Trading Case ST2
Important Note: This is an advanced module case. To run this case the FTS Trader must be downloaded from the Trader Help section of the Virtual Classroom page (from the hyperlink Trading Case ST2). Similarly, the FTS Market must be launched from the hyperlink under Instructor Help on the Virtual Classroom page. To see this requires logging in as a moderator). The case will not run properly under the regular FTS Markets.
To understand how a market maker hedges the price risk from inventory changes by applying delta hedging and other option trading strategies. Making market in options in a “Black Scholes” world. To gain experience with real world option support systems.
Delta and gamma hedging in a world where prices evolve in continuous time but trading takes place at discrete points in time (every week). Trading takes place in an idealized constant volatility world. The environment is the same as trading case ST1 except that market making in some options is permitted.
ST2 is a trading case designed to introduce you to the problem of hedging the position profits associated with an active market maker's inventory of stock. This inventory of stock will change over time as a result of active market making in the stock.
Your objective is to hedge the profits generated from market making activities in the underlying stock at positive bid/ask spreads. However, the spread profit is exposed to price risk because the number of buyers and sellers at a point in time is random and therefore the trading book is rarely balanced. This imbalance means that although you are earning a return from a posted spread, you cannot avoid taking some residual changing position in the stock. The changing residual is the source of price risk that you are exposed to in this trading exercise.
To manage the price risk you can trade in the option markets. In one put/call market you can only take market but in the other put/call market you can make market and take market.
As an aid to this exercise you are provided with a set of real-time analytical support tools. Using these tools you can monitor the delta of your position at each point in time.
The Stock Market
The stock market trades the stock of a large computer manufacturer called IMB. Although this stock has suffered from major price corrections over recent history analysts expect that these corrections are finished. The following statistical process describes expected future price behavior:
Volatility of return ():
30% per annum
Expected Drift ():
5% per annum +/- error
Unit of Time:
1 month (45 seconds FTS time)—default parameters)
This process is expected to remain stationary over the next year. In addition, due to the recent weakness in the stock price, analysts expect no dividend payments over the next year.
Your inventory of stock is marked to the market price of IMB at the end of the trading period (approximately one year of calendar time).
The Treasury strip market is a risk-free zero-coupon bond that pays $900 at the end of one year, regardless of which path the stock market takes. The riskfree rate is 3.25% per annum (continuously compounded).
The securities are European options (call/put/call/put securities 3, 4, 5, and 6 respectively) defined on one IMB stock. The strike or exercise price for these options are 320, 320, 360, 360 respectively. That is there is a put and call option for each strike price and for example, security 4 is the put with strike price equal to 320.
The time to maturity for each option is one year and the terminal payoff for each option depends on the realized value for IMB at the time of their expiration. For example, for the options with a strike price equal to 320, the following terminal values apply:
At the end of their life options are automatically exercised if they are "in the money."
As a trader your task is to manage the exposure of your position to price risk. Your underlying stock position can change every week, reflecting the market making activities of your firm in the IMB stock. This stock position cannot be traded. However, you can manage your exposure by trading in the options market.
Trading is restricted to the options and the strip markets only.
Option trading is permitted in all option markets. In the strike 320 options you are a market taker only, and in the strike 360 options you can both make market and take market.
An option contract is for one stock. You can trade upto 10000 contracts in a single trade (i.e., click of the mouse). You can build a position through multiple trades (i.e., repeated clicks of the mouse).
Shortselling in the treasury strip market is permitted. This allows you to borrow (lend) at the risk-free rate by shortselling (buying) treasury strips. Holding market cash pays zero interest and borrowing is not permitted in the cash market. If you want to buy options but have insufficient cash you must first shortsell the required amount of treasury strips and then purchase the desired amount of options.
The spot risk-free rate of interest for a Treasury strip with one year to maturity is currently 3.25% per annum . This rate is not expected to change over the next year.
You should launch the Excel spreadsheet ST2 for your trading support system. See instructions for ST1. Your ST2 support spreadsheet is the same as the ST1 support spreadsheet with the addition of option pricing support. This option pricing support can be used as a guide to your market making strategies.
Your trading objective is to earn as much grade cash as possible.
Securities are exchanged using market cash in a trading period lasting year and which is referred to as one trading trial.
Multiple independent trials will be conducted. This means that for each trial you will restart with an initial endowment that is either Type A or Type B, and an independent path for the stock prices is generated (starting from a spot price around 347).
If at the end of any trial you have a closing balance of $45,000 market cash you will earn $6 of grade cash. If you have a closing balance of market cash that is lower than $45,000 you will earn $0 grade cash. Any amount of market cash that is greater than $45,000 and less than or equal to $200,000 earns grade cash as follows:
Above $400,000 market cash earns the maximum $23.75 grade cash for one trial.
Trading is conducted over a number of independent trials and a record of your cumulative grade cash is maintained.