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Hamish Raw

Hamish Raw

Hamish Raw has an MBA from Cass, London where he specialised in financial engineering, in particular, the pricing and risk management of conventional options.Raw has…

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Brent Oil Tunnel & Eachway Tunnel Options: Selling Volatility

The usual method of speculating on a market’s volatility is to trade conventional options straddles and strangles. The problem for the speculator who takes the view that the market is not going to move is that selling short straddles and strangles can become prohibitively expensive as the central clearing houses are now running scared of the short trader. The General Clearing Members over the last few years have proven not to be infallible themselves when it comes to managing their own risk, with many clients now being prohibited in taking out large short options positions. To compound the situation, the GCMs are now putting the squeeze on the traded options market-makers as they too have suffered casualties, further creating illiquidity in the options market.

A more recent development has been the CBOE’s introduction of a ‘new’ instrument, the Range Option, which is in fact a standard condor where the middle two strikes are far apart in relation to the closeness of the outer two strikes. This is clearly a half-hearted attempt to replicate a binary tunnel option.

The introduction of the Range Option is likely a response to the problems outlined in the opening paragraph which can be alleviated by trading binary tunnel options.

Tunnel Options

A conventional call spread consists of a same series long lower strike call plus a short higher strike call. Should the long and short calls be binary calls then one has a tunnel option as opposed to a call spread.

The profile of the tunnel option at expiry is between the strikes the option settlement price is 100, outside 0, so that the profile is box-like in shape. This strategy is very easy to understand and provides an efficient limited risk manner to trade volatility in a similar manner to conventional straddle and strangle trading.

Example:
   
The following chart illustrates the price of Brent oil futures:

Brent Oil Price Chart
Brent Oil Price Chart

Related Article: Why are Banks Allowed to Manipulate the Oil Markets?

Since the rally from June 2012 petered out in late August the market has moved sideways with a pennant formation developing over the last ten weeks. One may wish to view this as being the precursor to a breakout from the current narrowing range, or alternatively one may forecast more of the same. While Brent is trading in the $100.50 region either of these views can be accommodated by using the tunnel option with strikes of, say, $108.50 and $112.50. Below are the price profiles of the Brent oil tunnel option from 25 to 0.1 days to expiry.

Brent Crude Oil Tunnel Option Price Profiles
Brent Crude Oil Tunnel Option Price Profiles

A purchase of the tunnel option would be similar to a sale of a straddle, and vice versa. Clearly this strategy can be used not only as a volatility play but should the price of Brent be outside the strike range then the strategy could be used as a directional play also.

Related Article: To Prevent Market Manipulation Physical Delivery should be Enforced

Eachway Tunnel Options

Below illustrates the Brent Crude eachway tunnel option where the settlement prices at expiry have an extra level between the outside two strikes and their adjacent strikes. In the example below if the price of Brent is outside the inner two strikes but inside the outer two strikes the strategy settles at 40 at expiry.

The advantage of this strategy, apart from being of limited risk to the ‘vol’ seller, is that one still receives a return should one’s forecast be just wide of the mark. The fact that the strategy provides a return for a ‘place’ will be of particular attraction to those uncomfortable with the all-or-nothing scenario.

Brent Crude Oil Eachway Tunnel Option Price Profiles
Brent Crude Oil Eachway Tunnel Option Price Profiles

The assumption that binary options consist purely of at-the-money calls and puts is wide of the mark. The limited risk profiles of all binaries bring a welcome dimension to trading and for the clearers themselves, remote traders are easier to handle when they are constrained to trading such instruments.

By. Hamish Raw - see more on Google




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