Derivatives trading

strategies

1
Research
Monetisation

Aymeric KALIFE - 2008 2

 Enhance, Expand and Monetize Through…Nuance
1. Detailed view on direction (determines strikes):

Precise expressions of extent of bullishness/bearishness

Explicit entry and exit points (fundamental valuation for floor /
Option market pricing can serve as
ceiling) a valuable basis for comparison

Views that stocks won’t move

Views when stock will breakout (in either direction)
2. Explicit time horizons (influences expiry):

Unlike stock, option life is “finite” thus it is critical to think
carefully about your time horizon

One can combine options of different expiries (i.e. calendar
trades) to express
views across different time periods
3. Discuss volatility (impacts strategy):

Upcoming newsflow and events

Uncertainly in models & market/sector risks
4. Views on dividends:

Important to option pricing, especially long-dated
Aymeric KALIFE - 2008 3

There is an active market for dividend “swaps”
 Nuanced Equity View: The Value of an “Edge”
Nuance is a subtle variation or difference in view

Relative to stock investing, options enable a wider range of directional

views and a more precise implementation through two key variables:

the strike price: determine the level you believe the stock will reach

the expiration date: specify the time period for your view

Volatility is a key input into option pricing, and therefore to evaluating

option strategies. Option “value” can be measured using its market price or
its implied volatility level.Implied Volatility: Determine whether implied
volatility is cheap, rich or fair

Discussions of volatility / uncertainty fall within an analyst’s core
competency

Upcoming newsflow and events

Sensitivity to economic conditions or sector risks

Uncertainty in valuation models
Aymeric KALIFE - 2008 4
 DB Company Research Recommendation Change Set
Recommendation Cash Commerciality of Idea
Change Action Cash Option
Sell Buy

Buy Sell

Hold Buy With options, all views

have value if they
Hold Sell provide an “edge” and
are published:
Buy Buy i). Exploit info above
threshold “equally”
Sell Sell ii). Capture value from
previously
Buy Hold unpublished material
Limitations exist not
Sell Hold with ideas but with the
investment vehicle
Publication Hold Hold
Threshold

Information that is not regularly published

because it is not exploitable using stock
(e.g. “stock will not move”, dividend forecasts)

Aymeric KALIFE - 2008 5

Nuance + Vol Angle: Maximize Value of Company Research

Optionsallow you to pursue strategies that you cannot

implement via stock
 Tailor a payoff profile to match your specific view
 Get paid to take on specific risks that you think are overpriced by the
market
 Pay premium to eliminate the possibility of suffering losses under
specific scenarios
 Get paid to pre-commit yourself to entry and exit points
 Profit from a view that a stock will be range-bound
 Capitalize from a view that a stock will breakout even if you are unsure
of which direction

Options in combination with stock (i.e. overlays) provide

unique advantages as well
 “Yield enhancement”
 Hedging and gaining outright short exposure

Aymeric KALIFE - 2008 6

 Express your directional view more precisely & effectively through options…
1. “I think this stock will rally, but I don’t want downside risk if I am wrong.”
 Buy a call:
call gain upside exposure while limiting your downside

2. “I like owning this stock, but worry about a short-

short-term sell-
sell-off.”
 Buy a put:
put hedge your position against a decline

3. “I like owning this stock, but see no near-

near-term catalysts and think the upside is limited for now.”
 Sell a call:
call cap your near-term upside in exchange for enhanced yield

4. “I like the stock but the price is too high right now. I would be a buyer on dips.”
 Sell a put:
put commit to buy the stock at a lower price, and get paid to do it

5. “I like owning the stock long-

long-term, but I think there is more downside risk than upside potential over the next few months.”
 Collar the stock:
stock sell a call to finance the purchase of a put; forfeit near-term upside for downside protection
6. “I believe the stock has solid downside support and significant upside potential.”
 Enter bullish risk reversal:
reversal sell a put to finance the purchase of a call; sell downside for upside participation

7. “This stock is dead-

dead-money. I think it is range-
range-bound for the time being.”
 Sell strangle (sell call and put): monetize your view that the stock will not significantly move in either direction

