Options: Trading & Risk Management

This course forms part 1 of the Options Training Week. Programme objectives This three day workshop provides participants with a comprehensive and practical analysis of options – pricing, risk characteristics and risk management. The agenda also provides a practical focus on the varied applications of options in corporate exposure management, portfolio hedging and tactical asset allocation, trading and investment applications, and in the engineering of structured products. The programme evaluates options from a number of different perspectives – from a trader or risk manager’s point of view, focusing on the dynamic risks of options and the implications for their management, as well as from a sales and end user perspective, to gain understanding of the many strategies in which options are used to efficiently manage risk or monetise specific views and expectations, or achieve specific objectives. The agenda covers all of the main asset classes – FX, equity, rates and commodities, and in addition examines closely related volatility products – variance swaps and listed volatility futures. The course assumes a general familiarity with derivative instruments and, whilst not based upon detailed theoretical or mathematical approach, it does require basic mathematical fluency. Course highlights Attend this practical three day programme and learn how to: Build option pricing and valuation models Gain practical understanding of option risks and dynamic hedging Design option strategies for hedging and risk management Understand how options can be used to monetise market views Examine volatility trading and strategies used to exploit volatility expectations Using options in financially engineered structured products Understand FX, interest rate, equity and commodity options Training Methodology The training will comprise a combination of classroom based teaching combined with computer based simulations and computer based exercises, based upon utilising a range of spreadsheet-based software. We believe that technical knowledge and skills are best achieved through active participation, via individual or group case studies and simulations. Delegates will spend a significant fraction of the course duration carrying out a number of computer based case studies and exercises, replicating the day to day realities of financial markets and market behavior. You will enhance your practical skills with computer-based simulations and workshop case studies on option pricing, risk management and designing option strategies. PLUS: Delegates will receive free copies of option pricing and risk management software for their own use after the programme. Who should attend? This course has been specifically designed for the benefit of: Traders and dealers Derivatives sales personnel Structurers Risk managers and risk controllers Audit managers Corporate account officers Asset managers Corporate treasury personnel The course assumes a general understanding of ‘vanilla’ derivative instruments and, whilst not based upon a detailed theoretical or mathematical approach, does require basic mathematical fluency.
Option Valuation – Principles and Option Pricing Models Fundamental concepts and properties of options - Key terminology - Put-Call parity Intuitive understanding of option pricing principles and price determinants - Intrinsic value and time value - European styles Versus American style options Continuous stochastic processes; Brownian motion Analytical models: The Black-Scholes option pricing framework Underlying concepts, assumptions and derivation of the Black-Scholes pricing model Advantages and shortcomings of the Black-Scholes framework Rationalising distortions to the Black-Scholes model framework - Discontinuous market behaviour - Stochastic Volatility - Imperfections in modeling assumptions Numerical methods: Binomial and trinomial lattice models Arbitrage-free derivation of a generalised binomial model Valuing American and other path dependent options Simulation methods of option valuation – Monte Carlo simulation Case Study: Building option pricing models; valuation of European, American option styles Volatility Understanding volatility; the role of volatility in option pricing Volatility as an ‘asset class’ Historic, implied and realised volatility measures Volatility surfaces - Volatility smiles and skews - Volatility term structure effects Rationalising and interpreting volatility surfaces - Skewness and Kurtosis - Vanna-Volga approach to constructing volatility surfaces Volatility analysis - Volatility relative value analysis (Implied Vs. realized) - Volatility cones - Skew interpretation and analysis Local Volatility models Stochastic volatility modeling - Heston stochastic volatility model Option Risks; Hedging and Risk Management of Option Positions First order price risks: Delta, vega, theta, rho, phi Delta hedging and risk analysis - Dynamic delta risk management - Delta hedging an option portfolio - Limitations and risks inherent in delta hedging - PIN risk - Expiration effects - Liquidity effects Gamma - Interpreting gamma - Gamma characteristics of in-, at- and out-of-the-money options - Long and Short Gamma – risks and opportunity - Impact of Gamma on Delta hedge management - Implied Vs. realized volatility exposure - ‘Shadow’ Gamma - Maximising profitability from Gamma trading and management; Gamma ‘scalping’ Vega - Implied volatility risk - Vega characteristics - Smile and skew risks: Sega and Rega Theta; option price time decay - Theta as cost of carry - Inter-relationship between Theta, Gamma Rho; Interest rate sensitivity Understanding and actively managing interrelationships between option price sensitivities Active management of portfolio delta, gamma and vega risks Other higher order risks - Delta time decay (Charm) - Gamma sensitivity (Speed, Colour) - Vanna and Volga risks - Management of higher order risks - Risk reversals in management of skew (Vanna) risk - Butterflies in management of smile (Volga) risk Limitations of option ‘Greeks’ - Discontinuities in market price behaviour, option risks - Expiration trading - Strategies for managing risk when ‘Greeks’ experience large, discrete changes - Stress testing and portfolio scenario analysis; identifying potential future risks Case Study: Dynamic management of option risks in a single option position/portfolio context; Delta hedging and the analysis of trading p/l over a trading horizon. Exercise will involve