Add training workflow, datasets, and runbook
This commit is contained in:
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10a COMPleTe gUiDe TO THe FUTUres MarKeT
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initial months (and sometimes even years) of trading. By monitoring the volume and open interest
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fi gures, a trader can determine when the market’s level of liquidity is suffi cient to warrant participa-
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tion. Figure 1.1 shows February 2016 gold (top) and april 2016 gold (bottom) prices, along with
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their respective daily volume fi gures. February gold’s volume is negligible until november 2015,
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at which point it increases rapidly into December and maintains a high level through January (the
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February contract expires in late February). Meanwhile, april gold’s volume is minimal until Janu-
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ary, at which point it increases steadily and becomes the more actively traded contract in the last
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two days of January—even though the February gold contract is still a month from expiration at
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that point.
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The breakdown of volume and open interest fi gures by contract month can be very useful in
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determining whether a specifi c month is suffi ciently liquid. For example, a trader who prefers to
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initiate a long position in a nine-month forward futures contract rather than in more nearby con-
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tracts because of an assessment that it is relatively underpriced may be concerned whether its level
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of trading activity is suffi cient to avoid liquidity problems. in this case, the breakdown of volume and
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open interest fi gures by contract month can help the trader decide whether it is reasonable to enter
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the position in the more forward contract or whether it is better to restrict trading to the nearby
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contracts.
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Traders with short-term time horizons (e.g., intraday to a few days) should limit trading to the
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most liquid contract, which is usually the nearby contract month.
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FIGURE 1.1 V olume shift in gold Futures
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Chart created using Tradestation. ©Tradestation T echnologies, inc. all rights reserved.
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Gapter 1: Definitions 19
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cised but were not. If XYZ closed at 51 and a customer who owned a January 45 call
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option failed to either sell or exercise it, it is automatically exercised. Since it is worth
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$600, this customer stands to receive a substantial amount of money back, even after
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stock commissions.
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In the case of an XYZ January 50 call option, the automatic exercise procedure
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is not as clear-cut with the stock at 51. Though the OCC wants to exercise the call
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automatically, it cannot identify a specific owner. It knows only that one or more XYZ
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January calls are still open on the long side. When the OCC checks with the broker
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age firm, it may find that the firm does not wish to have the XYZ January 50 call exer
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cised automatically, because the customer would lose money on the exercise after
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incurring stock commissions. Yet the OCC must attempt to automatically exercise
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any in-the-money calls, because the holder may have overlooked a long position.
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When the public customer sells a call in the secondary market on the last day of
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trading, the buyer on the other side of the trade is very likely a market-maker. Thus,
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when trading stops, much of the open interest in in-the-money calls held long
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belongs to market-makers. Since they can profitably exercise even for an eighth of a
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point, they do so. Hence, the writer may receive an assignment notice even if the
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stock has been only slightly above the strike price on the last trading day before expi
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ration.
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Any writer who wishes to avoid an assignment notice should always buy back ( or
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cover) the option if it appears the stock will be above the strike at expiration. The
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probabilities of assignment are extremely high if the option expires in-the-money.
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Early Exercise Due to Discount. When options are exercised prior to
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expiration, this is called early, or premature, exercise. The writer can usually
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expect an early exercise when the call is trading at or below parity. A parity or
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discount situation in advance of expiration may mean that an early exercise is
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forthcoming, even if the discount is slight. A writer who does not want to deliv
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er stock should buy back the option prior to expiration if the option is apparently
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going to trade at a discount to parity. The reason is that arbitrageurs (floor
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traders or member firm traders who pay only minimal commissions) can take
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advantage of discount situations. (Arbitrage is discussed in more detail later in
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the text; it is mentioned here to show why early exercise often occurs in a dis
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count situation.)
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Example: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered
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at a discount price of 9.80. The call is actually "worth" 10 points. The arbitrageur can
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take advantage of this situation through the following actions, all on the same day:
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12 Part I: Basic Properties of Stock Options
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Example: On January 1st, XYZ is selling at 48. An XYZ July 50 call will sell for more
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than an April 50 call, which in turn will sell for more than a January 50 call.
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FIGURE 1-2.
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Six-month July call option (see Table 1 ·4).
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.g
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a.
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C
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0
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a
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11
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10
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9
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8
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7
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6
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5
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Greatest
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Value for
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Time Value
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Premium
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0 4 ----------------------
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3
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2
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0
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FIGURE 1-3.
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40 45
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represents the option's
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time value premium.
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--------L---------50\ 55 60
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Stock Price Intrinsic value
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remains at zero
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until striking price
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is passed.
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Price Curves for the 3-, 6·, and 9-month call options.
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/
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Intrinsic Value
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9-Month Curve
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Striking Price
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Stock Price
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As expiration date draws
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closer, the lower curve
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merges with the intrinsic
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value line. The option
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price then equals its
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intrinsic value.
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Chapter 40: Advanced Concepts 849
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Let us now take a look at how both volatility and time affect the delta of a call
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option. Much of the data to be presented in this chapter will be in both tabular and
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graphical form, since some readers prefer one style or the other.
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The volatility of the underlying stock has an effect on delta. If the stock is not
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volatile, then in-the-money options have a higher delta, and out-of-the-money
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options have a lower delta. Figure 40-1 and Table 40-1 depict the deltas of various
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calls on two stocks with differing volatilities. The deltas are shown for various strike
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prices, with the time remaining to expiration equal to 3 months and the underlying
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stock at a price of 50 in all cases. Note that the graph confirms the fact that a low
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volatility stock's in-the-money options have the higher delta. The opposite holds true
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for out-of-the-money options: The high-volatility stock's options have the higher delta
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in that case. Another way to view this data is that a higher-volatility stock's options will
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always have more time value premium than the low-volatility stock's. In-the-money,
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these options with more time value will not track the underlying stock price move
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ment as closely as ones with little or no time value. Thus, in-the-money, the low
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volatility stock's options have the higher delta, since they track the underlying stock
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price movements more closely. Out-of-the-money, the entire price of the option is
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composed of time value premium. The ones with higher time value (the ones on the
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high-volatility stock) will move more since they have a higher price. Thus, out-of-the
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money, the higher-volatility stock's options have the greater delta.
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Time also affects delta. Figures 40-2 (see Table 40-2) and 40-4 show the rela
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tionships between time and delta. Figure 40-2's scales are similar to those in Figure
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40-2, delta vs. volatility: The deltas are shown for various striking prices, with XYZ
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assumed to be equal to 50 in all cases. Notice that in-the-money, the shorter-term
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options have the higher delta. Again, this is because they have the least time value
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premium. Out-of-the-money, the opposite is true: The longer-term options have the
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higher deltas, since these options have the most time value premium.
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Figure 40-3 (see Table 40-3) depicts the delta for an XYZ January 50 call with
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XYZ equal to 50. The horizontal axis in this graph is "weeks until expiration." Note
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that the delta of a longer-term at-the-money option is larger than that of a shorter
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term option. In fact, the delta shrinks more rapidly as expiration draws nearer. Thus,
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even if a stock remains unchanged and its volatility is constant, the delta of its options
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will be altered as time passes. This is an important point to note for the strategist,
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since he is constantly monitoring the risk characteristics of his position. He cannot
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assume that his position is the same just because the stock has remained at the same
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price for a period of time.
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Position Delta. Another usage of the term delta is what has previously been
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referred to as the equivalent stock position (ESP); for futures options, it would be
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594 Part V: Index Options and Futures
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Cash Surrender Value = $10 x Final Value/ 1,245.27
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This shortened version of the formula only works, though, when the participa
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tion rate is 100% of the increase in the Final Index Value above the striking price.
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Otherwise, the longer formula should be used.
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Not all structured products of this type offer the holder 100% of the appreci
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ation of the index over the initial striking price. In some cases, the percentage is
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smaller ( although in the early days of issuance, some products offered a percentage
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appreciation that was actually greater than 100%). After 1996, options in general
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became more expensive as the volatility of the stock market increased tremendous
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ly. Thus, structured products issued after 1997 or 1998 tend to include an "annual
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adjustment factor." Adjustment factors are discussed later in the chapter.
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Therefore, a more general formula for Cash Surrender Value - one that applies
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when the participation rate is a fixed percentage of the striking price - is:
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Cash Surrender Value =
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Guarantee + Guarantee x Participation Rate x (Final Index Value/ Striking Price - I)
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THE COST OF THE IMBEDDED CALL OPTION
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Few structured products pay dividends. 1 Thus, the "cost" of owning one of these
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products is the interest lost by not having your money in the bank ( or money market
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fund), but rather having it tied up in holding the structured product.
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Continuing with the preceding example, suppose that you had put the $10 in
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the bank instead of buying a structured product with it. Let's further assume that the
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money in the bank earns 5% interest, compounded continuously. At the end of seven
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years, compounded continuously, the $10 would be worth:
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Money in the bank = Guarantee Price x ert
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= $10 x e 0-05 x 7 = 14.191, in this case
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This calculation usually raises some eyebrows. Even compounded annually, the
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amount is 14.07. You would make roughly 40% (without considering taxes) just by
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1Some do pay dividends, though. A structured product existed on a contrived index, called the Dow-Jones
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Top 10 Yield index (symbol: $XMT). This is a sort of "dogs of the Dow" index. Since part of the reason for owning a
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"dogs of the Dow" product is that dividends are part of the performance, the creators of the structured product
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(Merrill Lynch) stated that the minimum price one would receive at maturity would be 12.40, not the 10 that was
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the initial offering price. Thus, this particular structured product had a "dividend" built into it in the form of an ele
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vated minimum price at maturity.
