Manipulating the Payoff Function

Given the recent market volatility and cash constraints that many asset managers face, financial engineers are looking for ways to make options cheaper (and more customized). For example, you may want to simply change the contract parameters, such as the time to maturity or the strike price. More elaborate schemes may involve changing the reference index to a high dividend yielding stock, which puts a break on the upward movement of a call option, or referencing a basket of (uncorrelated) indices, which will reduce the potential payoff through a reduction in volatility.

One way to make options cheaper is by changing the payoff function. Changing the payoff function can be done, among other ways, by linear segmentation, such as the introduction of a second strike. Using a simplistic example, if an investor believes the market will go up by ~10% for a particular security, a product could be created by simply going long a call at $163.39 (K₁ ) which is at-the-money, and short a call at $179.73 (K₂ ), thus resulting in a segmented payoff function (or bull call spread), where and are the premiums, respectively. The short call is used to subsidise the premium of the long call.




After running this bull call spread through FactSet’s Monte Carlo VaR, I can see that the loss is capped at the difference between the premiums (in this example, $2). Also interesting to note is that when I close the short position, I can see that the distribution has a maximum loss of $4 (this is the post-trade distribution), which is the premium of the long call, and there is a higher chance of making a gain.





You don't need an engineer to create the above; just enter into two different contracts at two different strikes. From an engineering perspective, the payoff can be segmented any number of ways to match your desired payoff, which will ultimately be based on your view of the market. You can even integrate partial call spreads if you want to take part in an up market, but your conviction is not strong (the upside is positively sloped and not capped).

Later posts will involve manipulating the payoff function and other techniques to make options cheaper.

Guest blogger Mike Joel is a FactSet Portfolio Analytics specialist in London.

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