Mastering Derivatives: If volatile, then options

If you have a choice between two stocks and you want to set up a derivative position on one of them, which would you choose? This week, we discuss two factors that should drive your decision to choose an underlying on which to set up a derivative position.

Trend and volatility

Taking position on an underlying is optimal when its price is trending up or down. Now, futures move in line with the underlying with a delta close to one. So, it will be optimal to set up a long position in futures if you believe the underlying is on an uptrend and a short position if you believe the underlying is trending down.

The same argument cannot work for options. Why? Your objective is to capture much of the price movement of the underlying through the derivative position. Options are not optimal when the underlying is trending up or down. The reason is because an option price consists of time value which must become zero at option expiry. This means options cannot move one-to-one with the underlying as time value component of the option price must decay through the life of the option. That means the delta of a tradable strike will be less than one.

Note that we consider tradable strike because liquidity is important for European options; you must close a long position to take profits as exercise is possible only at expiry. Deep in-the-money (ITM) options have delta close to one as the time value of such options are small. But the time value is small because they are not actively traded; that means you may be unable to close your position to take profits. Your ITM strike on which you have unrealised gains must, therefore, be no more than two strikes away from the ATM option.

The factor that works in favour of options is volatility. Why? More volatile an underlying, more the underlying is likely to jump up or down in the future. With no visible trend, options become preferable over futures; for an option gives the buyer a right, but not an obligation to buy (for calls) or sell (for puts) an underlying. At worst, the option will expire worthless. It is the right to exercise that makes options more valuable the more volatile an underlying is. Stated differently, an underlying that is trending in one direction has low volatility. So, futures are preferable. An underlying that does not have a clear trend is likely to be volatile. Options are then preferable.

Delta gains

Experienced traders typically prefer futures even if the underlying is volatile, as greater delta means larger gains

Optional reading

Experienced traders typically prefer futures even if the underlying is volatile, as greater delta means larger gains. Such traders implement strict stop-loss rules if the futures position moves against them. Taking stops despite the regret requires discipline, which comes from long years of trading experience. Such traders also implement repair strategies to salvage unrealised losses on their initial position. This includes shorting options against futures position to moderate losses.

The author offers training programmes for individuals to manage their personal investments

COMMENT NOW