Derivatives: Markets, Valuation, and Risk Management

CHAPTER 10

Risk Management Strategies: Options

Chapters 7 through 9 deal with option valuation. Knowing how to value options, in turn, provides a means for measuring risk. The focus now turns to option trading strategies. Two major categories exist—dynamic strategies and passive strategies. Dynamic strategies are those that focus on value changes over the next instant in time. Dynamic expected return/risk management, for example, attempts to manage changes in portfolio value caused by unexpected changes in the asset price, volatility, and interest rates, as well as the natural erosion of option's time value as it approaches expiration. These strategies are of particular importance to exchange-traded option market makers or OTC option dealers who, in the normal course of business, acquire option positions with risks that need to be managed on a day-to-day (minute-to-minute) basis. The first two sections of the chapter are devoted to dynamic strategies. In the first, we tie the expected return/risk characteristics of options and option portfolios to the CAPM. In the second, we consider the dynamic risk management problem faced by an option market maker.

Passive strategies, on the other hand, are those that involve holding an option over some discrete interval of time such as a week, a month, or even held to expiration. In this instance, the rates of return of the option and the asset are not perfectly correlated and the mechanics for analyzing the position are somewhat different. ...