Option hedging strategies pdf

Without loss of generality, we investigate the effectiveness of several trading constraints and technical indicators by scrutinizing and back testing with the long-term market data. The second issue is to use the spread strategies for risk control when being an options seller. Note that a spread position is constituted where one buys an option and sells another option against it.

In general, we develop a scheme to simulate different trading strategies and thus identify some simple but profitable strategies. Moreover, rising demand from institutions, electronification and improved market access may drive continuous volume growth.

In other words, the futures options market may still be in relative infancy and has not experienced the growth in other similar market. Also, the market has evolved to become a trading arena that supports increasingly sophisticated investment strategies today. A futures option is an option contract in which the underlying is a single futures contract e.

The option buyer has the right but not the obligation to assume a particular futures position at a specified price i. On the other hand, the option seller must assume the opposite futures position when the buyer exercises this right. One of the main reasons why investors trade options is to avoid the reverse fluctuation of market risk, resulting in loss of underlying assets and to arbitrage between the same target and different types of financial instruments, or using the underlying asset price change to make a profit.

Thus, the primary function of futures options is to hedge stocks or index, which is the most commonly used tool for institutional investors [1]. The usual rules in a trading strategy include indicators based on technical analysis, fundamental analysis, quantitative methods, or a combination of several factors. In this work, we investigate two crucial factors to determine an appropriate trading strategy.

The first one is to discover the appropriate timing for profitable trading. There are many technical indicators being created to predict the trend and can be included in our strategy. The second one is hedging that is closely related to risk tolerance of an investor.

Note that there are always risks in the financial market, especially for being a seller who earns the time value to the futures options [2]. The rest of this paper is organized as follows. Preliminaries and related works are generally reviewed in Sec. Our proposed scheme is developed and illustrated in Sec. To evaluate the effectiveness of our approach, experimental studies based on real market data are explored in Sec.

Finally, this paper concludes with Sec. Next, to know how to hedge, the method of hedging is discussed in Sec. Moreover, prior works on identifying future trends using different technical indicators are explored in Sec.

The trading of futures options can be modeled as a zero-sum game. In other words, the gain of one party necessarily implies the loss of the other party, i. Options represent the right, but not the obligation, to take some action on the specified date [4]. There are two types of options, i. In European options, a call option is bought when the investor expects the underlying value will rise before the expiry date, and also gives the trader the right to buy an asset at a strike price on the expiry date.

This is opposite of a put option, which bought when the trader expects the underlying value will plunge before the expiry date, and gives the trader the right to buy an asset at a strike price on the expiry date. And there are two sides to each of the option transaction — the party of selling the options, and the party of buying the options.

Each side takes its own risks and has a different portfolio. The relationship of the payoff of a call option and the price of the underlying investment is shown in Fig. Figure 1. Payoff of a call option In prior works, a number of options trading and hedging strategies are developed, including single trading strategy, bullish strategies, bearish strategies, neutral or non-directional strategies. The trading volume of futures options is more than that of any other derivate product.

For example, futures options account for over 50 percent in trading volume in Taiwan [5]. However, before that, those options are valuable no matter for time value or hedging value. An futures option is a derived and volatile trading tool that a trader can either be the buyer or seller [7]. The seller in the futures options like an insurer, if there is not an unexpected situation appears they can obtain a stable profit and the buyer on the contrary.

In other words, the buyer and the seller have different views of the volatility. If buying and selling different options at the same time, it can combine a strategy to reduce the volatility risk.

However, Specifically, being the options seller has several advantages [7], including 1 The odds are in the favour; 2 Taking profits becomes simple; 3 Time is on the side; 4 Being close is good enough; 5 Perfect timing is no longer necessary; and 6 Definable risk control. There are two types of analysis which investors perform in the stock.

In fundamental analysis, the intrinsic value of a security is measured by examining related economic and financial factors, which can be both qualitative and quantitative. On the other hand, technical analysis is a kind of method used to evaluate investments and determine trading opportunities by analyzing demographic trends gathered from trading activities, such as price movement.