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Chapter 13: Reverse Spreads
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Buy 2 July 45 calls at 1 each
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Sell 1 July 40 call at 4
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Net
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2 debit
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4 credit
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2 credit
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233
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These spreads are generally established for credits. In fact, if the spread cannot
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be initiated at a credit, it is usually not attractive. If the underlying stock drops in
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price and is below 40 at July expiration, all the calls will expire worthless and the
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strategist will make a profit equal to his initial credit. The maximum downside poten
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tial of the reverse ratio spread is equal to the initial credit received. On the other
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hand, if the stock rallies substantially, the potential upside profits are unlimited, since
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the spreader owns more calls than he is short. Simplistically, the investor is bullish
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and is buying out-of the-money calls but is simultaneously hedging himself by selling
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another call. He can profit if the stock rises in price, as he thought it would, but he
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also profits if the stock collapses and all the calls expire worthless.
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This strategy has limited risk. With most spreads, the maximum loss is attained
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at expiration at the striking price of the purchased call. This is a true statement for
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backspreads.
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Example: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth
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less for a loss of $200 and the July 40 call will have to be bought back for 5 points, a
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$100 loss on that call. The total loss would thus be $300, and this is the most that can
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be lost in this example. If the underlying stock should rally dramatically, this strategy
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has unlimited profit potential, since there are two long calls for each short one. In
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fact, one can always compute the upside break-even point at expiration. That break
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even point happens to be 48 in this example. At 48 at July expiration, each July 45
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call would be worth 3 points, for a net gain of $400 on the two of them. The July 40
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call would be worth 8 with the stock at 48 at expiration, representing a $400 loss on
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that call. Thus, the gain and the loss are offsetting and the spread breaks even, except
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for commissions, at 48 at expiration. If the stock is higher than 48 at July expiration,
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profits will result.
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Table 13-1 and Figure 13-2 depict the potential profits and losses from this
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example of a reverse ratio spread. Note that the profit graph is exactly like the prof
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it graph of a ratio spread that has been rotated around the stock price axis. Refer to
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Figure 11-1 for a graph of the ratio spread. There is actually a range outside of which
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profits can be made - below 42 or above 48 in this example. The maximum loss
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occurs at the striking price of the purchased calls, or 45, at expiration.
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There are no naked calls in this strategy, so the investment is relatively small.
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The strategy is actually a long call added to a bear spread. In this example, the bear
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Chapter 25: LEAPS 39S
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✓,,FREE" COVERED CALL WRITES
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In Chapter 2, a strategy of writing expensive LEAPS options was briefly described.
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In this section, a more detailed analysis is offered. A certain type of covered call
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write, one in which the call is quite expensive, sometimes attracts traders looking for
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a "free ride." To a certain extent, this strategy is something of a free ride. As you
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might imagine, though, there can be major problems.
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The investment required for a covered call write on margin is 50% of the stock
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price, less the proceeds received from selling the call. In theory, it is possible for an
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option to sell for more than 50% of the stock cost. This is a margin account, a cov
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ered write could be established for "free." Let's discuss this in terms of two types of
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calls: the in-the-money call write and the out-of-the-money call write.
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Out-of-the-Money Covered Call Write. This is the simplest way to approach
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the strategy. One may be able to find LEAPS options that are just slightly out-of-the
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money, which sell for 50% of the stock price. Understandably, such a stock would be
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quite volatile.
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Example: GOGO stock is selling for $38 per share. GOGO has listed options, and a
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2-year LEAPS call with a striking price of 40 is selling for $19. The requirement for
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this covered write would be zero, although some commission costs would be
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involved. The debit balance would be 19 points per share, the amount the broker
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loans you on margin.
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Certain brokerage firms might require some sort of minimum margin deposit, but
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technically there is no further requirement for this position. Of course, the leverage
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is infinite. Suppose one decided to buy 10,000 shares of GOGO and sell 100 calls,
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covered. His risk is $190,000 if the stock falls to zero! That also happens to be the
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debit balance in his account. Thus, for a minimal investment, one could lose a for
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tune. In addition, if the stock begins to fall, one's broker is going to want maintenance
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margin. He probably wouldn't let the stock slip more than a couple of points before
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asking for margin. If one owns 10,000 shares and the broker wants two points main
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tenance margin, that means the margin call would be $20,000.
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The profits wouldn't be as big as they might at first seem. The maximum gross
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profit potential is $210,000 if the 10,000 shares are called away at 40. The covered
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write makes 21 points on each share - the $40 sale price less the original cost of $19.
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However, one will have had to pay interest on the debit balance of $190,000 for two
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years. At 10%, say, that's a total of $38,000. There would also be commissions on the
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purchase and the sale.
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886 Part VI: Measuring and Trading Volatility
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that is somewhat variable. But, for the purposes of such a projection, it is acceptable
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to use the current volatility. The results of as many as 9 stock prices might be dis
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played: every one-half standard deviation from -2 through + 2 (-2.0, -1.5, -1.0,
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-0.5, 0, 0.5, 1.0, 1.5, 2.0).
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Example: XYZ is at 60 and has a volatility of 35%. A distribution of stock prices 7
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days into the future would be determined using the equation:
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Future Price = Current Price x eav-ft
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where
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a corresponds to the constants in the following table: (-2.0 ... 2.0):
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# Standard Deviations
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-2.0
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- 1.5
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- 1.0
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||||
-0.5
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||||
0
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||||
0.5
|
||||
1.0
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||||
1.5
|
||||
2.0
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Projected Stack Price
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54.46
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55.79
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57.16
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58.56
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60.00
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||||
61.47
|
||||
62.98
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64.52
|
||||
66.11
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Again, refer to Chapter 28 on mathematical applications for a more in-depth
|
||||
discussion of this price determination equation.
|
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Note that the formula used to project prices has time as one of its components.
|
||||
This means that as we look further out in time, the range of possible stock prices will
|
||||
expand - a necessary and logical component of this analysis. For example, if the
|
||||
prices were being determined 14 days into the future, the range of prices would be
|
||||
from 52.31 to 68.82. That is, XYZ has the same probability of being at 54.46 in 7 days
|
||||
that it has of being at 52.31 in 14 days. At expiration, some 90 days hence, the range
|
||||
would be quite a bit wider still. Do not make the mistake of trying to evaluate the
|
||||
position at the same prices for each time period (7 days, 14 days, 1 rnonth, expiration,
|
||||
etc.). Such an analysis would be wrong.
|
||||
Once the appropriate stock prices have been determined, the following quanti
|
||||
ties would be calculated for each stock price: profit or loss, position delta, position
|
||||
gamma, position theta, and position vega. (Position rho is generally a less important
|
||||
risk measure for stock and futures short-term options.) Armed with this information,
|
||||
the strategist can be prepared to face the future. An important item to note: A model
|
||||
@@ -0,0 +1,33 @@
|
||||
814 Part VI: Measuring and Trading Volatility
|
||||
TRADING THE VOLATILITY PREDICTION
|
||||
The volatility trader must have some way of determining when implied volatility is
|
||||
sufficiently out of line that it warrants a trade. Then he must decide what trade to
|
||||
establish. Furthermore, as with any strategy- especially option strategies - follow-up
|
||||
action is important too. We will not be introducing any new strategies, per se, in this
|
||||
chapter. Those strategies have already been laid out in the previous chapters of this
|
||||
book. However, we will briefly review important points about those strategies and
|
||||
their follow-up actions where it is appropriate.
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||||
First, one must try to find situations in which implied volatility is out of line.
|
||||
That is not the end of the analysis, though. After that, one needs to do some proba
|
||||
bility work and needs to see how the underlying has behaved in the past. Other fine
|
||||
tuning measures are often useful, too. These will all be described in this chapter.
