214 Part 3  Thinking about options Frequently, however, on a rally the skew can remain in place, and the implieds of all strikes are unchanged. Effectively, the implied volatility decreases because the focal point of the skew moves to the new at-the- money strike. The solid line of Figure 20.9 illustrates this: XYZ rallies from 100 to 105, and the new ATM implied, now at the 105 strike, is less than that of the former 100 strike. This situation often occurs with skews in stock indexes as they rally to former levels. The options market is unfazed by the upside retracement. This also occurs in commodities that have negative put skews as the commodities retrace from a rally; there the graph is the mirror image of Figure 20.9. Another possibility is that on a break, the skew can remain in place. Effectively, the implied volatility increases because the focal point of the skew moves to the new at-the-money strike. The dotted line of Figure 20.9 illustrates this: XYZ breaks from 105 to 100, and the new ATM implied, now at the 100 strike, is greater than that of the former 105 strike. This latter situation often occurs with skews in stock indexes as they break. The options market is fearful that this is the big one. When it really is the big one, then the entire skew will shift vertically upward, and the put wing will become more positive. 100 105 XYZ 36 38 34 22 32 30 28 26 24 20 Figure 20.9 Horizontal skew shift, negative call skew, positive put skew 20  Volatility skews 215 A note on market sentiment In all cases where a straight long or short option is chosen for a directional strategy, skew risk can be minimised by trading the long or short call or put spread. Volatility skews are indicators of market senti- ment. Positive skews indicate fear, while negative skews indicate complacence. Sentiment, as we know, can often be wrong, but it cannot be ignored. Volatility skews are indicators of market sentiment part 4 Basic non-essentials Introduction Most of us won’t spend our options careers trading arbitrage, but when the opportunity arises, as it does from time to time, it’s an almost risk-free way to make money. So if you learn about the arb, then you’re prepared to take advantage of it when you see it. Read Part 4 at least once. Think about it from time to time. When you’re scanning the markets, ask yourself, ‘Is there an arbitrage here? Can I lock in a profit with this trade until expiration?’ If you keep this in mind, then some day you’ll find yourself making a lot of money in a very short time. If you’re prepared. 21 Futures, synthetics and put–call parity It is possible to combine options and underlying positions in ways that simulate straight call or put positions. An underlying itself may be simu- lated with a combination of options. As an example of the former, a long at-the-money call plus a short underlying position has the same risk/ return profile as a long at-the-money put, and is therefore known as a syn- thetic put. Synthetic positions are used primarily by professional market-makers to simplify the view of their options inventory in order to manage risk better. They are of little practical use to traders who take options positions based on market outlooks, but they can be studied in order to understand how options markets work. In order to understand synthetics, it is best if you understand why they exist. Like all options positions, they are based on a relation to an under- lying contract, which may be a cash investment or a futures contract. If we briefly take this subject step by step, then we will avoid future disorientation. What a futures contract is A futures contract is simply an agreement to trade a commodity, stock, bond or currency at a specified price at a specified future date. Because no cash is exchanged for the time being, the future buyer is said to have a long position, and the future seller is said to have a short position. As a result, the holder of the long position profits as the market moves up and takes a loss as the market moves down. The holder of the short position has the opposite profit/loss. 222 Part 4  Basic non-essentials If short selling were not possible, investors would only be able to buy from those who wanted to sell physical holdings; liquidity would suffer and market volatility would increase. Most exchanges require a security deposit in order to open a futures contract, and this deposit is known as initial margin. The value of the contract as traded on the exchange invariably fluctuates, and so results in a profit to one party and a loss to the other. The party who has a loss is then required to deposit the amount of the loss, and this additional deposit is known as variation margin. Margin may be in the form of cash, or it may be in the form of liquid securities such as treasury bills or gilts, for which the depositor still collects interest. Meanwhile the party who has the profit is credited with variation margin, and he receives interest on the balance. Futures contracts have traditionally been used in commodities markets in order to hedge supply shortages and surpluses. They are now used in stocks, stock indexes, bonds and currencies. Many excellent books describe how these forms of futures contracts operate. An example of a futures contract Consider the following example of a closing price of the S&P 500 index with the settlement price of the December futures contract and the settle- ment prices of the at-the-money call and put on the futures contract. S&P index: 1133.68 December future: 1140.70 December 1140 call: 34.40 December 1140 put: 33.70 Here, the S&P futures contract multiplier is $250. An investor who trades one of the above December contracts is hedging 1140.70 × $250 = $285,175 worth of stocks that track the index. The options contract multi- plier is $25. We know that the December future, here with approximately six weeks until expiration, trades at a premium to the cash. This is because taking a long position in the futures contract instead of buying all the stocks in the index requires a margin deposit only. The holder of the futures position therefore has the use of his cash for the next six weeks. The value of the futures contract is increased by the cost of carrying on the stocks. 