In short, fundamental analysis is mostly based on the underlying value of the investments in the long-term. On the contrary, technical analysis is more focused on current trends and is thus more appropriate for short-term trading. In prior works, several technical indicators combined with machine learning methods are used to predict stock price index movement [12]. Exponential moving average EMA is also used to develop options trading strategies [14]. Several technical indicators are used to decide which strategy to use.

To control the risk, there are five primary techniques [7]: 1 Spread the market; 2 Set an exit point based on the value of the options itself; 3 Rolling options; 4 Basing risk on value of underlying; and 5 Take profits early. In the simple language, a spread position is formed by buying and selling in the same timing, same asset, same underlying security but with different strike prices or expiration dates.

The aim of the spread strategy is expanding profit interval to earn stable profits. There are some advantages including less risk and provides the trading edge, lower volatility risk. As we have known, being an options seller need to take the unlimited risk.

In light of that, using the spread strategy helps to limit the risk [8]. Besides, we can use a different combination to create different profit interval to formulate an appropriate trading strategy. Furthermore, the options values and volatility are in direct correlation. By entering the spread, the position is noticeably less sensitive to changes in implied volatility There are many researches to dig into the diversified spread strategies.

The fast Fourier transform is used to extend the original Black-Scholes model to price the generic spread options [9]. Trinomial tree model is used to price the spread options [10]. The spread strategy is used to hedge in commodity price risk management [11].

First is the moving average MA. In statistics, a moving average is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. The simple moving average SMA is the most widely known one. It is often seen the trading signal after the price is reflected.

Therefore, there is another indicator derived from SMA that can be more sensitive to the trend. It is called exponential moving average EMA. In EMA, the weighted influence of each value decreases exponentially with time. That means the more recent data, the more influential, but the older data also gives a certain weight. In other words, EMA is more sensitive on market trends.

When the volatility of the market is high, this index rises. Relationship between VIX and TAIEX indices Because VIX can show the current turmoil in the market, we think it can be used as a reference for the number of commodities at the time of trading, because when the market volatility becomes higher, the risk of trading increases.

If an option has intrinsic value, it is called an ITM option. In the opposite, if the option does not has intrinsic value, it is called an OTM option. In other words, we can use less money to reach the same purpose. For the above reasons, we decide to use OTM options to be our main trade options. The spread strategy we use to hedge is that for each OTM option including call and put search the other option which OTM degree is higher than a protected option to combine to a spread which including selling a lower OTM option and buying a higher OTM option.

The spread example shown in Fig. The way we search is using the 10 to 40 percent premium which we get from selling the lower OTM option. If we cannot find the higher OTM option which matches the condition the premium of the higher OTM option is too high, or the lower OTM option is too low , then we give up this opportunity.

Given that another factor the rest date to the expiration date, we divide nearby month and back month to research the difference of their profit ratio and explore are there any characteristic we can expand to use in our work.

Bull Put Spread 3. Our proposed scheme can be divided into four parts as shown in Fig. Step 1: The OTM points and the minimum premiums are set to be constraints. For step one, we attempt to determine whether being sellers or buyers has more profits and is there more profit in the OTM options.

Step 2: The technical indicators are set to build the strategy and we back test different OTM options and different minimum premiums data to find the best parameters. Step 3: The spread strategy is added to hedge. The different percent of premiums are used to buy another option to combine into a spread strategy for controlling risk. Step 4: We compare the various combination strategy and the sub-strategies profit and risk and recommend different strategies for different needed investors.

Figure Figure 4. Then, we evaluate that whether sellers in the options market get better results in winning rate and the total profit.

Furthermore, we compare the spread and naked strategy and confirm the spread strategy is better than naked when the market encounters some issues. Note that TXO is an index option, i.