7
8. “The stock is going to move, but it could be up or Aymeric
down.” KALIFE - 2008
Simple Step-
Step-by-
by-Step Guide to Option Trade Generation

Step 1: Directional view

(bullish/bearish/neutral and timing)

Receive draft note from analyst/Equity Focus

(as early as possible!!; SA + CROP)

Contact analyst for more detail

Step 2: Volatility view (rich/cheap/fair)

Check eDerivatives for volatility evaluation

Client

Assess potential strategies
Base/Business using direction
(enhance DB value)
and vol view (use laminate)

Send analyst option payoff diagram of
potential strategy (with breakevens etc)

Aymeric KALIFE - 2008 8

Step 1: Directional View on GlaxoSmithKline (GSK.L)
 RIC: GSK.L
 Current price: 1455 GBp
 Rating / TP: HOLD, 1650 GBp
 Directional View: Neutral
 Collaborated with Mark Purcell and team
 Justin wrote 16-Jun: “…believe that in general pipeline expectations are
low (GSK aside)…”
 “…perception of risk has shifted to the downside at GSK (HOLD)…appears
18% over-valued relative to sector…”
 Q2 earnings announcement:
Client 26-Jul (confirmed)
Base/Business
 2nd Interim dividend: 11 GBp (net) expected before Aug expiry
(enhance DB value)

 “I like owning the stock, but see no near-term catalysts and think the
upside is limited for now.”
Aymeric KALIFE - 2008 9
Step 2: eDerivatives.db.com to Evaluate Volatility

Client
Base/Business
(enhance DB value)

Choose from a broad menu Access recent company, option Print, Save and send as pdf
Enter RIC or look it up
including options, cross- and relative value research
markets and relative value Aymeric KALIFE - 2008 10
The “Tearsheet”: Stock Snapshot
Implied Vol: market’s expectation of vol going Realised Vol: stock volatility Term structure: the market’s
forward, backed out from option prices over period looking back schedule for future volatility

Comparison of implied to
realised vol: how the market
expects future vol to differ
Client
from recently realized vol

Base/Business
(enhance DB value)

All data defaults to the past Implied/Realized vol data Open interest: Number of contracts Volume: Amount contract traded
year defaults to 3 month outstanding for a particular option within a given time period

Aymeric KALIFE - 2008 11

Volatility View/Option Strategy on GlaxoSmithKline (GSK.L)

 Implied volatility: 2M ATM levels are near 1-year highs (roughly 23%)
 Realized volatility: 2M levels have declined from their recent highs (about
16%)
 Q2 earnings announcement: 26-Jul (confirmed): does this justify these
levels? (vols subside post-announcement historically)
 2nd Interim dividend: 11 GBp (net) expected before Aug expiry (stock/call
should fall by that amount)

 Long-stock + Neutral direction + Rich volatility = Overwrite?

Client
Base/Business
(enhance DB value)

Aymeric KALIFE - 2008 12

Overwriting - Sale of a Call Option Against Stock You
Own “I like owning the stock, but see no near-term catalysts and think the upside is limited for now.”

Directional View : Neutral to moderately bullish

Composition: Long stock + short call

Nuance: Enhance yield in the event of a modest rally or a sell-off

in exchange for capped upside (upside breakeven at 1532 GBp)

130 GSK Overwrite:

Aug-06 1500 strike
110
Own stock Underperforms long
Outperforms long
90 Initial price: 1455 GBp stock if the price ends
stock (by the
Sell call option Overwrite above 1532 GBp ceiling
premium) if the price 70
Net Payoff at Expiry

Strike price: 1500 GBp (stock “called away”)

ends below 1532 GBp 50 Option price: 32 GBp
(strike plus premium) 
30

10

-10

Strike price
Initial price

Breakeven
-30

-50

-70
1380 1400 1420 1440 1460 1480 1500 1520 1540 1560
Stock Price (GBp) at Expiry

Aymeric KALIFE - 2008 13

Trade Idea: Overwrite Aug-
Aug-06 1500 GBp on GlaxoSmithKline

EquityView
 Collaborated with Mark Purcell and team
 Justin wrote: “…believe that in general pipeline
expectations are low (GSK aside)…”
 “…perception of risk has shifted to the
downside at GSK (HOLD)…appears 18% over-
valued relative to sector…”
 Directional View: Neutral to moderately bullish
(HOLD)
 “I like owning the stock, but see no near-term
catalysts and think the upside is limited for now.”