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||||
DETERMINING WHEN VOLATILITY IS OUT OF LINE
|
||||
There is much disagreement among volatility traders regarding the best method to use
|
||||
for determining if implied volatility is "out ofline." Most favor comparing implied with
|
||||
historical volatility. However, it was shown two chapters ago that implied volatility is
|
||||
not necessarily a good predictor of historical volatility. Yet this approach cannot be dis
|
||||
carded; however it must be used judiciously. Another approach is to compare today's
|
||||
implied volatility with where it has been in the past. This concept relies heavily on the
|
||||
concept of the percentile of implied volatility. Finally, there is the approach of trying
|
||||
to "read" the charts of implied and historical volatility. This is actually something akin
|
||||
to what GARCH tries to do, but on a short-term horizon. So the approaches are:
|
||||
1. Compare implied volatility to its own past levels (percentile approach).
|
||||
2. Compare implied volatility to historical volatility.
|
||||
3. Interpret the chart of volatility.
|
||||
In addition, we will examine two lesser-used methods: comparing current levels of
|
||||
historical volatility to past measures of historical volatility, and finally, using only a
|
||||
probability calculator and trading the situation that has the best probabilities of
|
||||
success.
|
||||
THE PERCENTILE APPROACH
|
||||
In this author's opinion, there is much merit in the percentile approach. When one says
|
||||
that volatility tends to trade in a range, which is the basic premise behind volatility trad-
|
||||
@@ -0,0 +1,41 @@
|
||||
Finding Mispriced Options • 157
|
||||
to eyeball the ATM volatility for the one- and two-month contracts.
|
||||
3. If there is a large bid-ask spread, the relevant forward volatility
|
||||
to use is equal to the implied volatility we want to transact. In
|
||||
other words, use the ask implied volatility if you are thinking
|
||||
about gaining exposure and the bid implied volatility if you are
|
||||
thinking about accepting exposure (the online application shows
|
||||
cones for both the bid implied volatility and the ask implied
|
||||
volatility).
|
||||
Basically, these rules are just saying, “If you want to know what the
|
||||
option market is expecting the future price range of a stock to be, find a
|
||||
nice, liquid near ATM strike’s implied volatility and use that. ” Most op-
|
||||
tion trading is done in a tight band around the present ATM mark and for
|
||||
expirations from zero to three months out. By looking at the most heavily
|
||||
traded implied volatility numbers, we are using the market’s price-discov-
|
||||
ery function to the fullest. Big announcements sometimes can throw off
|
||||
the true volatility picture, which is why we try to avoid gathering infor -
|
||||
mation from options in these cases (e.g., legal decisions, Food and Drug
|
||||
Administration trial decisions, particularly impactful quarterly earnings
|
||||
announcements, and so on).
|
||||
If I was looking at Oracle, I would probably choose the $32-strike
|
||||
options expiring in September. These are the 50-delta options with
|
||||
61 days to expiration, and there is not much of a difference between
|
||||
calls and puts or between the bid and ask. The August expiration op-
|
||||
tions look a bit suspicious to me considering that their implied volatility
|
||||
is a couple of percentage points below that of the others. It probably
|
||||
doesn’t make a big difference which you use, though. We are trying to
|
||||
find opportunities that are severely mispriced, not trying to split hairs
|
||||
of a couple of percentage points. All things considered, I would prob-
|
||||
ably use a number somewhere around 22 percent for Oracle’s forward
|
||||
volatility.
|
||||
C12.02 11.75 N/A 55.427% 0.9897 C0.00 0.02 N/A 50.831%- 0.01032011.90
|
||||
C11.03 10.70 N/A 123.903% 0.9869 C0.01 0.03 N/A 48.233%- 0.01312112.35
|
||||
C10.04 9.50 N/A 64.054% 0.9834 C0.03 0.05 37.572% 46.993%- 0.01660.012210.10
|
||||
C0.06 0.04 20.455% 21.147% 0.0463 C5.03 5.55 N/A 36.111%- 0.95584.95370.05
|
||||
1.65 1.65 22.720% 23.311% 0.6325 0.84 +0.07 0.82 22.989% 23.384%- 0.36790.80311.68-0.13
|
||||
1.06 1.08 22.019% 22.407% 0.4997 1.23 +0.05 1.25 22.284% 22.672%- 0.50081.23321.10-0.12
|
||||
0.66 0.65 21.378% 21.813% 0.3606 1.88 +0.16 1.82 21.453% 22.106%- 0.64021.79330.67-0.07
|
||||
0.02 0.01 21.354% 23.409% 0.0155 C6.99 7.55 N/A 44.342%- 0.98716.85390.02+0.01
|
||||
0.03 0.01 19.050% 22.144% 0.0266 C6.00 6.30 17.134% 30.947%- 0.97576.15380.030.00
|
||||
SEP 20 ´13
|
||||
@@ -0,0 +1,37 @@
|
||||
Gaining Exposure • 195
|
||||
by using relatively less leverage when I want to commit a significant amount
|
||||
of capital to an idea constitute, I have found, given my risk tolerance and
|
||||
experience, the best path for me for a general investment.
|
||||
In contrast, we all have special investment loves or wild hares or
|
||||
whatever, and sometimes we must express ourselves with a commitment
|
||||
of capital. For example, “If XYZ really can pull it off and come up with a
|
||||
cure for AIDS, its stock will soar. ” In instances such as these, I would rather
|
||||
commit less capital and express my doubt in the outcome with a smaller
|
||||
but more highly levered bet. If, on average, my investment wild hares come
|
||||
true every once in a while and, when they do, the options I’ve bought on
|
||||
them pay off big enough to more than cover my realized losses on all those
|
||||
that did not, I am net further ahead in the end.
|
||||
These rules of thumb are my own for general investments. In the spe-
|
||||
cial situation of investing in a possible takeover target, there are a few extra
|
||||
considerations. A company is likely to be acquired in one of two situations:
|
||||
(1) it is a sound business with customers, product lines, or geographic
|
||||
exposure that another company wants, or (2) it is a bad business, either
|
||||
because of management incompetence, a secular decline in the business, or
|
||||
something else, but it has some valuable asset(s) such as intellectual prop-
|
||||
erty that a company might want to have.
|
||||
If you think that a company of the first sort may be acquired, I be-
|
||||
lieve that it is best to buy ITM call options to attempt to minimize the time
|
||||
value spent on the investment (you could also sell puts, and I will discuss
|
||||
this approach in Chapter 10). In this case, you want to minimize the time
|
||||
value spent because you know that the time value you buy will drain away
|
||||
when a takeover is announced and accepted. By buying an ITM contract,
|
||||
you are mainly buying intrinsic value, so you lose little time value if and
|
||||
when the takeover goes through. If you think that a company of the second
|
||||
sort (a bad company in decline) may be acquired, I believe that it is best to
|
||||
minimize the time value spent on the investment by not buying a lot of call
|
||||
contracts and by buying them OTM. In this case, you want to minimize the
|
||||
time value spent using OTM options by limiting the number of contracts
|
||||
bought because you do not want to get stuck losing too much capital if
|
||||
and when the bad company’s stock loses value while you are holding the
|
||||
options. Typical buyout premiums are in the 30 percent range, so buy-
|
||||
ing call options 20 percent OTM or so should generate a decent profit if
|
||||
@@ -0,0 +1,44 @@
|
||||
Chapter 28: Mathematical Applications
|
||||
TABLE 28-5.
|
||||
Calculation of expected returns.
|
||||
Price of XYZ in 6 Months
|
||||
Below 30
|
||||
31
|
||||
32
|
||||
33
|
||||
34
|
||||
Above 35
|
||||
467
|
||||
Chance of XYZ Being at That Price ·
|
||||
20%
|
||||
10%
|
||||
10%
|
||||
10%
|
||||
10%
|
||||
40%
|
||||
100%
|
||||
Since the percentages total 100%, all the outcomes have theoretically been
|
||||
allowed for. Now suppose a February 30 call is trading at 4 and a February 35 call is
|
||||
trading at 2 points. A bull spread could be established by buying the February 30 and
|
||||
selling the February 35. This position would cost 2 points - that is, it is a 2-point
|
||||
debit. The spreader could make 3 points if XYZ were above 35 at expiration for a
|
||||
return of 150%, or he could lose 100% if XYZ were below 30 at expiration. The
|
||||
expected return for this spread can be computed by multiplying the outcome at expi
|
||||
ration for each price by the probability of being at that price, and then summing the
|
||||
results. For example, if XYZ is below 30 at expiration, the spreader loses $200. It was
|
||||
assumed that there is a 20% chance of XYZ being below 30 at expiration, so the
|
||||
expected loss is 20% times $200, or $40. Table 28-6 shows the computation of the
|
||||
expected results at all the prices. The total expected profit is $100. This means that
|
||||
the expected return (profit divided by investment) is 50% ($100/$200). This appears
|
||||
to be an attractive spread, because the spreader could "expect" to make 50% of his
|
||||
money, less commissions.
|
||||
What has really been calculated in this example is merely the return that one
|
||||
would expect to make in the long run if he invested in the same position many times
|
||||
throughout history. Saying that a particular position has an expected return of 8 or
|
||||
9% is no different from saying that common stocks return 8 or 9% in the long run.
|
||||
Of course, in bull markets stock would do much better, and in bear markets much
|
||||
worse. In a similar manner, this example bull spread with an expected return of 50%
|
||||
may do as well as the maximum profit or as poorly as losing 100% in any one case. It
|
||||
is the total return on many cases that has the expected return of 50%. Mathematical
|
||||
theory holds that, if one constantly invests in positions with positive expected returns,
|
||||
he should have a better chance of making rrwney.
|
||||
@@ -0,0 +1,51 @@
|
||||
Chapter 37: How Volatility Affects Popular Strategies
|
||||
Stock Price:
|
||||
Strike Price:
|
||||
Time Remaining:
|
||||
Implied Volatility:
|
||||
Theoretical Call Value:
|
||||
100
|
||||
100
|
||||
1 month
|
||||
38.1%
|
||||
4.64
|
||||
759
|
||||
So, if implied volatility increases from 20% to 26% over the first month, then
|
||||
this call option would still be trading at the same price - 4.64. That's not an unusual
|
||||
increase in implied volatility; increases of that magnitude, 20% to 26%, happen all
|
||||
the time. For it to then increase from 26% to 38% over the next month is probably
|
||||
less likely, but it is certainly not out of the question. There have been many times in
|
||||
the past when just such an increase has been possible - during any of the August,
|
||||
September, or October bear markets or mini-crashes, for example. Also, such an
|
||||
increase in implied volatility might occur if there were takeover rumors in this stock,
|
||||
or if the entire market became more volatile, as was the case in the latter half of the
|
||||
1990s.