managing position Gamma in order to attempt to maximise profitability. Option Strategies – Hedging and Risk Management Risk reduction strategies with options Using options in corporate FX, rates and commodity risk exposure management Option based hedging strategies in portfolio management - Simple hedging strategies - Vanilla Call/Put hedges - Tailoring client objectives and constraints using strike variation - Costs and benefits of options versus outright forward hedges Structuring tailored hedges with options - Zero cost Collars/Cylinders and Range Forwards - Option spreads and Participating Forwards - Seagulls - Extendible flat forwards Tailoring structures to meet client expectations, objectives and constraints: - Strike selection - ‘Pain thresholds’ – minimum/maximum strike levels - Budget constraints: zero cost strategies - Impact of market factors (swap points, volatility surfaces) on economics of strategies - Incorporating covered option sales into hedging strategies Rationale for using non-linear (options) Vs. linear hedges - When is it rational to use options for hedging? - Comparative analysis of risk management strategies - Advantages/shortcomings of risk management solutions: cost/benefit analysis - Tailoring strategies to client risk management policy, constraints and expectations - Using options in hedging contingent risks Case Study: Delegates will conceive, structure and price a range of vanilla and structured option based hedging strategies to meet varying objectives and constraints. Delegates will be presented with a range of different ‘client’ circumstances and background information (market data, financial reporting data, and additional anecdotal client information) and will be responsible for analysis and evaluation, preparation and pricing of a number of proposed alternative hedging strategies. Option Strategies – Trading, Investment and Arbitrage Strategies Overview of trading applications of options - Directional trading - Volatility trading - Distinguishing Vega from Gamma trading strategies - Higher order volatility trading strategies - Convexity trading - Dispersion trading - Arbitrage strategies - Limited Vs. unlimited risk strategie - Premium generation (yield enhancement) strategies Put-Call parity and arbitrage strategies - Conversions and Reversals - Synthetic forwards - Box spreads Directional Trading: Vertical Spreads - Call and put (Bull and Bear) spreads - Trading Rationale - Pricing; impact of skew - Risk characteristics - Delta hedging - Gamma - Skew risk Volatility trading strategies Calendar Spreads - Rationale - Volatility term structure (calendar skew) impact - Sensitivities; volatility/time decay exposure Straddles and Strangles - Structure and rationale - Risk characteristics - Vega and Gamma trading - Skew and smile effects - Dynamic risk management Risk reversals - Skew trading using risk reversals - Using risk reversals to manage Vanna (Skew) risk Butterflies - Volatility trading with Butterflies - Using Vega neutral butterflies to manage and trade Smile risk - Management of Volga risk Yield enhancement strategies - Over and under-writing strategies - Rationale for covered call/put strategies - What are the risks in premium generation strategies? - What is an optimal tenor/strike for yield enhancement strategies? Dispersion trading - Correlation trading - Monetising implied Vs. realised correlation - Practical challenges in dispersion trading - Rationale for dispersion trading Embedded Option Strategies Embedding options into structured products Long and short volatility structured products Yield enhancement structured products - Callable bonds and notes - Reverse convertibles - Inverse FRNs Capital guaranteed notes Interest Rate Options Generic European style interest rate caps and floors Conventional pricing methods: Black (1976) model Why do markets use this model? Advantages and disadvantages Calibration to a volatility surface Pricing and hedging caps and floors - Stochastic term structure models (BDT, LIBOR market model) - SABR model Risk management - Delta hedging caps and floors - Gamma and Vega management; risk bucketing Practical applications - Asset and liability risk management - Embedded caps and floors; capped FRNs, Minimax FRNs - Reverse FRNs Swaptions - Pricing swaptions: Black Vs. Term structure models - European and Bermudan style swap options - Calibration of swaption volatility surfaces - Compatability and consistency with Cap pricing - Option Embedded Swaps - Extendible and cancellable swaps (European, Bermudan styles) FX Options Fundamental properties of Currency Options Market conventions, terminology, price quotation Pricing Vanilla FX Options – Garman-Kohlhagen model Building volatility surfaces for FX options: Risk Reversals and Butterflies Applications of Vanilla FX options in Currency Risk Exposure Management Risk reduction (Hedging) strategies with options Using options in corporate FX risk exposure management Rolling and layered hedging programmes Simple hedging strategies - Vanilla Call/Put hedges - Tailoring client objectives and constraints using strike variation - Costs and benefits of options versus outright forward hedges Structuring tailored hedges with options - Zero cost Collars/Cylinders and Range Forwards - Option spreads and Participating Forwards - Seagulls Tailoring structures to meet client expectations, objectives and constraints: - Strike selection - ‘Pain thresholds’ – minimum/maximum strike levels - Budget constraints: zero cost strategies - Impact of market factors (swap points, volatility surfaces) on economics of strategies - Incorporating covered option sales into hedging strategies: finding client target or ‘indifference’ levels Rationale for using non-linear (options) Vs. linear hedges - When is it rational to use options for hedging? - Comparative analysis of risk management strategies - Advantages/shortcomings of risk management solutions: cost/benefit analysis - Tailoring strategies to client risk management policy, constraints and expectations - Using options in hedging contingent risks Equity Options European and American styles Single stock and index options Incorporating dividend assumptions into pricing models Correlation dependency of basket and index options Analysing relative value of index options: Implied vs. realised correlation patterns Course summary and close Delegates will receive free copies of option pricing and risk management software for their own use after the programme.