Trading, Hedging and Investment Strategies

Question 1

what are intra-market spreads?

Answer 1

trades based on the simultaneous buying and selling of futures with different expiry dates, but on the same underlying assets

Question 2

what are the motivations for intra-market spreads?

Answer 2

• anticipating changes in basis
• reducing risk (less risky than taking an outright position)
• arbitrage (taking advantage of price differences)
• to roll over an existing hedge so that it continues further into the future

Question 3

what are inter-market trades?

Answer 3

based on simultaneously buying and selling futures on different underlying but likely correlated assets

Question 4

what is the motivation behind inter-market spread trading?

Answer 4

often the price relationship between two corelated products has temporarily broken down or has moved outside its normal range, trader anticipates this being re-established

Question 5

what markets are inter-market trades popular in?

Answer 5

interest rate markets, long term and short term interest rates (yield curve)

also used in industries for hedging the production process or to exploit anticipated changes in cost

Question 6

how do hedgers offset price risk?

Answer 6

taking an opposite position in the futures market on their underlying position i.e., if they are long in a position, they’ll sell an equal amount on the other side (short)

Question 7

what is the implied repo rate?

Answer 7

measure of the funding cost in implied futures prices, reflects the difference between a bond’s cash price and the price of a futures contract

Question 8

what is a CTD bond?

Answer 8

cheapest to deliver, deliverable bond with the highest implied repo rate

Question 9

what is the number of contracts used to hedge based on?

Answer 9

the basis of holding the CTD bond in the portfolio

Question 10

how is the number of contracts needed to hedge calculated for most bonds?

Answer 10

dividing the portfolio size/value by contract size/value

Question 11

how is the number of contracts needed to hedge calculated for bonds?

Answer 11

price factor x (nominal value of CTD portfolio / nominal value of contract)

Question 12

how would one hedge a portfolio if they didn’t have a portfolio of CTD bonds?

Answer 12

= (P x DP) / (FC x DF)

P = Nominal value of the non-CTD portfolio
DP = Duration of portfolio
FC = Interest-rate futures price
DF = Duration of the underlying asset in the interest-rate future

Question 13

what is a portfolio’s Beta?

Answer 13

its volatility relative to the entire market

Question 14

how is a portfolio’s Beta calculated?

Answer 14

= Covariance (Rp,Rm) / Variance Rm

where:
Rp = return of the portfolio/stock
Rm= return of the overall market i.e., the stock index of that jurisdiction

Question 15

what do the Beta values between 0 AND 1 mean in relation to a portfolio and the market?

Answer 15

More than 1 = the stock or portfolio is more volatile than the market
Equal to 1 = in line with the market
Between 0 and 1 = less volatile than the market
Equal to 0 = no relationship
Less than 0 = inverse relationship

Question 16

how is the hedge ratio calculated in the case of STIR futures?

Answer 16

price change in portfolio given one basis point change in yields/price change in STIR futures given one basis point change in yields

Question 17

what is basis trading?

Answer 17

implementing strategies to profit from an anticipated change in basis’ and there being a discrepancy between cash and futures prices

Question 18

what is the disadvantage of changes in basis for hedgers?

Answer 18

derivatives used to hedge iwll be analysed by auditors, auditors are unlikely to allow firms to use derivatives to hedge if they are too volatile

Question 19

what are the main advantages of changes in basis?

Answer 19

to speculators and arbitrageurs, allows them to profit from their predictions, carries less price risk than trading outright on either legs of the basis

Question 20

why will an options hedge underperform?

Answer 20

because of the premium paid to leverage it but it provide flexibility and allow overall profits if the underlying moves in the investor’s favour

Question 20

how is a covered short call constructed?

Answer 20

by combining a long underlying position with a short call position

Question 21

what are the motivations behind a covered short call?

Answer 21

enhance returns in a stagnant market and partly hedge a long underlying position

Question 22

what do the different market conditions mean for a covered short call?

Answer 22

stagnant: investor will enhance return on the asset since they have collected the option’s premium on one side and on the other side the option will expire unexercised

falling market: premium will reduce the loss but won’t provide a true hedge

rising market: overall gains will be limited since the call will be exercised on one side, further gains above the strike price won’t be realised

Question 23

what is a naked short?

Answer 23

where the investor sells call options without owning the asset

Question 24

what are the two ways a covered short put can be constructed?

Answer 24

1. writing a put but also holding sufficient funds to buy the asset
2. already having a short position then writing a put on the original contract

Question 25

what is the motivation behind a covered short put?

Answer 25

enhance the return on funds in a stagnant market and to partially hedge a short underlying position

Question 26

what is an options spread?

Answer 26

simultaneous purchase and sale of options in the same class i.e., call or put on the same underlying asset

Question 27

what is a vertical spread?

Answer 27

buying and selling calls or puts with different strike prices but the same expiry

Question 28

what is a horizontal (calendar) spread?

Answer 28

buying and selling options with the same strike but different expiry months

Question 29

what is a diagonal spread?

Answer 29

buying and selling options with different strikes and different expiry months

Question 30

what is a bull spread?

Answer 30

where the investor buys the lower strike and sells the higher strike

Question 31

what is a bear spread?

Answer 31

where the investor sells the lower strike and buys the higher strike

Question 32

what is the summary of a bull call?

Answer 32

motivation behind the trade is that the trader is moderately bullish on the underlying (think the share price will rise to an extent), they’ll buy the call at a lower strike price and sell the call at a higher strike price. Net premium will be paid out as they will receive less for the higher strike they’re selling than what they pay for the lower strike. Max reward will be the differences in the strike minus the net premium paid out. Break even will be lower strike price + the net premium paid to cover all of their costs.

Question 33

what is the summary of a bear call?