|
||||
Perhaps this example was distorted by the fact that an implied volatility of 20%
|
||||
is a fairly low number to begin with. What would a similar example look like if one
|
||||
started out with a much higher implied volatility - say, 80%?
|
||||
Example: Making the same assumptions as in the previous example, but now setting
|
||||
the implied volatility to a much higher level of 80%, the Black-Scholes model now
|
||||
says that the call would be worth a price of 16.45:
|
||||
Stock Price:
|
||||
Strike Price:
|
||||
Time Remaining:
|
||||
Implied Volatility:
|
||||
Theoretical Call Value:
|
||||
100
|
||||
100
|
||||
3 months
|
||||
80%
|
||||
16.45
|
||||
Again, one must ask the question: "If a month passes, what implied volatility
|
||||
would be necessary for the Black-Scholes model to yield a price of 16.45?" In this
|
||||
case, it turns out to be an implied volatility of just over 99%.
|
||||
Stock Price:
|
||||
Strike Price:
|
||||
Time Remaining:
|
||||
Implied Volatility:
|
||||
Theoretical Call Value:
|
||||
100
|
||||
100
|
||||
2 months
|
||||
99.4%
|
||||
16.45
|
||||
@@ -0,0 +1,62 @@
|
||||
Chapter 38: The Distribution of Stock Prices
|
||||
TABLE 38-5.
|
||||
Index price movements.
|
||||
Total Indices: 135
|
||||
Upside Moves:
|
||||
Downside Moves:
|
||||
TABLE 38-6.
|
||||
3cr
|
||||
32
|
||||
None
|
||||
4cr
|
||||
15
|
||||
Scr
|
||||
3
|
||||
Index price movements, least volatile period.
|
||||
Total Indices: 66
|
||||
Upside Moves:
|
||||
Downside Moves:
|
||||
3cr
|
||||
l
|
||||
3
|
||||
4cr
|
||||
l
|
||||
0
|
||||
Scr
|
||||
0
|
||||
0
|
||||
789
|
||||
Dates: 10/22/99-12/7/99
|
||||
>6cr
|
||||
0
|
||||
Total
|
||||
50
|
||||
Dates: 7/1/93-8/17/93
|
||||
>6cr
|
||||
0
|
||||
0
|
||||
Total
|
||||
2
|
||||
3
|
||||
Total number of indices moving >=3cr: 5 (8% of the indices studied)
|
||||
indices made oversized moves - probably a bias because of the strong Internet stock
|
||||
market during that time period. The low-volatility period showed a more reasonable,
|
||||
but still somewhat eye-opening, 8% making moves of greater than three standard
|
||||
deviations. So, even selling index options isn't as safe as it's cracked up to be, when
|
||||
they can make moves of this size, defying the "normal" probabilities.
|
||||
Since that period in 1999 was rather volatile, and all on the upside, the same
|
||||
study was conducted, once again using the least volatile period of July 1993.
|
||||
In Table 38-6, the numbers are lower than they are for stocks, but still much
|
||||
greater than one might expect according to the lognormal distribution.
|
||||
These examples of stock price movement are interesting, but are not rigorous
|
||||
ly complete enough to be able to substantiate the broad conclusion that stock prices
|
||||
don't behave lognormally. Thus, a more complete study was conducted. The follow
|
||||
ing section presents the results of this research.
|
||||
THE DISTRIBUTION OF STOCK PRICES
|
||||
The earlier examples pointed out that, at least in those specific instances, stock price
|
||||
movements don't conform to the lognormal distribution, which is the distribution
|
||||
used in many mathematical models that are intended to describe the behavior of
|
||||
stock and option prices. This isn't new information to mathematicians; papers dating
|
||||
back to the mid-1960s have pointed out that the lognormal distribution is flawed.
|
||||
However, it isn't a terrible description of the way that stock prices behave, so many
|
||||
applications have continued to use the lognormal distribution.
|
||||
@@ -0,0 +1,37 @@
|
||||
Chapter 40: Advanced Concepts 905
|
||||
Can one possibly reason this risk measurement out without making severe
|
||||
mathematical calculations? Well, possibly. Note that the delta of an option starts as a
|
||||
small number when the option is out-of-the-money. It then increases, slowly at first,
|
||||
then more quickly, until it is just below 0.60 for an at-the-money option. From there
|
||||
on, it will continue to increase, but much more slowly as the option becomes in-the
|
||||
money. This movement of the delta can be observed by looking at gamma: It is the
|
||||
change in the delta, so it starts slowly, increases as the stock nears the strike, and then
|
||||
begins to decrease as the option is in-the-money, always remaining a positive num
|
||||
ber, since delta can only change in the positive direction as the stock rises. Finally,
|
||||
the gamma of the gamma is the change in the gamma, so it in tum starts as a positive
|
||||
number as gamma grows larger; but then when gamma starts tapering off, this is
|
||||
reflected as a negative gamma of the gamma.
|
||||
In general, the gamma of the gamma is used by sophisticated traders on large
|
||||
option positions where it is not obvious what is going to happen to the gamma as the
|
||||
stock changes in price. Traders often have some feel for their delta. They may even
|
||||
have some feel for how that delta is going to change as the stock moves (i.e., they
|
||||
have a feel for gamma). However, sophisticated traders know that even positions that
|
||||
start out with zero delta and zero gamma may eventually acquire some delta. The
|
||||
gamma of the gamma tells the trader how much and how soon that eventual delta will
|
||||
be acquired.
|
||||
MEASURING THE DIFFERENCE OF IMPLIED VOLATILITIES
|
||||
Recall that when the topic of implied volatility was discussed, it was shown that if one
|
||||
could identify situations in which the various options on the same underlying securi
|
||||
ty had substantially different implied volatilities, then there might be an attractive
|
||||
neutral spread available. The strategist might ask how he is to determine if the dis
|
||||
crepancies between the individual options are significantly large to warrant attention.
|
||||
Furthermore, is there a quick way (using a computer, of course) to determine this?
|
||||
A logical way to approach this is to look at each individual implied volatility and
|
||||
compute the standard deviation of these numbers. This standard deviation can be
|
||||
converted to a percentage by dividing it by the overall implied volatility of the stock.
|
||||
This percentage, if it is large enough, alerts the strategist that there may be opportu
|
||||
nities to spread the options of this underlying security against each other. An exam
|
||||
ple should clarify this procedure.
|
||||
Example: XYZ is trading at 50, and the following options exist with the indicated
|
||||
implied volatilities. We can calculate a standard deviation of these implieds, called
|
||||
implied deviation, via the formula:
|
||||
@@ -0,0 +1,34 @@
|
||||
O,apter 1: Definitions 7
|
||||
the last trading day; the holder does not have to wait until the expiration date
|
||||
itself before exercising. (Note: Some options, called "European" exercise
|
||||
options, can be exercised only on their expiration date and not before - but they
|
||||
are generally not stock options.) These exercise notices are irrevocable; once
|
||||
generated, they cannot be recalled. In practical terms, they are processed only
|
||||
once a day, after the market closes. Whenever a holder exercises an option,
|
||||
somewhere a writer is assigned the obligation to fulfill the terms of the option
|
||||
contract: Thus, if a call holder exercises the right to buy, a call writer is assigned
|
||||
the obligation to sell; conversely, if a put holder exercises the right to sell, a put
|
||||
writer is assigned the obligation to buy. A more detailed description of the exer
|
||||
cise and assignment of call options follows later in this chapter; put option exer
|
||||
cise and assignment are discussed later in the book.
|
||||
RELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE
|
||||
In- and Out-of-the-Money. Certain terms describe the relationship between
|
||||
the stock price and the option's striking price. A call option is said to be out-of-the
|
||||
money if the stock is selling below the striking price of the option. A call option is in
|
||||
the-money if the stock price is above the striking price of the option. (Put options
|
||||
work in a converse manner, which is described later.)
|
||||
Example: XYZ stock is trading at $47 per share. The XYZ July 50 call option is out
|
||||
of-the-money, just like the XYZ October 50 call and the XYZ July 60 call. However,
|
||||
the XYZ July 45 call, XYZ October 40, and XYZ January 35 are in-the-money.
|
||||
The intrinsic value of an in-the-money call is the amount by which the stock
|
||||
price exceeds the striking price. If the call is out-of-the-money, its intrinsic value is
|
||||
zero. The price that an option sells for is commonly referred to as the premium. The
|
||||
premium is distinctly different from the time value premium ( called time premium,
|
||||
for short), which is the amount by which the option premium itself exceeds its intrin
|
||||
sic value. The time value premium is quickly computed by the following formula for
|
||||
an in-the-money call option:
|
||||
Call time value premium = Call option price + Striking price - Stock price
|
||||
Example: XYZ is trading at 48, and XYZ July 45 call is at 4. The premium - the total
|
||||
price - of the option is 4. With XYZ at 48 and the striking price of the option at 45,
|
||||
the in-the-money amount (or intrinsic value) is 3 points (48-45), and the time value
|
||||
isl(4-3).