In other words, no actual stocks are bought or sold. The corresponding market data is crawled from Taiwan Futures Exchange website. The daily open price, close price, high price, low price and expire month are included.

We select all contracts between January and December based on two conditions: 1 transaction volume is not zero; and 2 dates between the expiring date of this month and the expiring date two months ago. If the agave skyrockets above that price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and actually would have been better off by not hedging.

Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate and currency - investors can even hedge against the weather. Fixed interest rate exposures Fixed interest-bearing investments, such as an investment in long-term government stock or shorter term bankers' acceptances, have basically two definable risks: a A specific risk that applies to each security; b A general market risk relating to the entire portfolio of investments in fixed interestbearing securities.

The specific risk of an individual security relates to the fact that individually it can move against the general market. This would mean that the individual security would decrease in value the market rate on that security increases when the general market value of interest-bearing securities increases the market rate decreases. The general market risk is that the market value of interest-bearing securities decreases, because of an increase in the market interest rate.

If securities in the investment portfolio follow the trend in the market, this increase in interest rates would result in a decline in the value of the portfolio.

Increased interest rate volatility has led to greater volatility in the return on bonds and other fixed-income assets. The volatility of the interest rates and the resulting value of fixed interest rate securities, can lead to an unexpected capital loss. In the same manner the current value of interest-bearing liabilities can increase and decrease in value if the market rate fluctuates.

The current value is arrived at by discounting the cash flows of the asset or liability back to the present date, making use of the current market rate.

Floating interest rate exposures In the case of interest-bearing assets where the interest received is linked to a floating interest rate, the risk is that the floating interest rate would move negatively resulting in interest received on an investment asset , such as cash kept on short-term deposit earning the prime rate, declining to less than the general money market interest rate or the expected yield.

For the purposes of clarity the investment risks discussed above can be defined as: a The risk of losses from holding capital; b The risk of losses from interest income declining.

Derivative instruments and methods of hedging When deciding on a technique to hedge a risk associated with a financial position, a number of aspects have to be taken into account. Some of the aspects to be considered are named below:.

The risk inherent to the derivative. Some derivatives have other risks associated to them that are not inherent to the original underlying position, such as immediate cash flow, the risk of the downside, etc. The risk of the specific derivative being considered must be taken into account before deciding on a strategy. Exposure to the downside. When certain instruments are bought or sold, a risk exists that the market does not move as anticipated, and that a larger loss will be suffered on the hedging than previously expected.

On certain instruments this loss is unlimited and it is possible to suffer large losses because of this position. On some instruments the downside loss opportunity is limited, such as purchased options Cash flow of the hedging method. When making use of futures as a hedge, there could be daily cash flow as opposed to caps or floors, where cash flow is only on settlement dates and only if the benchmark rate was exceeded.

This cash flow planning needs to be considered when deciding on a hedging method. Effectiveness of hedge. Sometimes a hedge is not a perfect hedge, in the sense that no direct derivative exists for the underlying position that needs to be hedged. This would, for instance, be the case where a share portfolio exists which does not represent the allshare index, but the value of the portfolio moves more or less in line with the all-share index.

To hedge this portfolio with a short all-share index future, there is a risk that the short all-share index future and the value of the portfolio move in corresponding directions resulting in losses on both sides.

If no perfect hedge exists, the risk of the hedge corresponding to the movement of the underlying asset must be taken into account. Tradability of derivatives used. In some cases the market does not move as anticipated, and the underlying position makes a profit while the hedging position suffers a loss.

In these cases it would be preferable if the hedging position could be sold in the market and closed out. This can, however, only be done if the instruments used in the hedge have an active secondary market and can be traded easily.

Joint enhancing strategies. Some hedging strategies, such as the writing of options, have only limited upsides. In such cases other policies or strategies must be implemented to stop the loss from exceeding the possible profit on the hedging position. An example of such a strategy is a stop-loss limit where a policy decision is made to liquidate a position should that position suffer a larger loss than a certain set limit.

