Monday, May 12, 2008

Using Options to Reduce Leverage

Most people think of options as a way of increasing leverage. You can put down a small amount of money to control a large amount of stock. But, of course, per contract, an out of the money option moves less than the underlying instrument for any given move in the underlying instrument. The delta of the option expresses how much the option moves for a 1 point move in the underlying. An at the money option has a delta of 0.5 (for a call, -0.5 for a put) and the further out of the money the option is the lower the delta. In the case of individual stocks there is no point in taking advantage of this because you can just trade less than 100 (in Aus 500 or 1000) shares if you really want to have a smaller position. But this effect could be useful for small futures traders, where the size of the underlying contract can be quite large. For example, the SPI futures contract (Australian stock index) is currently worth around $A145k per contract. Using an at the money option instead will result in an effective half-size position of $A72k, which is about the size of an S&P 500 E-Mini contract. One of my problems in trying to trade the SPI futures has been that I don't want to lose much money, so I set a tight stop, which then often gets hit before the index moves in my desired direction. I've got better results trading under simulation, where I'm less worried about the money.

The reason to look at options on SPI futures rather than the many other available warrants and options traded on the ASX is to reduce commissions paid. Using Interactive Brokers I can pay less than a 1/6 of the commission I need to pay Commonwealth Securities to trade ASX listed warrants. IB has Australian stocks, futures, and futures options, but not ASX warrants and options.

The downside of trading out of the money options is time decay (theta). A June at the money option is decaying at about 2.2 index points a day. That's $A55 a day, which for an overnight trade negates the commission advantage.* So this is only worthwhile intraday. But a September option decaying at about half that rate and a December option at about a third of the rate of the June option. So the question is how easy is it really to trade these options in terms of liquidity and bid-ask spreads. This statement: "The presence of Official Market Makers for SFE SPI 200® Options ensure tight bid ask spreads." is encouraging, but I can't actually see any bids and asks quoted on their site. I've requested permission to trade them (don't know why I didn't do this when I signed up for futures) and will soon find out under simulation first.

There is another way around time decay - if you buy an OTM call, short an equally OTM put at the same time. The net premium paid is then zero, but your delta doubles. This, therefore, makes no sense for an ATM option as you may as well trade the futures contract as shorting the put increases your delta to one. The downside for more OTM options is that now you have to deal with two bid-ask spreads and commissions and, therefore, this will only makes sense for longer term trades.

* This comparison is valid because I usually trade deep in the money warrants or barrier warrants through CommSec, which have little to no time decay.

1 comment:

Andy said...

Great post. I am currently trading some Visa sep 95 options which are way out of the money. I wrote a post on this recently and am hoping for a recovery.