|
||||
@@ -0,0 +1,44 @@
|
||||
174 Part VI: Measuring and Trading Volatility
|
||||
First, one can see that the bullish spread position has a total risk of 17 points, if
|
||||
XYZ is below 80 (the lower striking price of the put spread) at expiration. That, of
|
||||
course, is more than the 10-point cost of the July 100 call by itself, but if one is using
|
||||
a trading stop of any sort, he probably would not be at risk for the entire 17 points,
|
||||
since he wouldn't hold on while the stock fell all the way to 80 and below. Note also
|
||||
that the bullish spread position would have a loss of 10 points (the same as the call)
|
||||
at a price of 87 for the common at expiration. Hence, the combined position actual
|
||||
ly has less risk than the outright call purchase as long as XYZ is 87 or higher at expi
|
||||
ration. Since one is supposedly bullish initially when establishing this strategy, it
|
||||
seems likely that he would figure the stock would be 87 or higher at expiration.
|
||||
Figure 37-7 offers another comparison, that of the two positions after 30 days
|
||||
have passed. Note that the spread position once again does better on the upside and
|
||||
worse on the downside. The crossover point between the two curves is at about a
|
||||
price of 95. That is, ifXYZ is above 95 in 30 days, the bullish spread position will out
|
||||
perform the call buy.
|
||||
One final point should be made regarding the investment required. The out
|
||||
right call purchase requires an investment of $1,000 - the cost of the long call. The
|
||||
bullish spread position requires that $1,000, plus $700 for the spread (IO-point dif
|
||||
ference in the strikes, less the 3-point credit received for selling the spread). That's a
|
||||
total of $1,700, the risk of the bullish spread position. Hence, the rate of return might
|
||||
favor the outright call purchase, depending on how far the stock rallies.
|
||||
FIGURE 37-7.
|
||||
Results of the two positions in 30 days.
|
||||
1000
|
||||
en
|
||||
Ill
|
||||
0
|
||||
...J
|
||||
O 70 :;::,
|
||||
~ ... a.
|
||||
w
|
||||
-1000
|
||||
-2000-
|
||||
80
|
||||
95
|
||||
Bullish Spread
|
||||
Stock
|
||||
Spread
|
||||
110
|
||||
/
|
||||
1/
|
||||
Outright Call Purchase
|
||||
120
|
||||
@@ -0,0 +1,35 @@
|
||||
514 Part V: Index Options and Futures
|
||||
OPTION PREMIUMS
|
||||
The dollar amount of trading of a futures option contract is normally the same as that
|
||||
of the underlying future. That is, since the S&P 500 future is worth $250 per point,
|
||||
so are the S&P 500 futures options. The same holds true for the New York Stock
|
||||
Exchange Index options.
|
||||
Example: An investor buys an S&P 500 December 1410 call for 4.20 with the index
|
||||
at 1409.50. The cost of the call is $1,050 (4.20 x 250). The call must be paid for in
|
||||
full, as with equity options.
|
||||
An interesting fact about futures options is that the longer-term options have a
|
||||
"double premium" effect. The option itself has time value premium and its underly
|
||||
ing security, the future, also has a premium over the physical commodity. This phe
|
||||
nomenon can produce some rather startling prices when looking at calendar spreads.
|
||||
Example: The ZYX Index is trading at 162.00 sometime during the month of
|
||||
January. Suppose that the March ZYX futures contract is trading at 163.50 and the
|
||||
June futures contract at 167.50. These prices are reasonable in that they represent a
|
||||
premium over the index itself which is 162.00. These premiums are related to the
|
||||
amount of time remaining until the expiration of the futures contract.
|
||||
Now, however, let us look at two options - the March 165 put and the June 165
|
||||
put. The March 165 put might be trading at 3 with its underlying security, the March
|
||||
futures contract, trading at 163.50. The June 165 put option has as its underlying
|
||||
security the June futures contract. Since the June option has more time remaining
|
||||
until expiration, it will have more time value premium than a March option would.
|
||||
However, the underlying June future is trading at 167.50, so the June 165 put option
|
||||
is 2½ points out-of-the-money and therefore might be selling for 2½. This makes a
|
||||
very strange-looking calendar spread with the longer-term option selling at 2½ and
|
||||
the near-term option selling for 3. This is due to the fact, of course, that the two
|
||||
options have different underlying securities. One is in-the-money and the other is
|
||||
out-of-the-money. These two underlyings - the March and June futures - have a
|
||||
price differential of their own. So the option calendar spread is inverted due to this
|
||||
double premium effect.
|
||||
FUTURES OPTION MARGIN
|
||||
Most futures exchanges have gone to the form of option margin called SPAN, which
|
||||
stands for Standard Portfolio Analysis of Risk. This form of margining is very fair and
|
||||
attempts to base the margin requirement of an option position on the probability of
|
||||
@@ -0,0 +1,37 @@
|
||||
160 Part II: Call Option Strategies
|
||||
situation could arise to the downside. If:X'YZ were to plunge from 49 to 20, the ratio
|
||||
writer would make a good deal of profit from the calls by rolling down, but may still
|
||||
have a larger loss in the stock itself than the call profits can compensate for.
|
||||
Many ratio writers who are large enough to diversify their positions into a num
|
||||
ber of stocks will continue to maintain 2:1 ratios on all their positions and will simply
|
||||
close out a position that has gotten out of hand by running dramatically to the upside
|
||||
or to the downside. These traders believe that the chances of such a dramatic move
|
||||
occurring are small, and that they will take the infrequent losses in such cases in
|
||||
order to be basically neutral on the other stocks in their portfolios.
|
||||
There is, however, a way to combat this sort of dramatic move. This is done by
|
||||
altering the ratio of the covered write as the stock moves either up or down. For
|
||||
example, as the underlying stock moves up dramatically in price, the ratio writer can
|
||||
decrease the number of calls outstanding against his long stock each time he rolls.
|
||||
Eventually, the ratio might decrease as far as 1:1, which is nothing more than a cov
|
||||
ered writing situation. As long as the stock continues to move in the same upward
|
||||
direction, the ratio writer who is decreasing his ratio of calls outstanding will be giv
|
||||
ing more and more weight to the stock gains in the ratio write and less and less weight
|
||||
to the call losses. It is interesting to note that this decreasing ratio effect can also be
|
||||
produced by buying extra shares of stock at each new striking price as the stock
|
||||
moves up, and simultaneously keeping the number of outstanding calls written con
|
||||
stant. In either case, the ratio of calls outstanding to stock owned is reduced.
|
||||
When the stock moves down dramatically, a similar action can be taken to
|
||||
increase the number of calls written to stock owned. Normally, as the stock falls, one
|
||||
would sell out some of his long stock and roll the calls down. Eventually, after the
|
||||
stock falls far enough, he would be in a naked writing position. The idea is the same
|
||||
here: As the stock falls, more weight is given to the call profits and less weight is given
|
||||
to the stock losses that are accumulating.
|
||||
This sort of strategy is more oriented to extremely large investors or to firm
|
||||
traders, market-makers, and the like. Commissions will be exorbitant if frequent rolls
|
||||
are to be made, and only those investors who pay very small commissions or who have
|
||||
such a large holding that their commissions are quite small on a percentage basis will
|
||||
be able to profit substantially from such a strategy.
|
||||
ADJUSTING WITH THE DELTA
|
||||
The delta of the written calls can be used to determine the correct ratio to be used in
|
||||
this ratio-adjusting defensive strategy. The basic idea is to use the call's delta to
|
||||
remain as neutral as possible at all times.
|
||||
@@ -0,0 +1,41 @@
|
||||
Chapter 36: The Basics of Volatility Trading 739
|
||||
Note that Figure 36-4 indeed confirms the fact that $OEX options are consis
|
||||
tently overpriced. Very few charts are as one-dimensional as the $OEX chart, where
|
||||
the options were so consistently overpriced. Most stocks find the difference line
|
||||
oscillating back and forth about the zero mark. Consider Figures 36-5 and 36-6.
|
||||
Figure 36-5 shows a chart similar to Figure 36-4, comparing actual and implied
|
||||
volatility, and their difference, for a particular stock. Figure 36-6 shows the price
|
||||
graph of that same stock, overlaid on implied volatility, during the period up to and
|
||||
including the heavy shading.
|
||||
The volatility comparison chart (Figure 36-5) shows several shaded areas, dur
|
||||
ing which the stock was more volatile than the options had predicted. Owners of
|
||||
options profited during these times, provided they had a more or less neutral outlook
|
||||
on the stock. Figure 36-6 shows the stock's performance up to and including the
|
||||
March-April 1999 period - the largest shaded area on the chart. Note that implied
|
||||
volatility was quite low before the stock made the strong move from 10 to 30 in little
|
||||
more than a month. These graphs are taken from actual data and demonstrate just
|
||||
how badly out of line implied volatility can be. In February and early March 1999,
|
||||
implied volatility was at or near the lowest levels on these charts. Yet, by the end of
|
||||
March, a major price explosion had begun in the stock, one that tripled its value in
|
||||
just over a month. Clearly, implied volatility was a poor predictor of forthcoming
|
||||
actual volatility in this case.
