures, options lose their value exponentially as the time to expiration on the option nears. For this reason, options traders need to have a much more accurate picture of the timing of a market shift in order to make a profitable trade. While many traders have made the correct decision as to where the market is heading, they often need to determine within weeks, and sometimes days, as to when that shift will take place. Sudden consolidations can wipe out profits quickly. Traders who try to buy options with long expirations to get around this problem have to pay up on the option premium and thus don't experience the same leverage as a shorter dated option.

Time Decay of the Option on the S&P Index Future

Days Until Expiration

Options Have Wider Bid/Offer Spreads

In general, options are less liquid than futures and as a result often have wider bid/offer spreads. When an option has a wide bid/offer spread, the trader has less opportunity to take advantage of small shifts in the market. By confining trading to the most liquid contracts at the largest exchanges, traders can somewhat overcome this problem, however this issue still limits the opportunities available to trade markets with lower volatility.

Option Premiums Are High

Many people are skeptical about the opportunity to generate profits with options when option premiums are high. This skepticism is not always warranted. Futures options are mathematically valued rights to purchase underlying futures. Their "richness" or "cheapness" are all a matter of opinion on whether too much or too little volatility has been priced into the option. If history says that a future's recent implied volatility is 15% and the current option price implies a volatility of 20%, the option may be expensive. It may also reflect that future volatility will be higher than historical volatility. For an options trader, he must determine how long this high volatility period will last. If it will last beyond his time horizon for the trade, the relatively high premium paid for the option is inconsequential to the trading strategy. The high premium will be recouped upon selling the option. For example, someone who bought an option on the Japanese Yen in June of '95 might have been concerned about paying a relatively high premium (relative to historical volatility), but in fact would have benefited from even higher volatility over the following month.

Volatility

For illustrative purposes only.
This is not accurate data.

On the other hand, many traders use options to trade around big market announcements where there is a great deal of uncertainty surrounding the outcome. The implied volatility and thus the price paid for the option premium can be very high preceding the market announcement and drop dramatically once the outcome is known. The change in the price of the option due to the underlying price move can be less than the fall in the price of the option as a result of lower volatility. For example, buying and holding a Japanese Yen option in February of '94 could have been hazardous, regardless of whether the directional move was correct or not.

Options Don't Always Trade When the Underlying Future Trades

Option traders can wake up to significant surprises. While many futures contracts trade on Globex, options traders have to wait until the following morning to take any action. Because the options price is mathematically tied to the spot futures price, much of the value of an option can be lost in overnight trading. Traders have to be aware of this fact and may want to confine their option positions to commodities which only trade during day sessions.

We have only touched on some of the issues surrounding long options trading and we have not even touched on the factors involved in writing options. It is clear that buying options can create some significant hazards to the uninitiated. However, it is equally apparent that traders with the appropriate technical understanding of options and with hands on experience trading these instruments can use them to benefit their portfolio returns.

Mark Taborsky and Michele Ruston are partners in the firm of Gargoyle Fund Management, LP., which specializes in trading options and futures for clients. Both Mark and Michele have earned MBA's from the University of Chicago. For more information, please call (312) 629-3626 or send an e-mail to gargoyle1@pipeline.com.