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A Smart Trade?

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November 07, 2013 – Comments (2)

Board: Macro Economics

Author: FastMike

”…An investor bought $16.6 million in call options on the Standard & Poor’s 500 Index, a strategy that will be profitable if the U.S. equity benchmark rallies in the next five months…”---Bloomberg

Dear high rolling Fools:

Option contracts are complicated. Futures contracts are complicated. To complicate things further, index Futures and Options contracts are complicated. But to serve another slice of complicated pudding, there are Option Contracts on Futures Contracts.

This afternoon, in what seems like an incredibly risky bet, ‘a trader’ went long 17,800 March call contracts with a strike of 1925. A trade of this size represents a sizable chunk of the day’s trading:

http://www.bloomberg.com/news/2013-11-05/options-trader-bets...

While it was reported that this trader made a risky bet, the way I see it, this trader not only made a brilliant trade, but if all goes well, has nailed the yearly bonus early on. At worst, at the very, very worst the trader can unwind that position with minimal losses.

It works this way: IF the contract is held to expiration and the S&P is above the 1925 level by the expiration date in March, the trade profits. But even with all the current euphoria, the probability of being over that strike by March is, well, remote. So how’s this brilliant? Simple!

It would be madness to hold this trade until expiration. The idea is to unwind well before March. There is a high probability that the S&P will gain 3% to 4% between now and the end of January. This is an irrationally exuberant, like it or not, given. (Especially if the EU announces a rate cut tomorrow).

An option premium is based on several variables, one of which is called ‘delta’. To put it in perspective delta is like velocity, the rate of change of the premium. The further out of the money, the lower the delta, like a car sitting still. Related to delta is ‘gamma’. It’s the rate of change of the delta. Gamma is like acceleration. Again, because the contact was so far out, the contract’s gamma is very, very low, as if a car was starting from a dead stop.

As the S&P continues to gain, not only will the velocity of the contract value increase but so will the acceleration of the value. That is to say, the higher the S&P goes the more ground the contract's value will cover.

The only friction is because of time decay, which, being so far out from expiration will hardly affect the gains, in the near term.

So, in a nutshell, because it is soooo far out in both time and strike, there is very high downside resistance. It would take a rapid, deep drop in the S&P to cause a significant loss.

Using my trading platform’s (fancy schmancy) option analysis tools, this trade becomes profitable when the S&P futures contract exceeds 1759. (The index will be slightly less). The probability is about 40%, by the model. In the current reality however, I’d say it’s higher.

If I’m figuring this correctly, should the S&P reach 1780 to 1790 by the end of January, those contracts could be worth in the $60.00 to $70.00 range.

I’d suspect that this trader will unwind on the way up over the next 8 to 12 weeks, averaging out netting ten times the initial $16 million dollar investment.

Any correction to my calculations would be welcome.

Your impressed Fool,
FM

P.S.: A $1 dollar change in the index translates into a $250 change in the futures contract. The options contract is the premium paid for the right to purchase the futures contract. The reported numbers don't seem to 'jive' right, but premiums should be in the ballpark, by the model. 

2 Comments – Post Your Own

#1) On November 07, 2013 at 8:19 PM, Mega (99.96) wrote:

If it's such a great trade why aren't you doing it?

My opinion is that it's a stupid trade. In the short term, as far as any individual knows, the market is about as likely to go up as it is to go down.

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#2) On November 08, 2013 at 3:28 PM, FastMike (< 20) wrote:

Ah, yes megashort, I'll tell you exactly why: I don't have the $16 million dollars to throw at that trade. However, I will tell you that, from experience, the least risky way to profit from a 'naked' long call position, is to be far out of the money and far out in time. This type of position is not designed to be held until expiration. If the trader expects the underlying to increase in the near term, the premium for the call will increase. If the underlying stays flat or moves down, there's so much time premium, and low gamma that the loss is minimal. 

As far as the market being as likely to go one way as it is the other, I disagree. Four major central banks are being accomadative at the same time, and this is the time of year for retirement account money to start pouring in.

Can the market drop in spite of all that? Of course! Are the probabilities even? No way! 

 

 

 

 

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