|
||||
What about later in the year? In Figure 36-5, one can observe that implied and
|
||||
actual volatility oscillated back and forth quite a few times during the rest of 1999. It
|
||||
might appear that these oscillations are small and that implied volatility was actually
|
||||
doing a pretty good job of predicting actual volatility, at least until the final spike in
|
||||
December 1999. However, looking at the scale on the left-hand side of Figure 36-5,
|
||||
one can see that implied volatility was trying to remain in the 50% to 60% range, but
|
||||
actual volatility kept bolting higher rather frequently.
|
||||
One more example will be presented. Figures 36-7 and 36-8 depict another
|
||||
stock and its volatilities. On the left half of each graph, implied volatility was quite
|
||||
high. It was higher than actual volatility turned out to be, so the difference line in
|
||||
Figure 36-7 remains above the zero line for several months. Then, for some reason,
|
||||
the option market decided to make an adjustment, and implied volatility began to
|
||||
drop. Its lowest daily point is marked with a circle in Figure 36-8, and the same point
|
||||
in time is marked with a similar circle in Figure 36-7. At that time, options traders
|
||||
were "saying" that they expected the stock to be very tame over the ensuing weeks.
|
||||
Instead, the stock made two quick moves, one from 15 down to 11, and then anoth
|
||||
er back up to 17. That movement jerked actual volatility higher, but implied volatili
|
||||
ty remained rather low. After a period of trading between 13 and 15, during which
|
||||
time implied volatility remained low, the stock finally exploded to the upside, as evi
|
||||
denced by the spikes on the right-hand side of both Figures 36-7 and 36-8. Thus,
|
||||
@@ -0,0 +1,47 @@
|
||||
768
|
||||
TABLE 37-6
|
||||
Implied
|
||||
Volatility
|
||||
20%
|
||||
30%
|
||||
40%
|
||||
50%
|
||||
60%
|
||||
70%
|
||||
80%
|
||||
Stock Price = I 00
|
||||
Part VI: Measuring and Trading VolatHity
|
||||
90-110 Call
|
||||
Bull Spread
|
||||
(Theoretical Value)
|
||||
10.54
|
||||
9.97
|
||||
9.54
|
||||
9.18
|
||||
8.87
|
||||
8.58
|
||||
8.30
|
||||
model, using the assumptions stated above, the most important of which is that the
|
||||
stock is at 100 in all cases in this table.
|
||||
One should be aware that it would probably be difficult to actually trade the
|
||||
spread at the theoretical value, due to the bid-asked spread in the options.
|
||||
Nevertheless, the impact of implied volatility is clear.
|
||||
One can quantify the amount by which an option position will change for each
|
||||
percentage point of increase in implied volatility. Recall that this measure is called
|
||||
the vega of the option or option position. In a call bull spread, one would subtract the
|
||||
vega of the call that is sold from that of the call that is bought in order to arrive at the
|
||||
position vega of the call bull spread. Table 37-7 is a reprint of Table 37-6, but now
|
||||
including the vega.
|
||||
Since these vegas are all negative, they indicate that the spread will shrink in
|
||||
value if implied volatility rises and that the spread will expand in value if implied
|
||||
TABLE 37-7
|
||||
90-110 Call
|
||||
Implied Bull Spread Position
|
||||
Volatility (Theoretical Value) Vega
|
||||
20% 10.54 -0.67
|
||||
30% 9.97 -0.48
|
||||
40% 9.54 -0.38
|
||||
50% 9.18 -0.33
|
||||
60% 8.87 -0.30
|
||||
70% 8.58 -0.28
|
||||
80% 8.30 -0.26
|
||||
@@ -0,0 +1,33 @@
|
||||
Chapter 37: How Volatility Affects Popular Strategies 751
|
||||
Stock Price July 50 call July 50 put Implied Volatility Put's Vega
|
||||
50 7.15 6.54 69% 0.10
|
||||
7.25 6.64 70% 0.10
|
||||
7.35 6.74 71% 0.10
|
||||
Thus, the put's vega is 0.10, too - the same as the call's vega was.
|
||||
In fact, it can be stated that a call and a put with the same terms have the same
|
||||
vega. To prove this, one need only refer to the arbitrage equation for a conversion. If
|
||||
the call increases in price and everything else remains equal - interest rates, stock
|
||||
price, and striking price - then the put price must increase by the same amount. A
|
||||
change in implied volatility will cause such a change in the call price, and a similar
|
||||
change in the put price. Hence, the vega of the put and the call must be the same.
|
||||
It is also important to know how the vega changes as other factors change, par
|
||||
ticularly as the stock price changes, or as time changes. The following examples con
|
||||
tain several tables that illustrate the behavior of vega in a typically fluctuating envi
|
||||
ronment.
|
||||
Example: In this case, let the stock price fluctuate while holding interest rate (5% ),
|
||||
implied volatility (70%), time (3 months), dividends (0), and the strike price (50) con
|
||||
stant. See Table 37-1.
|
||||
In these cases, vega drops when the stock price does, too, but it remains fairly
|
||||
constant if the stock rises. It is interesting to note, though, that in the real world,
|
||||
when the underlying drops in price especially if it does so quickly, in a panic mode
|
||||
- implied volatility can increase dramatically. Such an increase may be of great ben
|
||||
efit to a call holder, serving to mitigate his losses, perhaps. This concept will be dis
|
||||
cussed further later in this chapter.
|
||||
TABLE 37-1
|
||||
Implied Volatility Theoretical
|
||||
Stock Price July 50 Call Price Coll Price Vega
|
||||
30 70% 0.47 0.028
|
||||
40 2.62 0.073
|
||||
50 7.25 0.098
|
||||
60 14.07 0.092
|
||||
70 22.35 0.091
|
||||
@@ -0,0 +1,37 @@
|
||||
Appendix C: Put-Call Parity • 291
|
||||
acts as a “negative drift” term in the BSM. When a dividend is paid, theory
|
||||
says that the stock price should drop by the amount of the dividend. Be-
|
||||
cause a drop in price is bad for the holder of a call option, the price of a call
|
||||
option is cheaper by the amount of the expected dividend.
|
||||
Thus, for a dividend-paying stock, to establish an option-based position
|
||||
that has exactly the same characteristics as a stock portfolio, we have to keep
|
||||
the expected amount of the dividend in our margin account.
|
||||
1 This money
|
||||
placed into the option position will make up for the dividend that will be
|
||||
paid to the stock holder. Here is how this would look in our equation:
|
||||
C
|
||||
K − PK + (K − Int) + Div = S
|
||||
With the dividend payment included, our equation is complete.
|
||||
Now it is time for some algebra. Let’s rearrange the preceding equa-
|
||||
tion to see what the call option should be worth:
|
||||
CK = PK + Int − Div + (S − K)
|
||||
Taking a look at this, do you notice last term (S – K )? A stock’s price
|
||||
minus the strike price of a call is the intrinsic value. And we know that
|
||||
the value of a call option consists of intrinsic value and time value. This
|
||||
means that
|
||||
/dncurlybracketleft/dncurlybracketmid/horizcurlybracketext/horizcurlybracketext/dncurlybracketright/horizcurlybracketext/horizcurlybracketext/dncurlybracketleft/dncurlybracketmid/dncurlybracketright=+ −−CP SKKK IntD iv + ()
|
||||
Time valueI ntrinsic value
|
||||
So now let’s say that time passes and at the end of the year, the stock
|
||||
is trading at $70—deep ITM for our $50-strike call option. On the day
|
||||
before expiration, the time value will be very close to zero as long as the op-
|
||||
tion is deep ITM. Building on the preceding equation, we can put the rule
|
||||
about the time value of a deep ITM option in the following mathematical
|
||||
equation:
|
||||
P
|
||||
K + Int − Div ≈ 0
|
||||
If the time value ever falls below 0, the value of the call would trade for less
|
||||
than the intrinsic value. Of course, no one would want to hold an option
|
||||
that has negative time value. In mathematical terms, that scenario would
|
||||
look like this:
|
||||
P
|
||||
K + Int − Div < 0
|
||||
@@ -0,0 +1,37 @@
|
||||
20: The Sale of a Straddle 309
|
||||
gh it is 7 points in-the-money. This is not unusual in a bullish situation.
|
||||
ver, the put might be worth 1 ½points.This is also not unusual, as out-of-the
|
||||
y puts with a large amount of time remaining tend to hold time value premium
|
||||
well. Thus, the straddle writer would have to pay 10½ points to buy back this
|
||||
dle, even though it is at the break-even point, 7 points in-the-money on the call
|
||||
This example is included merely to demonstrate that it is a misconception to
|
||||
ieve that one can always buy the straddle back at the break-even point and hold
|
||||
losses to mere fractions of a point by doing so. This type of buy-back strategy
|
||||
ks best when there is little time remaining in the straddle. In that case, the
|
||||
options will indeed be close to parity and the straddle will be able to be bought back
|
||||
for close to its initial value when the stock reaches the break-even point.
