This spike in equity market volatility improves the potential returns from a trading strategy I have developed to make money from movements in the FTSE 100 in the run-up to option expiry days throughout the year. 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, and Euronext (www.euronext.com), and are specifically FTSE 100 index options which have set dates for expiry every month.
Options for profit
Short-term daily fluctuations in the indices aside, we are now a month away from the start of one of the most profitable times of the year for investing and I want to have a call options trading strategy in place to exploit this. It’s also worth noting that the quarterly traded option expiry day, otherwise known as triple witching day, falls on Friday 21 December this year so is ideally timed to coincide with the trading days around Christmas. For those not party to this stock market secret, these days offer a real opportunity to make money out of the markets as volumes drop off and the only participants left are investing on the long side. This regularly lifts equity markets in the run up to options expiry.
The smart thing about the strategy I have devised is that I don’t need the FTSE 100, my preferred index for this trade, to rise at all as I have devised a relatively low risk trade by using a vertical spread trading strategy through the London traded options market. A couple of years ago, I explained how to use buy-call spread option strategies (Triple Witching Profits, 1 March 2010) and very profitably, too. I repeated the feat last year (Options for profits, 17 October 2011) and with the same results: we banked a 23.5 per cent gain on the trade in only nine trading days.
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 like Charles Stanley will also trade these products for retail clients (their traded options department direct line is 0207 667 2288).
Buy-call spread trading strategy
There are two parts to this trade. First, select 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. Then you sell a call option at a higher strike price, and ideally as close as possible to the current index level, so all the premium received is time value. In effect what this means is that if the FTSE 100 doesn't rise at all by the time the options expire on 21 December, but doesn't fall either, then you are losing very little capital through the erosion of time value on the call options purchased. And because the options written will expire worthless to the option buyer, the option premium you received will provide a very healthy net profit on your net position.
Equally, if the index rises between now and expiry, the increase in the value of the call options purchased will match the rise in the index point-for-point, and will completely offset the loss made on the call options written. Even in a worst case scenario where the FTSE 100 falls in value below the exercise price of the call options purchased, then at least the premium received on the call options written offsets some of the loss on the options purchased.
To see how this trading strategy works in practise, consider the call options series on the FTSE 1000 which expire on Friday 21 December 2012. With the FTSE 100 currently trading at 5832 at 9:12am on Thursday 26 October, the call options with a 5500 exercise price are priced at 357p, or the equivalent of 357 index points. In other words 332p of the option price is in-the-money and only 25p, or the equivalent to 25 points on the FTSE 100, is time value which will erode between now and expiry of the options in late December. By contrast the call options with a 5850 exercise price are priced at 103p, or the equivalent of 103 index points, all of which is time value.
So the idea is to buy the FTSE 100 December 5500 call options at 357p each and simultaneously write the 5850 call options to pocket the 103p option premium. This in effect significantly lowers your net investment to 254p and also provides a safety net on this short-term trade as you are in effect long of the index at 5754, or 78 points below the current index level.
Profitable options
To illustrate how the vertical buy-call spread option works, consider the following scenarios when the options expire on Friday 21 December:
■ FTSE 100 closes at 5850. The FTSE 100 December 5500 call options are worth 350p and the December 5850 options expire worthless so you pocket the 103p premium on these to make a net 96p gain, or a 38 per cent net return on the 254p invested. In fact, you will make this same return even if the FTSE 100 closes above 5850 at expiry as the profit on the December 5500 series options completely offsets the loss on the 5850 series calls you have written for every point the index rises above 5850.
■ FTSE 100 closes above 5754 but below 5850. The December 5850 call options expire worthless and the 103p option premium received offsets the loss on the December 5500 call options purchased. As long as the index stays above 5754 you make a profit equivalent to 1 per cent of your 254p net premium invested for every 2.5 points rise on the FTSE 100 above 5754.
■ FTSE 100 closes above 5500 but below 5754. You make a loss equivalent to 1 per cent of your 254p net premium invested for every 2.5 points fall on the FTSE 100 below 5754. So if the index falls back to 5600 by 21 December, the 5500 series calls options will expire at 100p and you make a 154p loss on the 254p net investment.
■ FTSE 100 closes below 5500. You lose all your 254p net investment. True, this could always happen, but it would also mean that the index would need to post a negative return for 2012 having ended last year at 5572.
Execution of strategy
The beauty of this trading strategy is that we can book profits at any time simply by selling the December 5500 call options in the market and buying the equivalent number of December 5850 call option to reverse the position on the options written. Moreover, this strategy has potential to produce a 38 per cent net gain even if the FTSE 100 fails to make any headway over the next seven weeks.
It’s worth noting that because my buy-call spread trading strategy involves playing the differential in premiums between two call option series with the same expiry date, the odds are skewed in our favour to making a profit. That’s because the premium paid for the deep ‘in-the-money’ December 5500 call options is far less sensitive to changes in market volatility and erosion of time value than the riskier ‘at-the-money’ December 5850 call options written. In effect, we are purchasing a call option whose time value will erode a small amount between now and 21 December, and are taking advantage of the spike in equity market volatility to in effect sell a same series call option but with a much higher exercise price and much higher levels of implied volatility.
So if the FTSE 100 is trading above 5754 in three or four weeks time as we enter the seasonally benign month of December then we are virtually guaranteed to make a profit on the trade. That’s because by then the erosion of time value on the December 5850 option series will be far greater than that on the December 5500 options as both series will only have three weeks still to run. Moreover, it’s odds on the implied volatility embedded in traded option prices will have fallen from current levels if the index is trading above 5754 at the end of November. That’s important because any fall in the implied volatility will have a far more dramatic negative impact on the price of December 5850 option series than the December 5500 series.
Risk warning
Clearly you should only put a small amount of your capital into leveraged investment products as these carry far greater risk. However, it’s also worth bearing in mind that this trading strategy is guaranteeing us a very attractive 38 per cent profit on our invested capital assuming of course the FTSE 100 is trading at 5850 in seven weeks time. It also has an automatic safety net built in to protect us against the first 78 points fall in the index before we would incur a loss on our invested capital.
