OK, so you've done your homework and you know AT&T is going to pop 10% over the next week. I know that the magnitude and timing of the increase will dictate your strategy here so just go with this assumption.
I'm on the sell side, so haven't had much exposure to this. How do the pros go long? I imagine at a more conservative mutual fund you just purchase equity. What about the prop desks? Do you buy the OTM call? Do you buy a ATM Call? Do you just take on some debt and lever up the old fashion way?
if you "know" something is going to pop, then the most bang for your buck is an OTM call WITH very little time to expiry---aka short-dated OTM calls.
Here's an example:
Yesterday AAPL was trading around 236.
an ATM option (strike at 236) was $8.34 an OTM option (strike at 255) was $2.28
If apply jumped $23.6 (10%), the next day:
the 236 strike call would go from $8.34 to $21.89 the 255 strike call would go from $2.28 to $11.58.
You can see for yourself where the best money was made.
Think of it as a bet, would you make more money betting $1 on a coin toss (1:1 even odds) or a roll of a dice (6:1)
In this analogy, the OTM call would be the dice and the ATM call is the coin toss
CD~
Assuming binaries are out the question, I'd do somewhat replicate it by a very tight, leveraged bull spread. That way you use the writing of the option to fund your purchasing.
Like CD said, short-term so the gamma is big.
In IBD as well so some of these terms are unfamiliar... What are binaries?
See below for an example of a Binary aka Digital Option
Sample Contract Specifications:
Underlying: AAPL
Current Price of Security: $254 Strike Price: $260 Premium: 30% Payout: $100,000 Expiry: May 15th, 2010-New York cut
Conditions: If AAPL trades above $260 at the expiry time. The holder of this binary (digital) option will receive $100,000. Otherwise, they receive nothing.
As you can see, your payout is $X or nothing, a binary decision.
Sorry I thought you meant sell-side as in market maker, not sell-side IBD. This makes more sense now.
Exactly like CD said, its essential a bet, either you lose the premium you paid for it, or you make a fixed payout. They are called binaries, digitals, etc.
Assuming you know/can google a call spread, if you do strikes right next to one another (and close) and in large quantities, you can replicate a binary option... its one of the ways as an options MM we can hedge digitals.
Delta is the change in option value from a 1% change in underlying price. Gamma is the rate of change of Delta... essentially the second derivative of option value by price. A large gamma essentially means that the option value changes very quickly, which is perfect for the type of play this would be. Digitals have a huge gamma, mainly because a 1 cent move from the strike can be the difference between ITM and OTM.
All else constant, gamma is largest in short dated options.
Revsly:
Can you really replicate a digital option with a bull call spreads given that trike prices are usually in intervals of $1.00, $2.50 or $5.00? If S= $28, and you buy a 30 call and sell a 32.5 call, you have a lot of variance in your possible outcomes.
OP: I’ll just build on what these guys are saying. A common method is a bull call spread. You mentioned buying an OTM call. A bull call spread entails buying an (generally) OTM call and selling an OTM call at a higher Strike.
Example: You like Google. It currently sells at $521.65. You buy a May 530 Call for $7.00. You sell a May 540 call for $3.60. Your net premium is $3.4. Selling the 540 call decreases your premium but limits the upside risk. It’s a great play if you project GOOG going into the 530’s this month and don't want to pay for upside over 540
No not really, since the strikes are too wide. I meant a bull spread in the spirit of a digital, highly levered close strikes. So its similar if you don't have the ability to buy digitals.
Assuming you know that the value of the stock would increase by 10%, buying the stock outright is better than buy a straight call option, since with a call you are paying for downside protection as well. Why pay that if you know its going up.
mm2, that is VERY inaccurate.
If you buy the stock outright, the greatest return you can achieve is 10% (exactly what the stock increases by)
There is 0 gamma in purchasing the stock so you cannot accelerate your returns when the underlying increases.
As we've shown in the simulation, buying the OTM call at 2.28 and having it reach 11.58 is a return in excess of 400%
OTM call option: you put $228 to work and get $1158.
If you bought the AAPL stock at 236 (say 1 share) you put $236 to work and got $259.6.....exactly 10%.
CD~
Yeah CD is absolutely correct. This is actually a pretty common interview question.
mm2 (or anyone for that matter) , feel free to answer the following question to solidify your understanding of options.
Question: Rank the following FOUR alternatives in order of greatest return on investment under the given circumstances:
-Stock Price: $100 -Expiry Date: Today @ 4:01 pm -You have inside information that the stock will rise 10% by the end of trading today
1) Buy a deep-in-the-money call option 2) Buy a deep-out-of-the-money call option 3) Buy the stock outright 4) Buy an at-the-money call option
I have absolutely no knowledge to add to this thread! But I will say, can we please see more if these informative threads and not these bs high school posts about irrelevant topics. Thanks and great topic!
Buyside CFA, The replication Revsly is referring to is much more effective in the FX Options space.
As you mentioned, Equities have pretty wide standardized strikes as listed on the exchanges. FX however, is OTC and VERY DEEP. As a result, strikes with very narrow intervals are very, very liquid and therefore, the replication of a digital option is constructed with ease.
Exactly, its so much easier to replicate a digital thanks to the liquidity in the FX markets. I still like the levered call spread though!
You all forgot putting on a crazy yen carry trade, to get more leverage then buying the options. Then you also run over to treasury and say "more balance sheet dammitttt"...
If you really want to juice it, you can try an OTM up and in - or deliver a worst of rainbow.
Also depending on your collateral reqs, you could try and load up on equity swaps.
Well if we want to get real serious we could do RKO (Reverse Knock-Out), Up-and-in Call, and more exotic structures. I figured the binary was enough for people to wrestle with haha.
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