Option Idea
 “Cap your near-term upside in exchange for
enhanced yield.”
 By selling the call, you outperform a long-only
position by 32 GBp (2.2%) assuming the stock
Client does not rise by more than 6.1% at expiry
Base/Business
 Commit to an effective exit price of 1532 GBp
(enhance DB value)
 Key Risk: Aug contract chosen to capture high
implied volatility due to July 26th earnings
announcement
 Rationale: enhance yield on a stock that you are
neutral on but do not want to (or cannot) sell
outright.

Aymeric KALIFE - 2008 14

Key vanilla
strategies

Aymeric KALIFE - 2008 15

 Overview

Trading strategies can be devised to meet almost any combination of views for
market conditions and the risk/reward profile of the client

All strategies fall into two basic categories: directional (bullish/bearish), non-
directional (range trading, correlation trading, buy/sell volatility)

Whether strategies are for hedging or speculative purposes, they can be used
either on a stand-alone basis, or in combination with an underlying (cash)
position any strategy can be divided up into the following key components:
Reward / Risk / Break-evens

Strategies can be tailored to fit views that are aggressive (strong directional
view, downside scenario unlikely, high risk / high reward/high leverage),
conservative (moderate directional view, protect downside, give up some upside
to do this, lower risk / lower reward)

In the end, any trading strategy is simply a portfolio which consists of some
combinations of Greeks

4 types of strategies:
 Take a position in the option and the underlying.
 Take a position in 2 or more options of the same type (a spread).
 Take a position in a mixture of calls & puts (a combination).
 Use European options (calls or puts or both) to replicate any arbitrary
Aymeric KALIFE - 2008 16
terminal payoff function f (ST ).


Long
View
a call Profit

Loss
Premium
K

 speculative Break-even

client believes underlying will rise and wishes to generate profit

 hedging

client short underlying and wishes to protect from rally

Structure
 client pays premium, participates fully in rise beyond the strike price

Characteristics
 profit increases as market rises
 break-even at strike plus premium
 loss limited to premium paid
 the choice of strike is important
 the further out-of-the-money, the higher the leverage but the less the chance
of ending in-the-money
 as time passes value of position decays towards expiration, i.e., holder suffers
time decay
 volatility is inversely related Aymeric
to rateKALIFE - 2008
of decay 17
 Short a put Profit
Net position

View
Underlying
 speculative Loss

client believes market is not going down and wishes to generate profit

actual volatility over the life of the option will be less than implied volatility

 hedging

client short underlying and wishes to improve the levels at which he is
short, i.e., break-evens
 Characteristics

profit is limited to premium received from sale

 at expiration, break-even point is strike price K minus premium

received
 maximum profit is realized if the market settles at or above K

 loss increases as market falls

the more confident client is on the market not falling, the higher K price he
can sell at

as time passes, value of position increases as option loses its time value
Aymeric KALIFE - 2008 18
 B
Call spread/bull spread Profit

View
 speculative
Loss A

purchaser thinks underlying exchange rate will rise moderately, however
not higher than B
 hedging

client wants to hedge short spot position at low cost, and does not think
a move beyond B likely

Structure
 long 1 call at A, short 1 call at B = short 1 put at B, long 1 put at A

Characteristics
 potential profit and loss are limited

maximum loss is at any spot lower than A

maximum profit is at any level above B
 holder of option suffers time decay around A and benefits from negative time
decay around B
 little or no effect between A and B

Comparison
 similar to call, but less aggressive
 lower cost

Aymeric KALIFE - 2008 19

 Long butterfly Profit
B

View
Loss A C
 client wishes to take advantage of high implied volatility
 client believes spot is not likely to move much, but wants to protect against a
break

