Performance of two zero-cost derivative strategies under different market conditions

Abstract

Zero-cost collars are option-based strategies which—by matching prices received and paid for the component derivatives—provide costless protection for stock or index investments. The investors’ risk appetite determines a return floor by selecting a relevant put strike and the associated call strike (reverse-engineered from the [known] call value) establishes the index return’s cap. Increasing the floor increases the cap and vice versa. A butterfly strategy involves the purchase of two call options and the sale of two put options. By choosing appropriate strikes, this assembly may also be structured such that it provides a costless investment strategy. Rolling strategies involve the purchase and later sale of the derivative components at a chosen frequency (usually monthly): but the literature has, to date, not explored the potential outcomes for such procedures. Using recent historical data, the effect of different strategy maturities and strike prices on potential index returns (from several jurisdictions) are investigated. The more profitable strategy is strongly influenced by the prevailing market conditions.

Keywords:

• zero-cost collar
• butterfly
• options
• derivative strategies

PUBLIC INTEREST STATEMENT

Zero-cost collars are option-based strategies which match prices received and paid for constituent derivatives, thereby providing costless protection. Investors’ risk appetite determines a loss limit and the associated call strike establishes the index return’s cap. Increasing the floor increases the cap and vice versa. A butterfly strategy requires the purchase of two call options and the sale of two put options: selecting appropriate strikes allows this assembly to also provide a costless investment strategy. Rolling strategies involve the purchase and later sale of the derivative components at a chosen frequency. The literature has, however, not explored the potential outcomes for such procedures to date (June 2018). Using recent historical data, the effect of different strategy maturities and strike prices on potential index returns (from developed and developing markets) are investigated.

The research shows that profitable strategies are strongly influenced by prevailing market conditions and financial milieu. These effects are calibrated in this article. This research may be applied to any jurisdiction which employs zero-cost derivative strategies and market period (bull or bear).

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

LJ Basson

LJ Basson completed his Honours degree in risk management at North-West University (Potchefstroom Campus), South Africa, in 2017. He now works as a risk analyst at Monocle Solutions, South Africa, and will be writing the CFA level I examination in December 2018.

Lee van den Berg

Lee van den Berg Basson completed his Honours degree in risk management at North-West University (Potchefstroom Campus), South Africa in 2017, and he is currently employed at King Price Insurance, South Africa, as a risk manager.

Gary van Vuuren

Gary van Vuuren is an extraordinary professor at North-West University (Potchefstroom Campus) where he teaches risk management. He is a nuclear physicist and he teaches at the IESEG and EDHEC Business Schools, in Lille (France).