In the right direction

In this, the second of a two-part series on advanced options, we look at the concept of directional strategies and consider various methods of employing them.

In the January issue, we looked at a number of option strategies that can be used when we either expect a great amount of market volatility but are unsure of the direction of that volatility, or we expect the market to be very tranquil, with very little price movement at all (see EPRM January 2002, pages 38-39).

Straddles, strangles, butterflies, and condors are each useful in certain circumstances (see last month), but they are not often considered hedge instruments, as they don’t provide protection for moves in any particular direction. Someone who has price exposure to a commodity, a foreign currency, interest rates or an equity would probably be more interested in an option strategy that protects that position from upward or downward price movement, but not both at the same time. Such strategies, often called directional strategies, are the topic of this month’s article.

The simplest of such strategies is the outright purchase of a put or call. If we are long crude oil and looking for a hedge, we are concerned about price declines, and would want to buy an option that makes money if prices go down. This would be a put – it is the option to sell at a predetermined level, which we can set by choosing the strike price. High-strike puts are, of course, more expensive than low-strike puts, so they require us to consider the trade-off between protection and cost – but, fundamentally, all puts work in the same way. If we are short crude oil, we would look to buy a call.

Another route would be to consider selling an option rather than buying one. The most straightforward example of this is the ‘covered call’, a common strategy in the stock market. As such, if we buy a stock for $40.00, we could sell a call with a strike price of $45.00, collecting $2.00 in premium. If the price of the stock goes up, we get to sell at a profit – the call is exercised, we sell at $45.00, and we also get to keep the $2.00 in premium we received.

However, we have very little protection in the case of a downward price move, having collected only $2.00 in premium to offset the losses from the stock price decline.

The opposite approach would be used when we are short an asset – in such a case, we could sell a put. Stock market examples of this are more difficult to find, since few people short-sell stock.

Selling an option is, then, only a partial hedge for an existing position, so it is a strategy that is used far less frequently as a hedge than buying an option is.

What if we want to buy a call, but the cost is too high for us? We can also sell a call at a higher strike, creating a bull call spread.

If we bought a $20.00 crude oil call for $0.60 a barrel (bbl) and sold a $22.00 call for $0.20/bbl, the net cost of $0.40/bbl would be lower than if we only bought the $20.00 call, but our profit potential – or our protection, if we are hedging – only extends up to $22.00. After that, the gains from the $20.00 call we bought are offset by losses from the $22.00 call we sold – this is the call side of our $18.00/$20.00/$22.00 butterfly strategy from January’s article.

But that might not be a worry to us, if we believe futures prices may rise but will not go beyond $22.00. If we want to buy a put, but are concerned about the cost, we could sell another put with a lower strike price. The profit-and-loss (P&L) profiles of these strategies are shown in figures 1 and 2.

SELLING CALL/PUT SPREADS

These call and put spreads can be sold as well as bought. Using the stock market example we introduced above, we could sell a $45.00 call and buy a $50.00 call against it. One difference between this approach and simply selling the $45.00 call is that less revenue would be collected, since we are not simply selling a call, but also buying a call at a higher strike price, which has some cost to it.

With each disadvantage comes an advantage, though.The advantage here is that if prices go beyond the second strike price, the strategy stops losing money.

In our example, if we had only sold the $45.00 call and the price of the stock went to $60.00, we would still be left with selling out our stock at $45.00 and collecting the $2.00 premium. But if we had bought the $50.00 call as well, collecting only $1.00 in net premium, we would in the end sell out our stock at $45.00, but would be able to buy it at $50.00 through the exercise of the $50.00 call we bought. With the price of the stock at $60.00, that option would be very valuable indeed.

DIRECTIONAL STRANGLE

In our example, we reduced the cost of a call purchase by selling a higher-strike call against it to create the call spread. If we want to reduce the cost of our call spread even further – possibly even turning it into a net credit strategy, in which we collect more premium than we pay out – we could sell a put as well.

This strategy goes by more than one name – it is sometimes called a directional strangle.

A strangle involves the sale of both a put and a call, with the strike price of the put below the strike price of the call. Strangles are inherently non-directional – the profit or loss performance is the same for an upward price move and a downward price move.

A directional strangle, also called a three-way spread, is the same as a strangle sale, but with a put or call purchase at a strike price between those of the strangle sale. That option length gives the strategy its directionality. For our example, we’ll assume the purchase of a call.

