To recap, the FTSE 100 volatility index (VFTSE) was trading around the 16 level on 25 October, up from 11.5 at the end of September. And although it subsequently peaked at 18.76 on 16 November, volatility on the blue-chip index has subsequently fallen sharply to 12 at close of trading on Thursday 29 November as equity markets rallied into their seasonal sweet spot.
This is precisely the scenario I had envisaged when I advised using traded options as a way of both exploiting the pick-up in market volatility and maximising returns from index trades in the final quarter of this year. That's because the implied volatility factored into the traded option price increases as market volatility rises and means the price of 'at-the-money' call and put options was far higher five weeks ago than it is now even though the FTSE 100 has risen in value in the interim period.
Moreover, this sharp spike and subsequent drop in equity market volatility has produced optimum returns from a trading strategy I outlined five weeks ago ('A smarter option', 25 October 2012) to make money from movements in the FTSE 100 in the run-up to option expiry days. To recap, my strategy involves buying and selling the same leveraged derivative products that are also used by experienced City traders and financial institutions. These contracts trade either through London Liffe Connect, the electronic market for trading Liffe products, or Euronext (www.euronext.com), and are specifically FTSE 100 index options which have set dates for expiry every month.
Buy-call spread trading strategy
There are two parts to my trade. First, I selected an 'in-the-money' call option with the highest strike price possible, but with virtually all the option price as intrinsic, rather than time value. I then simultaneously sold a call option at a higher strike price, and one that was 'out-of-the-money' so all the premium I received five weeks ago was time value. In effect, what this meant was that if the FTSE 100 didn't rise at all from my entry point of 5832 on Thursday 25 October by the time the call options expired on Friday 21 December, but equally didn't fall either, then I would be losing very little capital through the erosion of time value on the options purchased. And because the options written would expire worthless to the option buyer, the option premium received would provide a very healthy profit on my net investment.
Similarly, if the FTSE 100 rose between Thursday 25 October and expiry on Friday 21 December, the increase in the value of the call options purchased would match the rise in the index point-for-point, and completely offset the loss made on the call options written. Even in a worst-case scenario where the FTSE 100 fell below the exercise price of the call options purchased, then at least the premium received on the options written would offset some of the loss on the options purchased. So how did I fare?
Options for profit
With the FTSE 100 trading at 5832 at 9am on Thursday 25 October, the call options I recommended for this trade were the ones with a 5500 exercise price and which were priced at 357p, or the equivalent of 357 index points. In other words, 332p of the option price was 'in-the-money' when I purchased them and only 25p, or the equivalent to 25 points on the FTSE 100, was time value which would erode in the eight weeks between purchase of the options and expiry on Friday 21 December. By contrast, the FTSE 100 call options with a 5850 exercise price were priced at 103p, or the equivalent of 103 index points, all of which was time value since their exercise price was above the level of the FTSE 100 on Thursday 25 October.
So my trading strategy was simple: buy the FTSE 100 December 5500 call options at 357p and simultaneously write the 5850 call options to pocket the 103p option premium. This in effect significantly lowered my net investment to 254p and provided a safety net on this short-term trade as I was in effect long of the index at 5754, or 78 points below the index at the time.
And because volatility has fallen so sharply since I executed this strategy this means that I have made a large profit on both sides of the trade. In fact, with the FTSE 100 closing at 5875 on Thursday 29 November, the FTSE 100 call options with a 5500 exercise price have risen in value from 357p to 384p. And even though the FTSE 100 call options with a 5850 exercise price are now 'in-the-money', having risen above their exercise price of 5850, the combination of the erosion of their time value in the past five weeks and the drop-off in equity market volatility means that these options can now be purchased in the market at 79.5p, considerably less than the 103p I sold them for on Thursday 25 October.
Net gains
In other words, my initial net investment of 254p has increased in value to 304.5p, representing an impressive 20 per cent gain in a little over a month and with a safety net built in on this trading strategy.
True, I could easily bank this bumper profit by selling the FTSE 100 call options with a 5500 exercise price at 387p (to make a gain of 27p) and using only 79.5p of this sum to buy back the same number of FTSE 100 call options with a 5850 exercise price to neutralise the position (and crystallise the 23.5p gain on them).
However, I am not going to bank profits as there should be further gains to come as we enter the traditionally seasonally strong period for equity markets ('A lesson in Sirp', 26 November 2012). That's because even if the FTSE 100 is only trading at its current level of 5875 when both the options expire in three weeks time on Friday 21 December, then the FTSE 100 call options with a 5500 exercise price would be settled at 375p and the FTSE 100 call options with a 5850 exercise price would be settled at 25p. In other words, my initial investment of 254p - which is currently worth 304p - has potential to rise a further 15 per cent to 350p in the following three weeks even if the market doesn't budge a point!
It's worth noting, too, that even if the market rises above its current level of 5875 I am still guaranteed to increase my 304p net investment to 350p because the FTSE 100 call options with a 5500 exercise price will perfectly hedge off the rise in the FTSE 100 call options with a 5850 exercise price point-for-point.
Therefore, my advice is to run your 20 per cent profits on this trade if you followed my initial advice. And if you didn't you could still make a 15 per cent potential return in only three weeks simply by buying the FTSE 100 call options with a 5500 exercise price at 384p and simultaneously writing the FTSE 100 call options with a 5850 exercise price at 79.5p in order to pocket a premium that includes an attractive 55p - or 55 points on the FTSE 100 - of time value. And remember by executing this trade in this way you are in effect long of the FTSE 100 at 5804, a hefty 71 points below its closing level on Thursday 29 November, which is quite some safety net.
Executing traded options strategies
These traded option strategies are pretty easy to execute as there are several brokers accepting retail clients, including Sucden (www.sucden.co.uk), Man Financial Global Direct (www.mfglobaldirect.co.uk) and Rensburg (www.rensburgsheppards.co.uk). Large stockbrokers such as Charles Stanley will also trade these products for retail clients (their traded options department direct line is 0207 667 2288).
