Option Trading: Pricing and Volatility Strategies and Techniques

CHAPTER 2

Introduction to Options

No one said life would be interesting.

—My parents

 

Boring is good.

—“Squid,” with 15 years’ worth of option-trading experience

 

 

 

The fact that many people try to trade without understanding basic contract specifications has been illustrated several times in the ETF space recently.

Consider the case of the ultra-short ETFs. These are funds designed to return a multiple of the negative daily return of an index. They do this fairly well. However, due to the ways that returns compound, they will not deliver the negative return if we look over a longer period. Table 2.1 looks at the returns of FXI and FXP (which is intended to deliver negative two times the daily returns of FXI) in October and November of 2008.

We can see from this data that the ETF does a reasonable job of delivering the negative two times return each day. The relationship is not perfect, as FXP actually averages −1.75 times the daily return of FXI. This is mainly due to the large bid ask spread slightly distorting the closing prices. But the important point to notice is that over the full period, the FXI total return was 9.0 percent and FXP returned −49.2 percent. This is clearly nowhere close to negative two times the return of FXI. This is not due to any nefarious activity on the part of the fund manager. It is purely the effects of compounding.

TABLE 2.1 FXI and FXP

Compounding ...