Structure
 long 1 call A, short 2 calls B, long 1 call C

Characteristics
 limited profit and limited loss

maximum profit occurs at B at expiration

maximum loss in either direction is cost of spread
 decay negligible until near expiration, when it is negative (i.e., option owner
benefits) near B and positive near A and C

Comparison
 similar view to short straddle, but much less aggressive, i.e., worse break-
evens and lower maximum loss

Aymeric KALIFE - 2008 20

 Call ratio spread Profit
B

View
C
 usually entered when market is near A Loss A
 the client expects a slight rise in market but sees a potential for sell-off

Structure
 long 1 call at A, short 2 calls at B

Characteristics
 profit is limited

maximum profit is realized if the market is at B at expiration

loss is limited if market falls but open-ended if market rises
 at A, holder suffers from time decay
 at C, holder benefits from negative time decay

Comparison
 similar to a call spread but more aggressive, with unlimited downside

Aymeric KALIFE - 2008 21

 Long risk reversal, range forward, collar,
cylinders Profit

Forward

View Loss
 bullish on market, believe move will be a large and extended one, believe
market is well supported on the downside

Structure
 usually structured as a long call, short put with equal deltas on either side

since both deltas are equal, should theoretically be zero cost

in practice, may not be zero cost depending on how the market

perceives skew

Characteristics
 if S > F then theta and vega are positive
 if S < F then theta and vega are negative

Comparison
 similar view to a long forward but less aggressive (i.e., lower delta)

Aymeric KALIFE - 2008 22

 Equity Derivative Use

Different players
 Directional Accounts: View on a Stock and looking to enhance
yield/gain leverage
 Volatility Arb Funds / Dealers: Trading Volatility as an asset class
 Corporate Stock Holders: Portfolio & SIngle name protection
 Retail / Structured Product: Warrants / Principal protected notes

Different strategies
 Covered Call Writing: Earn premium, sell upside
 Downside Protection (Buy Put)
 Target Buy (Sell Put)
 Risk Reversal
 Zero Cost Structures (Collars, etc...)

Adjust your pay-off for any scenario using Options

Aymeric KALIFE - 2008 23
 Details of Covered Call Writing

Generally two outcomes are possible in overwriting

1) Stock price is trading above the strike price at maturity

 Investor sells at the strike
 Investor still keeps the option premium

2) Stock price is trading below strike at maturity

 Investor has outperformed the long-only position by the amount of the option
premium collected
 Can re-write another call option at same or different target price

Covered Call Payoff at

Expiry

Important Calculations Short call Covered call

 Break-even: initial underlying level - call

premium - dividends
 Max upside starts at strike
 Max upside: strike - initial underlying
Long underlying
level + call premium + dividends
Aymeric KALIFE - 2008 24
Underlying at Expiration
Call Overwriting As a Target Sell Order

One way to think of call overwriting is as a “Target Sell
Order”
 Get paid (option premium) to sell the stock at the
strike
 Fundamental Investor’s belief, however, is that the
upside beyond the strike is limited and therefore
getting paid to sell an unlikely event makes good
sense

Idea: “I like the stock here but 10% above I think
the stock is fairly valued, and I would be a seller”
 Think of the strike price as your target price
 Investoris getting paid to sell the upside in the stock
Aymeric KALIFE - 2008 25
beyond the strike
Naked Put Selling As a Target Buy Order

Write a put on stocks trading above buy-target levels where the strike is equal to the target
buy price
 Put premium: get paid for implementing target buy
 Put struck at target level
 Example: Write Barclays 1Month Put struck at £5.00, Current Price £5.15

Receive Put Premium up-front (+£0.18) 1Month Vol. ~34%

If Barclays goes below £5.00 and put is exercised, then buy Barclays at
strike price

Effective buy price of £5.00 - £0.18 = £4.82

Naked Put Selling is another way fundamental investors can extract value from their
fundamental view
 If stock is below the target buy-price at option expiry, option writer is obligated to
purchase the stock at the strike

Happy doing so if this represents a target buy price (plus keep option premium as
additional income)

If the stock does not fall below the strike, option writer still collects option premium
(in the Barclays example ~ 3.50%)
 If an investor perceives a stock as having a floor price, through rumoured bid activity for
example, put selling allows you to set and profit from target buy prices even if target
buy prices are never hit
 Less popular than call overwriting as maximum loss is equal to strike price less option
premium (risk of buy target changing before -expiry)
Aymeric KALIFE 2008 26
Protection Strategy (Risk Reversal)

Given a long equity position an investor may wish to gain
downside protection by giving up some upside exposure to
the stock.

