Will this options strategy work?

Discussion in 'Options' started by frank99, Oct 6, 2006.

  1. frank99


    I'm reading McMillan on Options, and they talk about a strategy that I have questions about.

    It's a hedged strategy for Index futures on index option expiration

    Here's the strategy:

    On Expiration Friday do the following:
    Buy five in-the-money expiring OEX calls
    Sell one S&P 500 near-term futures contract as a hedge.

    Can someone explain how they came up with this? I've read the section in the book, but still have more questions.

    What is the max risk using todays numbers? What is the max profit?

    What is the probability that this will be profitable?


  2. I'm not entirely sure what the benefit of this strategy is, but there are some interesting side effects to note with OEX:

    1) It settles at the close of the day despite the fact the futures continue to trade for an extra 15 minutes.
    2) It's cash settled, rather than underlying settled

    A strategy I've seen used often is to:
    1) Buy x ITM puts
    2) Sell y ES/SPX futures contracts

    Do this on a day when earnings are expected after market close which could really move the markets.

    If the market rallies hard after hours, exercise your puts and buy back your futures contract. Your puts will be exercised at the *close* of the day, not at the after-hours price. You should be able to do this for very little (if any) loss. If the market crashes hard, you win on both the futures and the puts.

    Perhaps this example takes advantage of some statistical rallying in the futures market after close on expiration?
  3. frank99



    Thanks for the reply. I'm interested
    in learning more about the strategy you offered as well.

    With the strategy you outlined,
    are you talking about buying OEX
    options? What is a good ratio
    of x to y?

    If the market rallies hard after hours,
    you said to buy back the puts. You're
    talking about the next day right? My
    broker wont let me trade options after

    Thanks again!!!


  4. I don't see any advantage to your strategy.

    The puts should be exercised no matter what the market does after 4pm. Their value doesn't change after close, if they are in the money you should exercise them.

    So basically you just have some short naked futures contracts.

    I know you said that you are not sure of the benefits of this strategy, it's possible there are none. Perhaps you omitted an important detail?

  5. Okay, just to make it simpler, pretend there was an OEX futures contract.


    Buy 1 OEX future @ 630
    Buy 1 OEX 660 put @ 33
    Sell 1 OEX 660 call @ .15

    You do this at the close of the market, when OEX is at 630.

    After hours, WMT announces great news which drives OEX up 10 points after hours.

    Sell 1 OEX future for 640
    Exercise your 660 put
    Buy back your 660 call @ .25

    NET: $10 - 3 - .10 = $6.90 win

    ($3 is your loss in exercising the 33 call which closed 30 ITM)

    After hours, WMT announces terrible news which drives OEX down 10 points after hours.

    Sell 1 OEX future for 620
    Sell your 660 put @ 42
    Buy back your 660 call @ .05

    NET: $-10 + 9 + .10 = $.90 loss

    Not a bad play. If you're right and the market rallies, you make $6.90. If you're wrong, you lose $.90. If you do nothing, you're still in a delta-neutral conversion.

    This is the simplest case. There are many more nuances here. In the winning case, instead of closing out the position, you could exercise your puts and buy them again @ $24. You still have a conversion, but you've pocketed an extra $9 along the way. Another after hours rally, and you could do the same thing again.

    One thing to note. Look how incredibly expensive the ITM puts are versus the OTM calls. The European S&P 100 options have 660 puts going for $30, not $33. That's solely due to this early exercise issue. The market is not going to let you have a free conversion, you're going to have to pay $2.85 to have the ability to play with your conversion in this way.

    In this particular case, notice also that the calls are almost inconsequential because they're so far OTM. As a result, you can pretty much leave out the short calls ending up with just long futures, long puts.

    This isn't the OP's case, but by getting creative with the ability to exercise (at the closing price) and continue to trade 15 minutes after close of the cash market, you can do some interesting things.
  6. How can you trade the options after 4pm on expiration day (exp day was the premise of your original note)?

    If it's not expiration day, then you have an ordinary conversion with n days until expiration. Conversions are essentially delta neutral and don't make a profit when the underlying moves.

    I did not bother to try and check your numbers given the apparent gross mis-understanding that exists.

  7. pretend? There is NO OEX future. If there were, chances are the options on that future contract will close at the same time the futures close. If you are talking about the ES options instead then you are wrong also as they close at 3:15cst. So, no, you cannot leg into a better than fair value future by thinking the ITM puts will be excerized at 3:00cst while you offset your futures later on. I suggest you research the contract you intend to trade this strat on, you will find out what you are suggesting cannot be done.
  8. frank99



    Very interesting. This discussion is getting more and more interesting. :)

    What about the original strategy that I posted? What do you think of it?



  9. OEX trades until 4:15. Exercise is at the price the cash market closed at 4:00. You can exercise until 4:20. Expiration day was the premise of the OP's comment, not mine.
  10. I'd venture a guess that you have not traded OEX options, Rally? (Or you have, but long only, OTM/ATM)?

    Fine, you are trading SP futures and OEX options at some ratio. In order to tell you what ratio, I'd need to figure out what the weighting of the "big mover" is in both indicies. It's probably something like 1 SP for 3 OEX.

    BOTH trade until 4:15 eastern. However, OEX exercises at 4:00 cash prices.

    In short, you are given a 15 minute window to see the future to decide whether you want to exercise your OEX options or not. If the market rallies enough for you to overcome the time value + the spread, you should probably exercise any ITM puts before 4:20.

    It's okay if you don't believe me. But I'd love to hear you explain the current CBOE prices (these are cash index options, not future options):

    OEX 660 put (4% ITM): 25% IV
    SPX 1390 put (4% ITM): 4% IV

    This isn't due to low liquidity. Both have equivalent bid/ask spreads.

    Before you throw flames about "not understanding what I'm trading", try doing some basic research.
    #10     Oct 8, 2006