Options Hedging fixed interest rate investments or non-interest-bearing investments with option contracts When an investment is made in a fixed interest-bearing instrument, the risk is that the secondary market rate at which these instruments trade will increase, with a resulting decrease in the value of the instrument.

Investments in non-interest-bearing assets such as shares, carry the risk that prices may decrease, resulting in a loss of value. This risk can be hedged by buying a put option with the investment as the underlying asset. The put option will establish investment as the underlying asset.

The put option will establish the rate or price at which the underlying asset can be sold to the writer of the option. The maximum possible loss or minimum possible profit is thus known. If the rates decrease or the prices increase beyond the strike price of the option, the asset can be sold in the market at a higher value than would be the case if the option were exercised.

In this case, the option would not be exercised, and the loss on the hedge is the option premium paid. If the investor is of the opinion that rates will increase, with the result of decreasing prices of assets, the investor may also write and sell a call option at current rates or rates that are expected to be less than future rates. If the rates increase, the option will most probably not be exercised, and the investor would have made a profit equal to the option premium received when the option was sold.

This is, however, not a full hedge of an underlying investment, as the maximum profit that can be made is limited to the premium received. The decline in the price of the investment might be more than the premium received. To enhance this strategy, an additional measure such as a stop-loss limit on the underlying asset should be put into place. Hedging floating interest rate investments with option contracts Option contracts, as seen previously, gives a right to but does not place an obligation on the holder.

When an OTC option is exercised, in most cases the underlying asset is physically delivered. Options can be applied to floating-rate investments in the same manner as with fixed-rate investments, where the underlying instrument can physically be delivered. Where the investment is a cash amount, for instance, in a short-term deposit, in some cases this asset cannot at will be liquidated and delivered for the exercising of an option.

Terms of an option are, however, in most cases negotiated between the two parties, and it is not impossible to negotiate an option that suits the investor. These options with customized terms are, however, not common and often cannot be traded effectively in the secondary market. Options traded on an exchange such as options traded on SAFEX are, however, cash settled in most cases and can effectively be used to hedge an income stream if movements in the rate of the underlying asset of the option and the rate of the position that needs to be hedged, coincide.

Futures Hedging fixed interest rate exposures and non-interest-bearing instruments with futures contracts An investor can guarantee a minimum price that he would get for his asset by selling a future closing a future contract to sell the underlying asset.

One of the major disadvantages of the future in comparison to options, for instance is that a futures contract places an obligation on both parties to honour the terms of the contract. There is no choice whether to exercise the contract or not. The investor could thus be forced to sell the underlying asset at the close-out date of the contract at a price that is lower than the market value of the underlying asset at that date. A prospective investor can determine the price at which he will buy the investment at a future date, by buying a future closing a contract to buy an asset at a future date.

This could, however, force the investor to buy the investment at a higher value than the market value at the close-out date of the contract. As is the case with options, when dealing with futures where the underlying asset is a fixed interest rate asset, the futures contract will specify the rate at which the asset will be bought or sold. The price will be the future cash flows discounted at the rate stipulated in the futures contract. Hedging floating interest rate investments with futures Similar to options, futures were mainly developed to determine and establish a fixed price received on an investment at a certain date in the future.

It was not specifically intended to hedge risks associated with floating-rate investments, although this risk can be managed if a financial future with an interest rate instrument as underlying asset is available, and the market rate movements on this instrument more or less matched the floating interest rate of the investment. The risk for the investor in a floating interest rate product would be that the rate and income stream from the investment decreases. The fact that futures are cash settled and not physically delivered gives this investor the chance to establish an interest rate income stream received for a future date, if he can match the nominal amounts of his investment and the futures contract.

By closing the futures contract now, the investor can fix the yield on his investment for the period of the futures contract. It is important to note that the yield can only be determined if the floating rate on his investment matches the market rate of the underlying asset to the future.

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