Option Tales: Cheap Options Part I

17-05-2016 | By Rob Soentken |

banking

 

Today in Rob Soentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. Today I’m discussing the first two solutions: Choose the strike further OTM and Choose shorter tenor.

 

1-Choose Out of The Money (OTM) Strike

Hedging the purchase of a certain amount of USD could be done by purchasing a USD call option with the strike set At The Money (ATM). In diagram 1 it shows that such an option would costs about 2.0%. The strike is 0% OTM, so ATM. A strike further OTM would cost less premium. For example, a strike set at 3% OTM would costs only 0.8%. The cost saving is 1.2%, but also the protection kicks-in only after USD has appreciated by 3%. Should we need to exercise the option to get our USD, it still means a combined hedging cost of 3.8%. Which is more than if we had bought the ATM option for 2% premium. Conclusion: Buying an OTM option reduces the up-front cost versus buying an ATM option. But ex-post hedging with an OTM option could result in total hedging cost which are higher than an ATM option.

2- Choose shorter tenor

Hedging the purchase of a certain amount of USD in 1-year time could be done by purchasing a USD call option with 25% chance of exercise. In diagram 2 it shows that such an option would have a strike 6.2% OTM and would cost 1.5%. Options with the same strike but with a shorter tenor would cost less up front. For example: choosing a 3-month time to expiry would make the option premium 0.2%. It must be noted that while the 3-month option has the same strike as the 12-month, its chance on exercise (Delta) is substantially less. By itself choosing a 3-month tenor is not ‘wrong’ when hedging a 12 months USD flow. It is just the on the expiry date of the option either the option is exercised, or the USD must be purchased from the market at the prevailing rate.

 

 

In my next two articles I will discuss the following solutions for minimizing premium expenses when buying options:

  • Choose longer tenor
  • Average rate option
  • Conditional Premium option
  • Reverse Knock Out

Want to read more in Rob Soentken’s Option Tales?

Option Tales – Options are for Wimps
Options Tales – ATM OR OTM?

 

Rob Soentken

 

 

Rob Soentken

Ex derivates trader

Option Tales: ATM or OTM?

banking10-05-2016 | By Rob Soentken |

 

When uncertainty is substantial and the decision was made to hedge with options, should the strike be put ‘At The Money’ (ATM) or ‘Out of The Money’ (OTM)? Diagram 1 shows the dilemma.

 

 

An ATM call option on USD with strike at 1.1400 costs about 2% while a 4% OTM option with the strike at 1.0944 costs only about 0.6%. The latter is substantially cheaper but the protection only kicks in once the USD has appreciated 4%.

option tales - 1

We know the premiums and the strikes, but each strike / premium combination has its merits. It would help if we would know the amount of Risk we are running. To speak in terms of insurance: We know the premium, but we do not know the potential loss. One thing we do know is the chance on that loss. This chance factor is called Delta. It is the chance of the USD appreciating below the strike of the option. The premium divided by the chance on the loss is the potential loss. It could be more, it could be less, but it is the estimated average loss. For example: The 1.14 strike costs 2% premium and has a 50% chance of being worth anything. Therefore the 2% is the premium on an insurance contract potentially worth 2% : 50% = 4%. Lets call this Risk.

Diagram 2 shows Premiums, Delta and Risk for various OTM strikes.option tales - 2 Risk appears fairly stabile across strikes, which makes sense because the premiums are calculated with one volatility on one underlying. The Risk on OTM is lower than that for ATM options. It appears that OTM premiums are relatively more expensive, they give protection against less potential loss.

Knowing the Risk to be around 3.5-4% on the USD to be purchased, it does not come as a surprise that in real life many option strikes are bought to protect for losses beyond this percentage amount. Hedgers are looking for protection beyond the expected potential loss on the underlying. These are OTM strikes in this case 3-4% OTM, with a Delta (chance of exercise) between 20-25%.

option tales - 3Diagram 3 shows Premiums, Delta and Risk for different tenors. ‘Time’ is the time to expiry of the options in fractions of years. Its shows that for longer tenors, the Risk is higher. But disproportionally. For the same chance on exercise a hedger could double the premium to buy a hedge for a 4x longer tenor.

Rob Soentken

 

 

Rob Soentken

Ex-derivatives trader