|
||||
Another follow-up strategy that can be employed, similar to the previous one
|
||||
but with certain improvements, is to buy back only the in-the-money option when it
|
||||
reaches a price equal to that of the initial straddle price.
|
||||
~mple: Again using the same situation, suppose that when XYZ began to climb
|
||||
heavily, the call was worth 7 points when the stock reached 50. The in-the-money
|
||||
option the call - is now worth an amount equal to the initial straddle value. It could
|
||||
then be bought back, leaving the out-of-the-money put naked. As long as the stock
|
||||
then remained above 45, the put would expire worthless. In practice, the put could
|
||||
be bought back for a small fraction after enough time had passed or if the underly
|
||||
Ing stock continued to climb in price.
|
||||
This type of follow-up action does not depend on taking action at a fixed stock
|
||||
price, but rather is triggered by the option price itself. It is therefore a dynamic sort
|
||||
of follow-up action, one in which the same action could be applied at various stock
|
||||
prices, depending on the amount of time remaining until expiration. One of the prob
|
||||
lems with closing the straddle at the break-even points is that the break-even point is
|
||||
C)nly a valid break-even point at expiration. A long time before expiration, this stock
|
||||
price will not represent much of a break-even point, as was pointed out in the last
|
||||
example. Thus, buying back only the in-the-money option at a fixed price may often
|
||||
be a superior strategy. The drawback is that one does not release much collateral by
|
||||
buying back the in-the-money option, and he is therefore stuck in a position with
|
||||
little potential profit for what could amount to a considerable length of time. The
|
||||
collateral released amounts to the in-the-money amount; the writer still needs to
|
||||
C.'Ollateralize 20% of the stock price.
|
||||
One could adjust this follow-up method to attempt to retain some profit. For
|
||||
example, he might decide to buy the in-the-money option when it has reached a
|
||||
@@ -0,0 +1,34 @@
|
||||
Option prices, measuring incremental changes in factors affecting Option
|
||||
series
|
||||
Options Clearing Corporation (OCC) Out-of-the-money (OTM) Parity,
|
||||
definition of Pin risk
|
||||
borrowing and lending money boxes
|
||||
jelly rolls
|
||||
Premium
|
||||
Price discovery Price vs. value Pricing model, inputting data into dates,
|
||||
good and bad dividend size “The Pricing of Options and Corporate
|
||||
Liabilities” (Black & Scholes) Put-call parity American exercise options
|
||||
essentials
|
||||
dividends
|
||||
synthetic calls and puts, comparing
|
||||
synthetic stock strategies
|
||||
theoretical value and interest rate Puts
|
||||
buying
|
||||
cash-secured long ATM
|
||||
married
|
||||
selling
|
||||
Ratio spreads and complex spreads delta-neutral positions, management
|
||||
by market makers through longs to shorts risk, hedging trading flat
|
||||
multiple-class risk ratio spreads backspreads
|
||||
vertical
|
||||
skew, trading Realized volatility trading
|
||||
Reversion to the mean Rho
|
||||
counterintuitive results effect of time on and interest rates in planning
|
||||
trades interest rate moves, pricing in LEAPS
|
||||
put-call parity and time
|
||||
trading
|
||||
Risk and opportunity, option-specific finding the right risk long ATM call
|
||||
delta
|
||||
gamma
|
||||
rho
|
||||
theta
|
||||
@@ -0,0 +1,33 @@
|
||||
Keys to Success
|
||||
No matter which trade is more suitable to Kathleen’s risk tolerance, the
|
||||
overall concept is the same: profit from little directional movement. Before
|
||||
Kathleen found a stock on which to trade her spread, she will have sifted
|
||||
through myriad stocks to find those that she expects to trade in a range. She
|
||||
has a few tools in her trading toolbox to help her find good butterfly and
|
||||
condor candidates.
|
||||
First, Kathleen can use technical analysis as a guide. This is a rather
|
||||
straightforward litmus test: does the stock chart show a trending, volatile
|
||||
stock or a flat, nonvolatile stock? For the condor, a quick glance at the past
|
||||
few months will reveal whether the stock traded between $65 and $75. If it
|
||||
did, it might be a good iron condor candidate. Although this very simplistic
|
||||
approach is often enough for many traders, those who like lots of graphs
|
||||
and numbers can use their favorite analyses to confirm that the stock is
|
||||
trading in a range. Drawing trendlines can help traders to visualize the
|
||||
channel in which a stock has been trading. Knowing support and resistance
|
||||
is also beneficial. The average directional movement index (ADX) or
|
||||
moving average converging/diverging (MACD) indicator can help to show
|
||||
if there is a trend present. If there is, the stock may not be a good candidate.
|
||||
Second, Kathleen can use fundamentals. Kathleen wants stocks with
|
||||
nothing on their agendas. She wants to avoid stocks that have pending
|
||||
events that could cause their share price to move too much. Events to avoid
|
||||
are earnings releases and other major announcements that could have an
|
||||
impact on the stock price. For example, a drug stock that has been trading
|
||||
in a range because it is awaiting Food and Drug Administration (FDA)
|
||||
approval, which is expected to occur over the next month, is not a good
|
||||
candidate for this sort of trade.
|
||||
The last thing to consider is whether the numbers make sense. Kathleen’s
|
||||
iron condor risks 4.35 to make 0.65. Whether this sounds like a good trade
|
||||
depends on Kathleen’s risk tolerance and the general environment of UPS,
|
||||
the industry, and the market as a whole. In some environments, the
|
||||
0.65/4.35 payout-to-risk ratio makes a lot of sense. For other people, other
|
||||
stocks, and other environments, it doesn’t.
|
||||
@@ -0,0 +1,26 @@
|
||||
CHAPl'ER 2
|
||||
Covered Call Writing
|
||||
Covered call writing is the name given to the strategy by which one sells a call option
|
||||
while simultaneously owning the obligated number of shares of underlying stock.
|
||||
The writer should be mildly bullish, or at least neutral, toward the underlying stock.
|
||||
By writing a call option against stock, one always decreases the risk of owning the
|
||||
stock. It may even be possible to profit from a covered write if the stock declines
|
||||
somewhat. However, the covered call writer does limit his profit potential and there
|
||||
fore may not fully participate in a strong upward move in the price of the underlying
|
||||
stock. Use of this strategy is becoming so common that the strategist must under
|
||||
stand it thoroughly. It is therefore discussed at length.
|
||||
THE IMPORTANCE OF COVERED CALL WRITING
|
||||
COVERED CALL WRITING FOR DOWNSIDE PROTECTION
|
||||
Example: An investor owns 100 shares of XYZ common stock, which is currently sell
|
||||
ing at $48 per share. If this investor sells an XYZ July 50 call option while still hold
|
||||
ing his stock, he establishes a covered write. Suppose the investor receives $300 from
|
||||
the sale of the July 50 call. If XYZ is below 50 at July expiration, the call option that
|
||||
was sold expires worthless and the investor earns the $300 that he originally received
|
||||
for writing the call. Thus, he receives $300, or 3 points, of downside protection. That
|
||||
is, he can afford to have the XYZ stock drop by 3 points and still break even on the
|
||||
total transaction. At that time he can write another call option if he so desires.
|
||||
Note that if the underlying stock should fall by more than 3 points, there will be
|
||||
a loss on the overall position. Thus, the risk in the covered writing strategy material
|
||||
izes if the stock falls by a distance greater than the call option premium that was orig
|
||||
inally taken in.
|
||||
39
|
||||
@@ -0,0 +1,34 @@
|
||||
180 Part II: Call Option Strategies
|
||||
the overall increase in risk is small - the amount paid to repurchase the short call. If
|
||||
he attempts to "leg" out of the spread in such a manner, the spreader should not
|
||||
attempt to buy back the short call at too high a price. If it can be repurchased at 1/s
|
||||
or 1/16, the spreader will be giving away virtually nothing by buying back the short call.
|
||||
However, he should not be quick to repurchase it if it still has much more value than
|
||||
that, unless he is closing out the entire spread. At no time should one attempt to "leg"
|
||||
out after a stock price increase, taking the profit on the long side and hoping for a
|
||||
stock price decline to make the short side profitable as well. The risk is too great.
|
||||
Many traders find themselves in the somewhat perplexing situation of having
|
||||
seen the underlying make a large, quick move, only to find that their spread has not
|
||||
widened out much. They often try to figure out a way to perhaps lock in some gains
|
||||
in case the underlying subsequently drops in price, but they want to be able to wait
|
||||
around for the spread to widen out more toward its maximum profit potential. There
|
||||
really isn't any hedge that can accomplish all of these things. The only position that
|
||||
can lock in the profits in a call bull spread is to purchase the accompanying put bear
|
||||
spread. This strategy is discussed in Chapter 23, Spreads Combining Calls and Puts.
