Abstract
This article examines the personal trading strategies of member proprietary traders in the natural gas futures options market. Trading activity is found to mirror previous findings in futures markets, specifically high frequency trading, with low risk exposure. The portfolio of risk holdings by member proprietary traders are also examined to identify whether they are instantaneously hedged using the underlying futures market, as well as to investigate how they manage their inventory holding, rebalancing, and volatility risk exposures. Findings of longer-term risk management practices by option markets indicate that instantaneous hedging does not take place in this market. Exposure to price and volatility risks is actively managed, while rebalancing risk exposure has a significant impact on profit for this trading group.
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Notes
For example, if the delta of an option is .5, then a $.10 change in the futures price will lead to an approximately $.05 change in the option value, holding all else constant. By selling one futures contract for every two options contracts, this will temporarily eliminate the futures price. The residual risk would be the other option pricing factors, such as volatility.
A subsample was also studied that evaluated the position risk positions matched by executing broker IDs after electronic trading in futures markets began because in theory option market makers could simultaneously trade in both markets using hand held devices. Our findings were insignificantly different and robust to the matching procedure using account numbers.
Bloomberg implied volatilities were also used with no significant changes in the results. Thus, our estimation of the implied volatility is robust to the methodology described.
Marking the position parameter levels to market each increment entails summing the positions of each increment to carry forward the balance (if the trader is net long in the increment) or debit (if the trader is net short in the increment) of trades. The balance is then added to the first trade in the increment and multiplied by the increment’s parameter estimate to calculate the increment’s parameter position level.
Due to the lack of trading in the first hour, the first 2 h of trade are combined for the incremental analysis.
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I would like to thank Peter Locke for his invaluable insights, comments and guidance, Li Sun, participants of the 2008 Financial Management Association doctoral consortium, the 2009 Financial Management Association and Southern Finance Association meetings, seminar participants from West Virginia University, Kansas State University, Clemson University and the University of Rhode Island for their helpful comments.
