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Technical Analysis

Part 1: Implementing a View Options

by Patrick Oberhaensli, on Apr 27, 2020 4:45:00 PM

Introduction

In this two part article following our discussion of Plain Vanilla Options, we will examine the use of options through a clearly expressed investor view. It is only in this context, that an advanced asset allocation can be properly considered. We start the discussion by describing in detail the three core views.

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The Large Market Move View

The large market move view encompasses two sub-types of perspectives:

  • Call respectively put stock warrant: When one "knows" in which direction the market will go.
  • Long straddle: When one just "knows" the market will sharply move.
Call Respectively Put Stock Warrant Detail
View Stock(s) moving sharply either up or down is “known” and happens before or at the long (time) horizon. A warrant – a security - implies a long(er) time horizon.

Typical Position

Gains are realized by selling the warrant (so, not necessarily a Buy-and-Hold).

Process of Implementation

Issuing of a call option (up move) or a put option (down move).

Result

If the view materializes then the option, either the call or the put, is In-The-Money before or at expiration. Investors can realize their gains simply by selling the warrant. If the market went against the investor’s view (in the opposite direction), the option is worthless. Moreover, when the warrant was bought, the option had time value and that disappears… with time.

Variants Underlying: there are a large number of underlyings possible, including derivatives such as futures (for example a futures on short term interest rates).

 


Long Straddle Detail
View

Stock moving sharply either up or down but the direction is “unknown”.

Typical Position

Realize gains by selling the position or just the losing part (before it is worth even less).

Process of Implementation

By buying both a call and a put option with the same strike, set at spot (when the position is implemented). It is therefore more expensive than a single option position.

Result

If the view materializes then the option, either the call or the put, is In-The-Money before or at expiration and the investor can realize gains – of course, the costs need to be covered. Investors can do that early (before expiration) simply by selling the position. If the market did not move (sufficiently), the options are worthless. Moreover, when the options were bought, they both had time value and that disappears… with time.

Variants

Underlying: there are a large number of underlyings possible, including derivatives such as futures.

The long strangle: Not using a single strike but 2 allows investors to buy options that are both (more or less) Out-of-The-Money and means to go long a strangle instead of a straddle. The main advantage would be a cost-reduction, but that comes at the expense of a need for an even stronger move in either direction in order to be profitable.

 


The Stable-At-Horizon Market View

The third core view and one key way to “invest” in the stable-at-horizon market optimization view is the reverse convertible (a type of Structured Product).

Reverse Convertible On A Stock Detail
View

Stock not having moved at the (time) horizon. And ready to take the underlying risk (possibly after the maturity of the product).

Typical Position

Typically Buy-and-Hold

Process of Implementation

In a bond which pay-out is associated to a European-style short put option. The investor therefore “cashes-in” the option premium in the form of a sharply increased coupon. It can also be seen as a capitalized short put.

Result

If the view materializes then the option is Out-of-The-Money at expiration and the investor is paid-back the initial 100% plus a last high coupon. Otherwise, the option is exercised and the investor gets an equivalent of the underlying stock with unrealized losses. In the case of an equity index option, the pay-out might be in cash: the investor realizes then the corresponding losses.

Variants

Underlying: an equity index or a bond (for example).

With partial capital protection: In this case, as long as a low price in the stock has not been reached, the pay-back at maturity will remain at 100%. But should that trigger-price have been touched, then the reverse convertible with partial protection will start to behave like a common reverse convertible. Logically, given that partial capital protection, the coupon will be smaller than for an equivalent common reverse convertible. The option that is used instead of the European-style short put is an exotic option called down-and-in (a knock-in) barrier put option

 


Conclusion

What we clearly see, is that investing via options – and it might be through a Structured Product for example – isn’t that complex per se. But it does require increased monitoring especially in the case in which time plays against the investor. In the second part article, we will explore further solutions based on options and therefore extend the range of possibilities to implement precisely a view.


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EVOLIDS FINANCE LLC, Disclaimer:

  • This content is not intended to be a solicitation nor an offer
  • The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible
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