38 lines
2.9 KiB
Plaintext
38 lines
2.9 KiB
Plaintext
Chapter 29: Introduction to Index Option Products and Futures 517
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Due to a phenomenon known as volatility skewing, it is possible for index
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options to have implied volatilities that are out of line with projected index or stock
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price movements. This phenomenon is discussed in detail in the chapter on advanced
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concepts.
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For example, suppose that index puts are expensive, as they became after the
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1987 stock market crash. When this happens it may actually be more profitable for a
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trader who is bearish on the market to buy a package of equity puts instead of buy
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ing index puts. The equity puts are forced to reflect the probability of stock price
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movement because arbitrage strategies will keep them in line. They will therefore be
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less expensive than index puts when this type of volatility skewing is present. Index
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puts can remain expensive for several reasons - primarily excessive demand and
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inflated margin requirements. In such situations, it is theoretically correct to buy a
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group of puts on stock options. In fact, one might even hedge this purchase by sell
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ing out-of-the money, overpriced index puts.
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SELLING INDEX OPTIONS
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In earlier chapters, we saw that many mathematically attractive strategies involve the
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sale of naked options - ratio writes, straddles, ratio spreads, etc. Index options pres
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ent an even stronger case for these strategies. Recall that the greatest risk in these
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strategies with naked options is that the underlying security might move a great dis
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tance, thereby exposing the position to great loss if the movement is in the direction
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in which the naked options lie. That is, if one is naked calls and the underlying secu
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rity rises dramatically, perhaps on a takeover bid, then large losses - potentially
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unlimited in the absence of follow-up action - could occur.
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The strategist would, of course, never let the loss run uncontrolled. He would
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attempt to take some follow-up action to limit the loss or to neutralize the position.
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However, even the best strategist cannot hedge his position if the movement in the
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underlying occurs while the market is closed. For example, if the underlying securi
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ty is a stock, certain news items might cause a large gap to occur between the closing
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price of a stock and its next opening price. Such news might be related to a takeover
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of the company or to a drastically negative earnings report, for example.
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Index options do not have this particular drawback. An index - especially a
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broad-based index - is not as likely to open on a wide gap as a stock is. An index can
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not be the subject of a takeover attempt. It cannot be severely depressed by bad earn
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ings on one of its components. Thus, index options are more viable candidates for
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strategies involving naked option writing than stock options are. Index futures and
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options may often open on small gaps of a point or so, due to emotion or possibly due
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to the fact that a market that opens earlier (T-Bond futures, for example) has already |