Action. Sell an OTM Call to fund an OTM Put - implement
a zero-cost position.

P/L

Capped Upside

90 110 Stock Price

100

Downside Protection

Aymeric KALIFE - 2008 27

Introduction to Skew

Most derivative markets exhibit persistent patterns of
volatilities varying by strike.

In some markets these patterns form a smile, In others
such as equity index markets it is more of a skewed curve.

Stocks exhibit a combination of skew and smile due to the
potential of shocks to the stock price to the upside as well
as the downside. (e.g. thru M&A activity)

Aymeric KALIFE - 2008 28

Trading Ratio Spreads to Benefit from
Steep Downside Skew
Skew steepness defined as
3-for-1 ratio put spread payoff profile
(80% vol -100% vol)/100% vol

80% strike volatility reached a level of double the ATM volatility in

April this year

A 3-for-1 ratio put spread could be traded for near zero premium,
leaving a large area of potential profit, with losses only beyond a
29
22.5% fall in the FTSE 100Aymeric
indexKALIFE - 2008
 Zero Cost Ratio Put Spreads

How many short
OTM puts needed
to offset the cost
of an ATM put?

When cost is
offset, what is the
breakeven point
beyond which
losses are
incurred?

Screen for lowest
breakeven point
Zero Cost Bearish Back-Spread Candidates
Long ATM Put Short OTM Put Number of OTM Break Even
Stock Price Expiry Strike Bid Premium Strike Ask PremiumPuts to sell Price
ALV 95.7 16-Dec-05 95.0 8.25 85.0 4.45 1.85 77.00%
MUV2 88.5 16-Dec-05 85.0 6.22 75.0
Aymeric KALIFE - 2008
3.18 1.96 74.00%
30
ING 21.3 16-Dec-05 20.0 1.49 18.0 0.88 1.70 72.00%
 Zero Cost Ratio Call Spreads

How many short
OTM calls needed
to offset the cost
of an ATM call?

When cost is
offset, what is the
breakeven point
beyond which
losses are
incurred?

Screen for highest
breakeven point
Zero Cost Bullish Back-Spread Candidates
Long ATM Call Short OTM Call Number of OTM Break Even
Stock Price Expiry Strike Bid Premium Strike Ask PremiumCalls to sell Price
DBK 65.1 16-Dec-05 65.0 6.00 70.0 4.00 1.50 23.00%
HSBC 8.8 16-Dec-05 9.0 0.51 9.5 0.32 1.60 17.00%
BBVA 12.5 16-Dec-05 12.5 0.90 13.5 0.51 1.76 18.00%
Aymeric KALIFE - 2008 31
 Volatility Pair Trades: Single Stocks

Volatility Pair
Trades, like price
90%
pair trades, are
80%
Credit Suisse
usually traded
70% UBS amongst highly
correlated stocks,
3M ATM Implied Vol

60%

Single-stock pairs
50% often hard to find
as a reasonable
40%
volatility gap is
30% needed to make
the risk worthwhile
20%

As cash market
10% uses “peer
0% comparison”
valuations, option
May-01

Nov-01

May-02

Nov-02

May-03

Nov-03

May-04

Nov-04
Jan-01

Jul-01
Sep-01

Jan-02

Jul-02
Sep-02

Jan-03

Jul-03
Sep-03

Jan-04

Jul-04
Sep-04
Mar-01

Mar-02

Mar-03

Mar-04 prices for same-

sector pairs also
tend to stay in line
Aymeric KALIFE - 2008 32
 Volatility Pair Trades: Single Stocks
Credit Suiss - UBS Vol Diff %

