The Second Leg Down

Chapter 3An Overview of Options Strategies

Most of the hedges described in this book are options structures. They rely upon buying and selling combinations of calls and puts with different strikes and maturity dates. We are mainly concerned with uncovering strategies that provide protection at low cost. In this chapter, we provide a non-technical overview of options, in preparation for the hedges we will dissect in Chapters 4 and 5. We make no effort to derive Black–Scholes or any other pricing formula. Rather, we will use the Black–Scholes formula as a way to adjust for different strikes and times to maturity. Value will be expressed in the currency of implied volatility. Normalising across strikes and maturity dates can help us decide which options are rich and which are cheap. We start with a bare-bones description of puts and calls, then transition into more complicated structures, such as spreads, butterflies and ratios. Our ultimate goal is to identify horses for courses, i.e. hedging structures that are well suited to a particular market environment. It will take some time before we can delve into regime-specific analysis. This chapter serves as necessary background material. Note that we will primarily focus on exchange-traded futures and options, as they are easier to analyse and trade at an accurate and timely price.

Options contracts have a long and varied history, possibly extending back to ancient Greece and carrying on through to England in the 1600s and the US ...