Sunday, October 11, 2020

Reducing leverage hurts options buyers

Financial options on funds are bets that, e.g., a fund's price will increase up to a specified strike price.  Leverage tends to make a fund more risky, and more likely that the fund price will hit the strike price at which the option pays off.  

So far so good.  But for every person who buys an option (long) hoping that the price will increase to the strike price, there is a seller on the other side (short), who hopes that it doesn't.  

Colleague Bob Whaley has pointed out that changes in leverage of the fund can reduce its volatility which would make it less likely to pay off (link).  Using data from 2018, Whaley gives an example:

...ProShares had reduced its leverage ratios in Ultra VIX Short-Term Futures fund (UVXY) and its Short VIX Short-Term Futures ETF (SVXY). The combined market value of options on the two names fell more than $116 million, ... 

These types of corporate events, not accounted for properly, result in “windfall transfers of wealth from outstanding long to outstanding short option holders,” Whaley concluded. 

BOTTOM LINE:  Beware of buying options on funds that can change their own volatility.  (I wonder if anyone sold options on the stock who had had control of the fund's leverage.  If so, it is a textbook example of Moral Hazard!)

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