Answer 33

motivation behind the trade is that the investor is moderately bearish (think the share price will fall to an extent). They will sell a call option at the lower strike price and buy call at the higher strike price. Net premium will be received as the premium they receive for the lower call will be greater than that paid for the higher call. Maximum loss will be the difference in the strike prices minus the net premium received, max reward will be the net premium received. break even will be the lower strike price plus the net premium received

Question 34

what is the summary of a bull put?

Answer 34

the investor is moderately bullish, they would buy at a lower strike price and sell at a higher strike price, net premium will be received. the maximum risk is the difference in the strike prices minus the net premium received, max reward is the net premium received, the break even point will be the higher strike price minus the net premium received.

Question 35

what is the summary of a bear put?

Answer 35

the investor will be moderately bearish that share prices of the underlying will fall. Will sell the put at a lower strike price and buy at a higher strike price. the investor will have to pay a net premium which will be their maximum loss. the max reward will be the difference in strike price minus the net premium paid. the break even point will be the higher strike price minus the net premium paid.

Question 36

what is the motivation behind horizontal spreads?

Answer 36

based on the view that volatility will rise, and involves selling shorter-maturity and buying longer-maturity options on the same asset with the same strike price. short dated options will lose time-value faster and react more quickly to changes in volatility

Question 37

how is the net profit/loss for a horizontal spread found?

Answer 37

by looking at the change in the premiums on either side and seeing if they rise/fall depending on the change in volatility then working it out from there.

Question 38

what is a diagonal spread and how are they constructed?

Answer 38

constructed by selling shorter-dated options and buying longer-dated options (put or call depending on if they’re bullish or bearish), directional depending on the market view

Question 39

what is a combination strategy?

Answer 39

involves the simultaneous purchase/sale of calls and puts

Question 40

what is the purpose of straddles/strangles?

Answer 40

attempt to profit from a change in the volatility of the underlying asset

Question 41

what are the mechanics of a long straddle?

Answer 41

investor will buy a call option for a premium and a put option for another premium. investor will exercise the call if the share price increases they will break even at the IV (difference between the share price and the price paid for the underlying) minus the net amount paid out for the premiums on both sides. They will make a profit at the point the share price rises above the strike price plus the net premium paid. if the share price falls, they will exercise the put, in order for them to break even, the share price will have to fall to lower than the strike price minus the premiums paid out. profit on either side provided the price movement is large enough to overcome the cost of net premium paid out.

Question 42

what is the rationale behind a short straddle?

Answer 42

investor in unsure about directional movement but is convinced that the price will not move too far away from the current price. Will look to sell both call and put.

Question 43

what are the mechanics of a short straddle?

Answer 43

if the share price rises, call will be exercised against the investor and they’ll lose the IV (difference between the share price and how much they sell it for), as long as this is less than the net premium from both options, they’ll still have a net profit. Movement above the strike price plus the net premiums will produce a net loss. Same will be the case in the opposite direction where if the share price falls, the put will be exercised against them and they’ll lose the IV, as long as this is less than the net premium, they’ll be making a net profit, anything below the strike price minus the net premium will create a net loss

Question 44

what is the point of maximum profit on a short straddle?

Answer 44

both options will be abandoned and the seller will keep the total premium, profit potential in either direction provided the price movement is low enough not to outweigh the net premium recieved.

Question 44

what is the difference between a long strangle and a straddle?

Answer 44

• strangle purchases put and call with same expiry but different strike prices, normally a lower put strike
• premium outlay on a strangle will usually be lower than on a straddle
• strangle needs more volatility to succeed as the net premium outlay as well as the difference in strike prices
• maximum loss on a long position will need to be crystallised over a range

Question 45

what are the differences between a short strangle and a short straddle?

Answer 45

• short strangle involves the sale of a call and put with the same expiry but different strikes
• total premium received on a strangle will usually be lower than on a straddle
• strangle can withstand more volatility than a straddle as both the sums of premiums as well as difference in strike prices need to be exceeded
• maximum profit on a short position will be crystallised over a range

Question 46

what is a synthetic long future?

Answer 46

buy a call and sell a put with the same strike and expiry, reversal

Question 47

what is a synthetic short future?

Answer 47

buy a put and sell a call with the same strike and expiry

Question 48

what is a synthetic long call?

Answer 48

buy a future and buy a put, same as having a hedged long position

Question 49

what is a synthetic short call?

Answer 49

sell a future and sell a put, effectively a short call position

Question 50

what is a synthetic long put?

Answer 50

buy a call and sell a future, same as a hedged short position

Question 51

what is a synthetic short put?

Answer 51

sell a call and buy a future, effectively a short put position

Question 52

what is the reason for using synthetics?

Answer 52

creating positions that may not be available on the underlying asset along with arbitrage between the prices of the options/ futures

Question 53

what are the two main routes to customers wanting to invest in derivatives?

Answer 53

accounts and pooled funds

Question 54

what does the account route to derivative investment preclude?

Answer 54

a discretionary account operates where the client entrusts money to a regulated firm which then undertakes to manage the funds according to the client’s objectives- client is liable for profits and losses but also benefits from professional coverage

Question 55

what does the pooled funds route to derivative investment preclude?

Answer 55

collective investment schemes managed by regulated fund management companies. maximum loss is limited to the amount invested in, risk is diversified because there are multiple sources of capital and potentially higher diversification of funds, lower transaction costs

Question 56

what are the different style/objectives of derivative-based funds?

Answer 56

• speculative
• guaranteed (structured funds with a lock in period and clients are guaranteed all or most of their money back, opportunity cost of returns elsewhere)
• synthetics (designed to replicate the performance of an index, relevant number of futures contracts to create the same output)