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Short-dated options get hot

11/06/2013 @ 10:20am

In the never-ending journey to create more confusion, futures exchanges across the globe have come up with a new product to enhance the customer risk hedging experience yet boost their own volumes and revenues.

Actually, this new product makes a lot of sense.

In fixed income interest rate options trading, when the world began to see lower interest rates longer, the volumes in those products started to suffer. Exchanges began to search for ways to bring products to the market that would boost revenues and also would help the customer. Short-dated new-crop options (SDNCO) were born. These options are an alternative to trading longer-dated underlyings with a shorter-dated expiry. In terms of the agricultural market, you can trade new-crop corn (December 2014) with options that expire with March 2014 options. You have the ability to buy and to sell cheaper options because they don’t have as long a life on underlying maturities that expire much later.

Typically, longer-dated maturities have more volatility. This volatility translates to more movement and a better chance to win on an options play while flattening out any extreme seasonality in your marketing plan. SDNCO’s may line up with points in the growing season that match better with your needs.

How do they work?

For example, it’s the middle of September (when this column was written) and you can trade an option that expires in February 2014 on December 2014 corn. Look at the short March $5.50 calls against the December 2014 $5.50 calls.

The short March 2014 calls expire into December 2014 corn. Against a current underlying price of $4.97, they are quoted at 9¢.

The December 2014 calls that expire into December 2014 are quoted at 25¢.

Depending on your hedging needs and time horizon, the short March calls are much cheaper than the longer-dated December calls. Both options expire to the December 2014 futures price, but one has a much longer life.

If you believe that your risks are sooner rather than later, the short-dated March calls would be an attractive bet at a 16¢ discount to the longer-dated December options.

The exchanges have added a further wrinkle by adding more expirations to the mix. May 2014, July 2014, and September 2014 are listed as alternatives to time horizons that all expire to the December 2014 price.

All of the previously mentioned SDNCO’s expire into December 2014.

In the last example, the March $5.50 calls with a March 2014 expiry based on the December 2014 underlying had a price of 9¢. The regular December 2014 expiring $5.50 call option had a price of 25¢.

It is interesting to see how the introduction or subtraction of time makes a difference to the price of the short-dated quoted option.

Continue to trade regular March, May, and July options, as well. This creates duration arbitrage between any two option classes and gives you a much more pinpointed hedging strategy.

Benefits

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