March certainly came in like a lamb if you were long US Equities. All four major US Equity Indexes were sharply higher today while volatility sold off in the options markets. As we promised on Friday, here is the explanation to last Thursday’s question.
Thanks again to everyone who participated in our second “Question of the Day” last Thursday. As reminder, the abbreviated version of the question was as follows:
According to most standard options pricing models, which of the following positions would most closely replicate the P&L of a Long April Gold futures position?
The correct answer was C. Generally speaking, when one refers to a “Risk Reversal” trade (as we often do in this section as an indication of skew), it involves buying (selling) and out of the money Call and selling (buying) an out of the money Put. These positions tend to act similarly to long and short futures position, but because they involve different strikes (many times the 25 Delta strikes), the overall delta of the position will be less than 100, so will not move exactly like a futures position would. Answer “B” is an example of a traditional Risk Reversal but, because it involved selling the Call and buying the Put, would tend to act more similarly (though, again, not the same) as a short future instead of a long future.
When one executes a similar trade to the Risk Reversal but that involves the same strike for the Call and Put, as we did in the correct answer C, it results in a position that is sometimes referred to as a “synthetic futures position” because the delta of the position is that of a futures position (100). The reason this holds true is due to a relationship that Calls and Puts have to one another called Put-Call parity which says that if you take the Strike Price plus the Call price minus the Put price it equals the price of the underlying future. In fact, sometimes, during extreme price moves when some futures markets are halted, you can get a “synthetic futures price” from the options market via this trade.
In the image below, using QuikStrike’s “Spreadbuilder” tool we used today’s at the money Call and Puts to generate a similar synthetic future for analysis. As you can see, the P&L graph on the right side looks just like that of a long futures position. Further, you can see the 100 Delta value that a future would have as well as zero Gamma, Vega and Theta values.
Answer A represents a straddle position which is a position dependent on volatility and could potentially profit from underlying price moves to the upside or downside and answer D is a deep in the money Put with a large negative delta (93) that would tend to gain in value as the price of the future declines (all else held constant).
Thanks again to all that participated and we’ll have two more “Questions of the Day” in March.