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Stock Index Options:  Trading/Hedging Exercise
©2009 OS Financial Trading System




FTS Stock Index Options Small Group Project:

Introduction

This is a small group project designed around the FTS Real Time Client.  The project has two phases and grading is based on both content and form of presentation. The two phases are:

In Phase I your objective is to learn how to apply the option pricing model, to stock index options defined on the S&P 500 index.  In addition, you are required to design and apply a simple trading strategy based upon your implementation of the option pricing model.  For example, you may choose to estimate volatility from historical S&P500 index prices over some recent length of time that you view as appropriate*.  You can use this historical volatility estimate for valuing and trading options and then compare this with using implied volatilities for valuing and trading options.  In turn this will let you to assess the question of market efficiency relative to your trading strategies.    

*Daily, weekly and monthly index data is available from:  <http://finance.yahoo.com/q/hp?s=%5EGSPC>


In Phase II you will apply the experience you have gained in phase 1, to a risk management trading problem.  In this exercise you are to take some initial position in the SPY Exchange Traded Fund and then hedge the price risk of this position using index options.  You should incorporate the knowledge you developed in phase 1 regarding the volatility input into your hedging strategy.  However, now in addition you will face basis risk in this phase because the tradable SPY is a proxy for the underlying S&P500 index.    

Note:  Before starting phase II all positions should be reset to constant starting values.  The moderator should contact FTS (at least 24-hours notice) to have positions reset.

Trading Objective:   Each team's trading/hedging performance in phase II is measured using the Sharpe ratio.  The FTS System automatically computes this ratio for you you Each team will be ranked over the duration of phase II using the Sharpe ratio this will determine your final performance ranking.

Background Information Relevant to the Option Pricing Model

The Black Scholes option pricing model, has six important inputs.  These are the strike price, time to maturity, underlying asset price, risk free rate, dividend yield and volatility.  The FTS real time position provides you with a powerful analytic support system that lets you automatically apply this model in real time using FTS inputs.  In addition, individual teams are encouraged to override default FTS inputs with their own assessed inputs of the non contract defined inputs (risk free rate, dividend yield and volatility).  Individual team assessments are automatically stored on FTS servers so that each team member immediately has access to their team's inputs no matter where they are using the internet from.  Some of the following web sites provide relevant information for refining inputs.  

You can reach these links by clicking on any of the index options in the FTS Real Time Client.  These links provide information on both LIBOR and the dividend yield.  The most important input though is volatility.  Options unlike futures, trade volatility and therefore, the synthetic option can only be formed using a dynamic trading strategy.

Estimating volatility

The starting place is to see what is implied from the current market prices.  This is obtained by looking at the analytical support for the options in the FTS Real Time Client.  By using the Parameters menu item you can enter your best estimate for the financial cost of carry (i.e., LIBOR given the life of the option) and your best estimate of the dividend yield from the underlying over the life of the option.  For the latter input you should refer to the Dividend support IndexArb as depicted above.  This will give you a good estimate of the current implied volatility for the option.  You may want to check nearby strike prices to assess the current shape of the implied volatility smile (i.e., implied volatility as a function of strike price).  You may want to export this data (or copy and paste) from the FTS Real Time Client into Excel and plot the implied volatility smile.

Tip:  In the FTS Real Time Client if you also click on Tutors and then select the sub menu item Tutors you can bring up an option calculator as a support for entering your own inputs for any option you want to work with even if not currently traded in the FTS Real Time Client.

Important Due Dates:

Phase I:  Due Date on or before the date announced by your instructor in either MS Word or pdf file format if electronic submission or otherwise hardcopy.

Phase II:  Due Date on or before the date announced by your instructor in either a MS Word or pdf format if electronic submission or otherwise hardcopy.

Required:

All projects should contain a cover sheet that lists the full name of each team member.

Phase I:  There are three parts to your phase I report.

Part A:   An Executive Summary (this is a summary not exceeding 1-page), 
Part B:  A write-up of the details associated with how your team applies the option pricing model to the S&P 500 options.  That is, suppose you are an analyst who must communicate to either a programmer who is programming your implementation strategy, or traders on your trading desk who are applying the option pricing model to trade options.  
Part C:   Given your answer to part B, now design a simple trading strategy around your implementation of the option pricing model to "buy low and sell high."  You should apply this strategy over some short period of time (relevant to your strategy) using the FTS Real Time Client.  Describe your trading strategy and analyze it's trading performance.  Based upon this application provide some brief conclusions regarding your assessment of the efficiency of the futures markets over the time period you traded.  You should make use of the FTS Real Time Client's reports to answer part C.
Your team's project write-up should not exceed 5-pages plus any appendix material you choose to add.  That is, your Executive Summary is 1-page and parts B and C should not exceed 4-pages combined.  You can provide additional details in appendices if you want to.  Finally, your report should be logically organized including a brief description of important assumptions, measurement issues etc.,. The report will be graded on both the form and content of the presentation.

Phase II:  In this phase you will apply the knowledge you have gained from phase I to implement a hedging strategy that is designed to hedge the price risk associated with your position in the SPY ETF security.  

Price Note:  All settlements in trading are at the real time real world price.  The ticker prices displayed on the screen are indicative prices only as no real time prices are transmitted.  However, traders using the FTS Real Time Client can access free real time quotes for the ETF's from the major financial sites using the built in browser and the internet.

Required Phase II:  There are three parts to your phase II report.  

Part A - An Executive Summary not exceeding 1-page, 

Part B the operational details associated with your trading/hedging strategy including the operational details with respect to how you implemented the strategy (e.g., static, dynamic and how basis risk was handled).  

Part C you should provide a short discussion of the following issue:  

Critically evaluate your hedging strategy including an assessment of the strengths and weaknesses of your strategy in the light of your performance relative to other teams. 

Your report should not exceed 5-pages plus any appendix material you deem to be necessary.  That is, your Executive Summary is 1-page and parts B and C should not exceed 4-pages combined.  You can provide additional details in appendices if you want to.  Finally, your report should be logically organized and laid out clearly as it will be graded on both the form and content of the presentation.