If traders think the outcome of the upcoming Scottish referendum will impact the markets they may use options to take a view on what they believe the outcome will be.
The FTSE fell after the results of the recent poll that put the Scottish independence campaign marginally ahead. If traders believe that Scots will side with the “No” campaign and remain within the United Kingdom, and see this as a positive for the markets, they could profit from a rise in the FTSE.
If we are expecting the market to go up to a target of 6,900 (say), then with £1,000 in our account we could use one of the following strategies.
Harriet – buys GBP 55 per point of the FTSE Sep 6,850 call at 18.
Igor – buys GBP 130 per point of the FTSE Sep 6,875 call at 10.5 & sells GBP 130 per point of the FTSE Sep 6,925 call at 3. This strategy is known as buying the 6,875/6,925 call spread, which he buys at 7.5 (10.5 – 3).
Javed – sells GBP 125 per point of the FTSE Sep 6,500 put at 6.
If Harriet, Igor and Javed are all correct in their view that the FTSE will rally to 6,900 at expiry then the result will be as follows:
Harriet: The 6850 call will expire at 50 giving a profit of 32 points x GBP 50 per point = GBP 1,600.
Igor: The 6,875 call will expire at 25 giving a profit of 14.5 points x GBP 130 per point = GBP 1,885. The 6,925 call will expire at 0 giving a profit of 3 points x GBP 130 per point = GBP 260. Igor will make a total of GBP 2,145 from the trade.
Javed: The 6,500 put will expire at 0 giving a profit of 6 points x GBP 125 per point = GBP 750.
It is important to note that if FTSE were to fall, to say 6,700, at expiry then the results at expiry will be as follows:
Harriet – The 6,850 call will expire at 0 giving a loss of 18 points x GBP 50 per point = GBP 900.
Igor – The 6,875 call will expire at 0 giving a loss of 10.5 points x GBP 130 per point = GBP 1,365. The 6,925 call will still expire at 0 giving a profit of 3 points x GBP 130 per point = GBP 260. Igor will lose a total of GBP 1,105 from the trade.
Javed – The 6,500 put will expire at 0 giving a profit of 6 points x GBP 125 per point = GBP 750.
Sell a put or buy a call?
As is evident from the results above, traders can profit from an increase in the underlying market by either selling a put or buying a call (or indeed a call spread).
For Harriet, Igor and Javed, who all believe that the market will increase to 6,900, either strategy will work although they carry different risk profiles, highlighted by the graphs. Javed, however, has another reason for trading the put instead of the call. He has noticed that the Implied Volatility for September options is much higher than for the same strikes on the following months.
ATM Implied Volatilities:
IV for FTSE Sep 6,775 put = 23.3%
IV for FTSE Oct 6,775 put = 12.9%
Javed thinks that the volatility premium seen in September options is due to the Scottish referendum, occurring a day before expiry, and suggests that September options are relatively more expensive.