filoraene's New Writeups

Option spread (thing)

2009-11-30T21:05:31Z

Introduction

An option spread is a combination of options. As such, it is an example of an option strategy. In this writeup, we will see two examples of an option spread: the regular spread, and the calendar spread. This writeup assumes the reader is familiar with what an option is.

The regular option spread

A regular option spread consists of two options, two calls or two puts. These two options have the same underlying, and time to expiry, but different strikes. Here, one is long one of the options, and short the other.

Call spread

As an example, consider a call spread. If one is long the option with the lower strike, and short the option with the higher strike, the following payoff at expiry is found:

If the underlying expires below the lowest strike, both options are worthless. The spread expires worthless.
If the underlying is above the

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risk reversal (thing)

2009-11-29T22:41:54Z

Introduction

A risk reversal is a combination of options. As such, a risk reversal is an example of an option strategy. In this writeup, we will see how a risk reversal is built, what the potential profit and risks are. This writeup assumes the reader is familiar with what an option is.

How to build a risk reversal

A risk reversal consists of two options with the same time to expiry on the same underlying. The first option is a short out the money call, and the second is a long out the money put. This means that the strike of the put is lower than the call. Normally, the strikes of the risk reversal are both equally far from the current price of the underlying. This strategy has the following payoff at expiration

Below the strike of the put: The call is worthless, and the long in the money put has a value of 1 for each 1 the underlying is below the the strike.
Above the

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hedge (thing)

2009-11-28T21:59:09Z

Introduction

One of the words you will hear most on a trading floor is the word hedge. A hedge, quite simply, is some way to reduce or remove the unwanted risk of a position, like hedging a bet. A proverb among trades is that "The only perfect hedge is in a Japanese garden". Although I cannot comment on Japanese horticulture, I can comment on the quality of some hedges, so that is what I will do. I will then explain why a hedge is very important in finance.

Basis risk

If you have a position in one asset, and do a trade in the same asset that perfectly compensates this position, one could say one has a perfect hedge. However, this is commonly just known as having no position. As such, having a hedge position almost by definition implies that the hedge is not perfect; a perfect hedge is not called a hedge, but a flat position. However, when a hedge is not perfect, we introduce basis risk. …

Reverse Convertible (thing)

2009-11-27T22:30:21Z

Introduction

A reverse convertible is not a car with a messed-up gearbox and no roof, but rather, a hybrid security that can behave like a bond or like shares, as the issuer desires. As such, it is vaguely similar to an ordinary convertible bond, where the choice is made by the investor. In this node, we'll take a look at precisely what this reverse convertible is, and why one would or would not want to buy one.

What is it?

In a reverse convertible, the issuer has the choice to pay you back in either cash or a certain number of shares. Now, if the value of these shares is lower than the value of the cash, you can expect to get the shares. If it is higher, you will probably get the cash. As such, the seller has in effect the option to sell you shares at a price equal to the value of the bond divided by the shares price. As such, this option has an effective strike equal to this price. It is noted that this "option" is…

convertible bond (thing)

2009-11-26T21:29:35Z

Introduction

A convertible bond is a hybrid security that has the behavior of (subordinated) debt and stock, as desired by the holder of convertible. As such, it is similar to a reverse convertible, only here, the holder, and not the issuer, has the choice between payoff as a bond or payoff in shares.

What is it?

When one buys a convertible, one buys a bond and a call warrant. This means one profits if the shares of the company rally, but is not affected as strongly by the downside, namely a drop in share price. The only point at which this becomes an issue is if the issuers goes bankrupt: in this case, both bond and shares are worthless.

Because the buyer of the convertible bond also receives a warrant, the interest rate on the bond is lower than for a normal bond of this company. As such, it represent an option for companies to…

Butterfly (thing)

2009-11-25T22:05:53Z

Introduction

This writeup is on an option combination, or strategy, known as a butterfly. It is an option strategy that is used to make money when an underlying ends up exactly at a certain level at expiry, while maintaining a modest risk profile.

How to set up a butterfly?

An ordinary butterfly consists of three option positions on the same underlying with the same expiry, but a different strike. The call butterfly consists of:

One long call with a strike K - X
Two short calls with a strike K
One long call with a strike K + X

So, an example could be a long 40 - short 2 times 50 - long 60. Let's investigate the payoff of this thing, by considering various scenarios that may occur at expiry.

Below or at the lowest strike: All options expiry worthlessly. Payoff is 0.
Above the lowest strike, and at or below the middle strike: The long call is in the money.

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