Description
The documentation about the various trading strategies adopted by Nick Leeson which ultimately resulted in the downfall of Barings bank.
Leeson believed that the Nikkei 225 was set to continue trading a narrow range. So he had taken a short straddle position. A short straddle will give profits if the index remained in the narrow range. However it will give heavy losses if the index moved in any direction. It is one of the most risky strategies. The profit loss position in case of a short straddle is as follows:
If he was of the view that the index will be more or less stable, then butterfly spreads would have been a better option. Butterfly spreads are created by buying a call option with a relatively low price and one with a relatively high price, and selling two options with intermediate price. The profit pattern for a butterfly spread is similar to a straddle however the loss potential is limited. The profit loss pattern for a butterfly spread is as follows:
From the diagram we can see that butterfly spread is a much safer or less risky option than straddle. However butterfly spread costs a small initial investment on the other hand writing a straddle gives a small income in the beginning. We can notice that Leeson was taking an extremely short term view for investments. We can comment that one of the reasons for his writing straddle can be to generate short term revenues to settle the margin payments on earlier investments. Lesson had chosen a very risky strategy for options trading. The risk was increased by the fact that his options positions were naked. An alternative to a naked position is a covered position. A naked position works well if the stock price performs according to expectations of the investor. However is has unlimited loss potential in the opposite direction. If a call is written, a naked option is profitable if the option is not exercised. In case of a covered option, the investor buys equal number of shares as written by the option. This strategy works well if the option is exercised. However if the price falls and the call option is not exercised, a covered position leads to loss. So a covered position does not provide an effective hedge. Lesson should have explored other options for hedging the options positions taken in the straddle. One such strategy is stop-loss strategy. According to this strategy, the investor takes a naked position when the stock is performing according to expectations and a covered position when it performs contrary to expectations. This is managed by deciding a threshold level. As soon as the price of stock crosses the threshold level, the investor buys or sells stock to switch position form naked to covered or vise versa. In Leesons case he had written both call and put options. In this case he could have taken a covered position whenever the index price crossed the threshold in any direction and a naked position when the index price was within the threshold levels. However this strategy has some drawbacks when it is used for a straddle position. In case of a straddle position,
the window over which the profit is expected is narrow and the stock price may cross the threshold many times. In this case the transaction costs associated with stop loss strategy will be very high rendering it impracticable. Another option that Leeson could have used is delta hedging. Delta is defined as rate of change in option price with respect to the price of the underlying. Delta is used to measure risk of the options. Using this ratio a hedge plan can be created. An investor with an exposure to ‘x’ shares due to a options contract can hedge it effectively by taking opposite position on delta multiplied by ‘x’ shares. Such hedging is called as delta hedging. Delta hedging aims to keep the value of the portfolio as unchanged as possible. The delta of an option keeps on changing and hence the hedge has to be adjusted periodically. This leads to transaction costs. Only one trade is necessary to zero out delta. For small portfolios, these costs are prohibitively high. However for a large portfolio, delta hedging is very much feasible. Lesson has a reasonable big portfolio and could have easily afforded to delta hedge his portfolio.
doc_818827682.docx
The documentation about the various trading strategies adopted by Nick Leeson which ultimately resulted in the downfall of Barings bank.
Leeson believed that the Nikkei 225 was set to continue trading a narrow range. So he had taken a short straddle position. A short straddle will give profits if the index remained in the narrow range. However it will give heavy losses if the index moved in any direction. It is one of the most risky strategies. The profit loss position in case of a short straddle is as follows:
If he was of the view that the index will be more or less stable, then butterfly spreads would have been a better option. Butterfly spreads are created by buying a call option with a relatively low price and one with a relatively high price, and selling two options with intermediate price. The profit pattern for a butterfly spread is similar to a straddle however the loss potential is limited. The profit loss pattern for a butterfly spread is as follows:
From the diagram we can see that butterfly spread is a much safer or less risky option than straddle. However butterfly spread costs a small initial investment on the other hand writing a straddle gives a small income in the beginning. We can notice that Leeson was taking an extremely short term view for investments. We can comment that one of the reasons for his writing straddle can be to generate short term revenues to settle the margin payments on earlier investments. Lesson had chosen a very risky strategy for options trading. The risk was increased by the fact that his options positions were naked. An alternative to a naked position is a covered position. A naked position works well if the stock price performs according to expectations of the investor. However is has unlimited loss potential in the opposite direction. If a call is written, a naked option is profitable if the option is not exercised. In case of a covered option, the investor buys equal number of shares as written by the option. This strategy works well if the option is exercised. However if the price falls and the call option is not exercised, a covered position leads to loss. So a covered position does not provide an effective hedge. Lesson should have explored other options for hedging the options positions taken in the straddle. One such strategy is stop-loss strategy. According to this strategy, the investor takes a naked position when the stock is performing according to expectations and a covered position when it performs contrary to expectations. This is managed by deciding a threshold level. As soon as the price of stock crosses the threshold level, the investor buys or sells stock to switch position form naked to covered or vise versa. In Leesons case he had written both call and put options. In this case he could have taken a covered position whenever the index price crossed the threshold in any direction and a naked position when the index price was within the threshold levels. However this strategy has some drawbacks when it is used for a straddle position. In case of a straddle position,
the window over which the profit is expected is narrow and the stock price may cross the threshold many times. In this case the transaction costs associated with stop loss strategy will be very high rendering it impracticable. Another option that Leeson could have used is delta hedging. Delta is defined as rate of change in option price with respect to the price of the underlying. Delta is used to measure risk of the options. Using this ratio a hedge plan can be created. An investor with an exposure to ‘x’ shares due to a options contract can hedge it effectively by taking opposite position on delta multiplied by ‘x’ shares. Such hedging is called as delta hedging. Delta hedging aims to keep the value of the portfolio as unchanged as possible. The delta of an option keeps on changing and hence the hedge has to be adjusted periodically. This leads to transaction costs. Only one trade is necessary to zero out delta. For small portfolios, these costs are prohibitively high. However for a large portfolio, delta hedging is very much feasible. Lesson has a reasonable big portfolio and could have easily afforded to delta hedge his portfolio.
doc_818827682.docx