Such an approach would give us considerable risk if futures prices were to fall, but if we are hedging, that risk would be offset by gains from our physical position. If we are speculating, the risk would have to be one we have considered and are willing to take in return for the premium we receive. The P&L profile of an $18.00/$20.00/$22.00 long directional strangle – short an $18.00 put, long a $20.00 call and short a $22.00 call – is shown in figure 3.

A put spread, combined with the sale of a call, would have a P&L profile mirroring that in figure 3.

RATIO WRITES AND BACKSPREADS

Another way to cut the cost of a call spread or put spread is to sell two high-strike calls or low-strike puts rather than only one.

The first of these strategies we will look at is the call ratio write, also called a call ratio spread or a one-by-two call spread. Taking such an approach, we would buy a $20.00 call, and sell two $22.00 calls against it. The P&L profile at expiration is shown in figure 4. The maximum profit from this strategy would occur if the futures price at expiration was exactly $22.00, since the long $20.00 call would have a $2.00/bbl profit but the two short $22.00 calls would fall just short of the levels at which they show any losses. As we are short two options and long only one, this strategy tends to profit from relatively tranquil markets, especially if futures prices are near that maximum-profit level.

A hedger would only consider this strategy if he or she were quite confident that futures prices would not exceed $22.00. For a speculator, this strategy is one way to sell a $22.00 straddle without the exposure to losses at low futures prices such a straddle would have – this strategy is exactly equivalent to selling a $22.00 straddle and buying a $20.00 put.

The same strategy can also be used with puts, and is called a put ratio write, a put ratio spread or a one-by-two put spread. Instead of buying an $18.00/$20.00 put spread, we could buy one $20.00 put and sell two $18.00 puts.

A hedger would use this strategy in place of an $18.00/$20.00 put spread when quite confident that prices will not fall below $18.00/bbl. A speculator would treat this approach as an $18.00 straddle, without the exposure to losses at higher futures prices such a straddle would have.

The opposite of these ratio writes are called backspreads. With a backspread, we would sell the one call or put, and buy two calls or puts at strike prices further away from the current futures price – higher in the case of calls, lower in the case of puts.

A backspread is not often used for hedging, though it can act much like a straightforward long call or put if it has a significant amount of time before expiration. Close to expiration, it is a strategy used only when one expects a very strong and rapid price move in the direction of the two long options.

For instance, a $20.00/$21.00 call backspread is equivalent to a long $21.00 straddle, combined with a short $20.00 put. This is a strategy that limits profits in the case of a downward move in futures prices, but does not limit profits in the case of an upward move, fitting the expectation of an upward price explosion. Bear in mind that it is close to expiration, so a slow upward price move does us little good.

CHRISTMAS TREES

A variation on the ratio writes and backspreads is, for some unknown reason, called a Christmas tree. Using this strategy, we would sell two options with different strike prices rather than two with the same strike price.

For the seller of the two options, the premium revenue is reduced but the range of prices at which the maximum profit is made is widened. For the buyer of the two options, the premium paid is reduced but the range of prices at which the maximum loss is incurred is widened.

This strategy does not have a different name for the seller and the buyer, so it is necessary to clearly specify which options are being bought and which are being sold.

FENCES

A more aggressive strategy, which retains the open-ended risk but does not limit the upside – as the directional strangle did – is called a fence. Using this method, we could buy a call and sell a put at a lower strike price – this is called a bull fence – or we could buy a put and sell a call at a higher strike price – known as a bear fence.

Those who trade options in the over-the-counter market, as opposed to on an exchange, would recognise this by another name: a collar. The P&L profile of a $19.00/$21.00 bull fence is shown in figure 5. We have covered quite a number of option strategies in these two articles, discussing the most popular of them. And we could go on doing so for some time, given the number of possible options.

We have not even considered option strategies that employ options with different expiration dates, or that employ options with different underlying assets. These more complex strategies have their uses, but are not as common as those we have outlined.

By employing both those covered and their more complex variations, we can greatly expand the flexibility – and therefore efficiency – of our hedging and speculative programs.

Doug Coyne is an energy consultant and faculty at The Oxford Princeton Programme headquartered in Princeton, New Jersey. He is based in Woodbury, Minnesota.
e-mail: dcoyne@oxfordprinceton.com

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