21  Futures, synthetics and put–call parity 223 On the other hand, the holder of the long futures position forgoes the dividends payable for the next six weeks, and therefore the value of the December future is decreased by that amount. The formula for the value of the futures contract is approximated as follows: Futures contract = cash value of index + interest or cost of carry on index until expiration – dividends payable until expiration In practice, the formula is more complicated because annualised rates of carry and dividend yields are used. Here, we are simply concerned with why the above future trades above or below the cash. Until recently short-term interest rates paid more than dividend yields, and so stock index futures traded at a premium to their underlying indexes. The situation is now reversed, and it is similar to the 1950s, where dividend yields paid more than short-term interest rates in order to compensate for the risk of owning stock. This was a holdover from the crash of 1929, when many stock-holders’ investments were wiped out. The reason now, however, is that after the recent bank- ing crisis, the central banks are trying to maintain liquidity by keeping interest rates low. Occasionally, shortly before expiration, there may be a large amount of dividends payable in a stock or stock index. Then the dividend outweighs the interest amount and the future trades at a discount to the index. Once the dividend or dividends are paid, then the future trades above the cash. In any event, the futures contract and the cash index converge at expira- tion because then there is no remaining differential between cost of carry and payable dividends. The futures contract simply expires to the current cash value of the index. There, the holder of the long futures contract pays the cash value of all the stocks in the index. The holder of the short futures contract receives the cash value of all the stocks in the index. The ultimate amount exchanged is deter- mined by the value of the index at expiration times the contract multiplier. In the case of a physical commodity such as corn or crude oil, the futures contract is deliverable to the quantity of the commodity specified in the contract at the settlement price. The futures contract and the cash index converge at expiration because then there is no remaining differential between cost of carry and payable dividends [...]... valued at 1140.70 Your synthetic options position is valued the same, and always will be, as a futures contract If, on the other hand, you sell the call at 34.40 and pay 33.70 for the put, then you have sold the synthetic future at 1140.70 Here, you have the obligation to sell the future above 1140, and the right to sell the future below 1140 The profit/loss of the two synthetics is graphed in Figure... Here, you could sell the call at 34.40, pay 33.70 for the put, and pay 1140.70 for the future You have then sold the synthetic at 1140.70 and you have bought the future at the same price There is no profit or loss to this position, nor will it change for the life of the options contract At expiration the short synthetic pairs off against the long future, and the result is no position There is minimal risk... 34.40 for the call, sell the put at 33.70, and sell the future at 1140.70 Here you have paid 1140.70 for the synthetic and sold the future at the same price Figure 22.2 shows a graph of the entire position Again, the arbs exploit the smallest price discrepancy with any of the components of the reversal Here, they might pay 34.30 for the call, or sell the put at 33.80, or pay 1140.60 for the future... as with the S&P example above, but often there is no underlying future for comparison Still ,the synthetic future exists In the stock options the synthetic future is often spoken of simply as the synthetic, or occasionally, the combo Synthetic long call position When a long XYZ 100 put is combined with a long underlying position, the profit/loss’s of the put and the underlying cancel each other below... futures 235 236 Part 4  Basic non-essentials Conversion and reversals on individual stocks and on other stock indexes The conversion and reversal markets on stocks operate in basically the same manner Remember that with stocks there are no futures contracts, but that the options combine to form synthetic futures contracts The situation is similar to the S&P 500 cash–futures–options relationship given in... long call and a short put at the same strike If XYZ is at 100, you could buy one 100 call, sell one 100 put, and sell or go short one XYZ to create a reversal Because the sum of the position is long the synthetic and short the underlying, there is no profit/loss change regardless of underlying price movement At expiration, the synthetic pairs off against the underlying to leave no position With the S&P... in the OEX The SPX options on the S&P 500 index, traded at the CBOE, are also based solely on the underlying index; they are European style Traders here sometimes used the S&P 500 futures contract at the CME in order to create a conversion or reversal The FTSE-100 contract is a hybrid The options are assigned to cash at monthly expirations like the OEX There is a futures contract as well, like the. .. call, buy one 100 put, and buy or go long XYZ to create a conversion Because the sum of the position is short the synthetic and long the underlying there is no profit/loss change 234 Part 4  Basic non-essentials regardless of underlying price movement At expiration, the synthetic pairs off against the underlying to leave no position Consider again the example from S&P 500 futures, and options on futures... Synthetic long December SPZ futures contract + synthetic short December SPZ futures contract 225 226 Part 4  Basic non-essentials Synthetics on individual stocks In the case of individual stocks, there are also a synthetic futures position, because the holder of a long call plus short put position at any strike controls a long stock position without having to pay for the stock The situation is the. .. 1140 put at 33.70 If the futures contract were eliminated, and the options were exercisable instead to cash, then the relationship would be the same as between stocks and stock options The OEX options are traded in this manner, without an underlying futures contract; they are American style Because there is no underlying cash instrument, apart from an unwieldy basket of stocks, there is no conversion . the other hand, you sell the call at 34.40 and pay 33.70 for the put, then you have sold the synthetic future at 1140.70. Here, you have the obligation to sell the future above 1140, and the. by the cost of carrying on the stocks. 21  Futures, synthetics and put–call parity 223 On the other hand, the holder of the long futures position forgoes the dividends payable for the. contract simply expires to the current cash value of the index. There, the holder of the long futures contract pays the cash value of all the stocks in the index. The holder of the short futures