Hedge funds
35% typically trade
volatility pair trades
30%
Credit Suiss - UBS in order to remain
Vol Diff %
25% flat exposure to a
market sector whilst
3M A T M Im p lie d V o l

20% targeting individual

15%
stocks

After Credit Suisse
10%
reduced its risk
5%
appetite in 2003,
dealers moved to
0% correct the volatility
disparity that had
-5%
existed between it
A u g -0 1

A p r-0 2

A u g -0 2

A p r-0 3

A u g -0 3

A p r-0 4

A u g -0 4
D e c -01
F eb -0 2

Ju n -0 2

D e c -02
F eb -0 3

Ju n -0 3

D e c -03
F eb -0 4

Ju n -0 4
O c t-01

O c t-02

O c t-03

O c t-04
and UBS as shown

Aymeric KALIFE - 2008 33

 Volatility Pair Trades:
1Y Skew Differential - Financials
Skew Vols (Pinned)
Pinned Not Pinned

2.50%
.
2.00%

1.50%

AAH .AS
1.00% BBVA .MC
BNPP .PA
CBKG . F

0.50% CRDI .MI

CSHN .0001
DBKG . F
HSBA .L
0.00% RBOS .L
90 92 94 96 98 100 102 104 106 108 110
SCH .MC
SOGN .PA
-0.50% SPI .MI
UBSCSH.0001

-1.00%

-1.50%

-2.00%

Aymeric KALIFE - 2008 34

Trade ideas

Aymeric KALIFE - 2008 35

Trade Idea 1: Short Jun-
Jun-06 €28 Put on ING

Equity View
 Collaborated with Mark Cathcart (joint push)
 Mark wrote: “Loyal and incentivised
management team with a range of nimble
flexes.”
 Directional View: Bullish (BUY; 19%
upside to TP)

Option Idea
 “Commit to buy the stock at a lower price,
but get paid to do it.”
 Volatility trading at its 90th percentile (very
expensive)
 Collect an upfront premium of €0.85 or 2.85%
Client of notional
Base/Business  Commit to an effective entry price of €27.15
(enhance DB value) (9% below current price)
 June contract chosen since analyst has 19%
upside to TP
 Key rationale for this trade was to sell
expensive volatility which cannot be done
with stock
Aymeric KALIFE - 2008 36
Trade Idea 2: Long Sept-
Sept-06 €25 – €27 Risk Reversal on Vivendi

EquityView
 Collaborated with Paul Reynolds (joint push)
 Highly non-consensus call on Vivendi (hated
stock)
 Paul wrote: “Strong downside
protection…” with 29% upside to TP
 Directional View: Very bullish (BUY; 29%
upside to TP)
 “I believe the stock has solid downside support
and significant upside potential.”

Option Idea
 “For low or no cost, obtain upside participation
through unlimited downside exposure.”
Client  Gain upside exposure with an upfront
Base/Business credit of €0.68 by selling a put and buying a
(enhance DB value) call
 Commit to an effective entry price of €24.32
 Sept contract chosen since positive catalysts
are expected in second half of year
 Key rationale was to gain upside exposure
without outlay which cannot be done with
Aymeric KALIFE - 2008 37
stock.
Trade Idea 3: Short Mar-
Mar-06 €14.5 - €17 Strangle on Nokia

Equity View
 Collaborated with Inge Heydorn (joint push)
 Inge wrote: “Close to fair value,
downgrade to Hold” with 0.57% upside to
TP
 Directional view: Range-bound (HOLD)
 “The stock is dead-money. I think it is range-
bound for the time being.”

Option Idea
 “Monetize your view that the stock will
not move significantly in either
direction.”
 Receive premium of €0.56 or 3.5% of
Client notional
Base/Business  Commit to an effective entry price of €13.94
(enhance DB value)
 Commit to an effective exit price of €17.56
 Mar contract chosen to avoid future event
risk
 Key rationale was to profit if stock
doesn’t move (i.e. sell volatility) which
Aymeric KALIFE - 2008
cannot be done with stock. 38