|
||||
OTHER USES OF BULL SPREADS
|
||||
Superficially, the bull spread is one of the simplest forms of spreading. However, it
|
||||
can be an extremely useful tool in a wide variety of situations. Two such situations
|
||||
were described in Chapter 3. If the outright purchaser of a call finds himself with an
|
||||
unrealized loss, he may be able to substantially improve his chances of getting out
|
||||
even by "rolling down" into a bull spread. If, however, he has an unrealized profit, he
|
||||
may be able to sell a call at the next higher strike, creating a bull spread, in an attempt
|
||||
to lock in some of his profit.
|
||||
In a somewhat similar manner, a common stockholder who is faced with an
|
||||
unrealized loss may be able to utilize a bull spread to lower the price at which he
|
||||
can break even. He may often have a significantly better chance of breaking even or
|
||||
making a profit by using options. The following example illustrates the stockholder's
|
||||
strategy.
|
||||
Example: An investor buys 100 shares of XYZ at 48, and later finds himself with an
|
||||
unrealized loss with the stock at 42. A 6-point rally in the stock would be necessary
|
||||
in order to break even. However, if XYZ has listed options trading, he may be able to
|
||||
significantly reduce his break-even price. The prices are:
|
||||
@@ -0,0 +1,35 @@
|
||||
596 Part V: Index Options and Futures
|
||||
asset value. Eventually, upon maturity, the actual price will be the cash surrender
|
||||
value price; so if you bought the product at a discount, you would benefit, providing
|
||||
you held all the way to maturity.
|
||||
Example: Assume that two years ago, a structured product was issued with an initial
|
||||
offering price of $10 and a strike price of 1,245.27, based upon the S&P 500 index.
|
||||
Since issuance, the S&P 500 index has risen to 1,522.00. That is an increase of
|
||||
22.22% for the S&P 500, so the structured product has a theoretical cash surrender
|
||||
value of 12.22. I say "theoretical" because that value cannot actually be realized, since
|
||||
the structured product is not exercisable at the current time - five years prior to
|
||||
maturity.
|
||||
In the real marketplace, this particular structured product might be trading at
|
||||
a price of 11. 75 or so. That is, it is trading at a discount to its theoretical cash sur
|
||||
render value. This is a fairly common occurrence, both for structured products and
|
||||
for closed-end mutual funds. If the discount were large enough, it should serve to
|
||||
attract buyers, for if they were to hold to maturity, they would make an extra 4 7 cents
|
||||
(the amount of this discount) from their purchase. That's 4% (0.47 divided by 11.75
|
||||
= 4%) over five years, which is nothing great, but it's something.
|
||||
Why does the product trade at a discount? Because of supply and demand. It is
|
||||
free to trade at any price - premium or discount - because there is nothing to keep
|
||||
it fixed at the theoretical cash surrender value. If there is excess demand or supply in
|
||||
the open market, then the price of the structured product will fluctuate to reflect that
|
||||
excess. Eventually, of course, the discount will disappear, but five years prior to
|
||||
maturity, one will often find that the product differs from its theoretical value by
|
||||
somewhat significant amounts. If the discount is large enough, it will attract buyers;
|
||||
alternatively, if there should be a large premium, that should attract sellers.
|
||||
SIS
|
||||
One of the first structured products of this type that came to my attention was one
|
||||
that traded on the AMEX, entitled "Stock Index return Security" or SIS. It also trad
|
||||
ed under the symbol SIS. The product was issued in 1993 and matured in 2000, so
|
||||
we have a complete history of its movements. The terms were as follows: The under
|
||||
lying index was the S&P Midcap 400 index (symbol: $MID). Issued in June 1993, the
|
||||
original issue price was $10, and $MID was trading at 166.10 on the day of issuance,
|
||||
so that was the striking price. Moreover, buyers were entitled to 115% of the appre
|
||||
ciation of $MID above the strike price. Thus, the cash value formula was:
|
||||
@@ -0,0 +1,37 @@
|
||||
Chapter 22: Basic Put Spreads 333
|
||||
above the higher strike. These are the same qualities that were displayed by a call bull
|
||||
spread (Chapter 7). The name "bull spread" is derived from the fact that this is a bull
|
||||
ish position: The strategist wants the underlying stock to rise in price.
|
||||
The risk is limited in this spread. If the underlying stock should decline by expi
|
||||
ration, the maximum loss will be realized with XYZ anywhere below 50 at that time.
|
||||
The risk is 5 points in this example. To see this, note that if XYZ were anywhere below
|
||||
50 at expiration, the differential between the two puts would widen to 10 points,
|
||||
since that is the difference between their striking prices. Thus, the spreader would
|
||||
have to pay 10 points to buy the spread back, or to close out the position. Since he
|
||||
initially took in a 5-point credit, this means his loss is equal to 5 points - the 10-point
|
||||
cost of closing out less the 5 points he received initially.
|
||||
The investment required for a bullish put spread is actually a collateral require
|
||||
ment, since the spread is a credit spread. The amount of collateral required is equal
|
||||
-1-r.. f-ha rliffa:rannci, hahuaan tho cfr-il;nrr r\rint::u.:- lace th.-:;). not nrorlit ror-A-iuorl fnr thA
|
||||
\..V l,,J...111._, Ul.J..J..V.lV.l.l.\..,V LIV\..VVVVJ..l '-- J.'L, oJ\..l..l.J.'-l.J.J..o .t'.l.J..\,.,VoJ J.VoJ,J I..J.J.'-' J..1.V\.. \,.,.l.V"-AJ.l.- .LVV'-'..l.Y'-'"'--4 .J..'-.-".I. .__...._.._ .......
|
||||
spread. In this example, the collateral requirement is $500- the $1,000, or 10-point,
|
||||
differential in the striking prices less the $500 credit received from the spread. Note
|
||||
that the maximum possible loss is always equal to the collateral requirement in a bull
|
||||
ish put spread.
|
||||
It is not difficult to calculate the break-even point in a bullish spread. ·In this
|
||||
example, the break-even point before commissions is 55 at expiration. With XYZ at
|
||||
55 in January, the January 50 put would expire worthless and the January 60 put
|
||||
would have to be bought back for 5 points. It would be 5 points in-the-money with
|
||||
XYZ at 55. Thus, the spreader would break even, since he originally received 5 points
|
||||
credit for the spread and would then pay out 5 points to close the spread. The fol
|
||||
lowing formulae allow one to quickly compute the details of a bullish put spread:
|
||||
Maximum potential risk = Initial collateral requirement
|
||||
= Difference in striking prices - Net credit received
|
||||
Maximum potential profit= Net credit
|
||||
Break-even price = Higher striking price - Net credit
|
||||
CALENDAR SPREAD
|
||||
In a calendar spread, a near-term option is sold and a longer-term option is bought,
|
||||
both with the same striking price. This definition applies to either a put or a call cal
|
||||
endar spread. In Chapter 9, it was shown that there were two philosophies available
|
||||
for call calendar spreads, either neutral or bullish. Similarly, there are two philoso
|
||||
phies available for put calendar spreads: neutral or bearish.
|
||||
@@ -0,0 +1,34 @@
|
||||
occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on
|
||||
October 16 were worth hundreds of dollars on October 19—if you could get
|
||||
the broker to pick up the telephone and trade them. (The editor had a client
|
||||
at Options Research, Inc. during that time who lost $57 million in three
|
||||
days and almost brought down a major Chicago bank; he had sold too many
|
||||
naked puts.)
|
||||
The most sophisticated and skilled traders in the world make their livings
|
||||
(quite sumptuous livings, thank you) trading options. Educated estimates
|
||||
have been made that as many as 90% of retail options traders lose money.
|
||||
That combined with the fact that by far it is the general public that buys
|
||||
(rather than sells) options should suggest some syllogistic reasoning to the
|
||||
reader.
|
||||
With these facts firmly fixed in mind, let us put options in their proper
|
||||
perspective for the general investor. Options have a number of useful
|
||||
functions, such as offering the trader powerful leverage. With an option, he
|
||||
can control much more stock than by the direct purchase of stock—his
|
||||
capital stretches much further. So options are an ideal speculative
|
||||
instrument (Exaggerated leverage is almost always a characteristic of
|
||||
speculative instruments.), but they can also be used in a most conservative
|
||||
way—as an insurance policy. For example, a position on the long security
|
||||
side may be hedged by the purchase of a put on the option side. (This is not
|
||||
a specific recommendation to do this. Every specific situation should be
|
||||
evaluated by the prudent investor with professional assistance as to its
|
||||
monetary consequences.)
|
||||
The experienced investor may also use options to increase yield on his
|
||||
portfolio of securities. He may write covered calls or naked puts on a stock
|
||||
to acquire it at a lower cost (e.g., he sells out of the money put options. This
|
||||
is a way of being long the stock; if the stock comes back to the exercise
|
||||
price, he acquires the stock. If not, he pockets the premium.)
|
||||
There are numerous tactics of this sort that may be played with options.
|
||||
Played because, for the general investor, the options game can be
|
||||
disastrous, as professionals are not playing. They are seriously practicing
|
||||
skills the amateur can never hope to master. Many floor traders, indeed,
|
||||
would qualify as idiot savants—they can compute the “fair value” of
|
||||
@@ -0,0 +1,36 @@
|
||||
Gaining Exposure • 191
|
||||
Value investors generally like bargains and to buy in bulk, so we
|
||||
should also buy our option time value “in bulk” by buying the longest
|
||||
tenor available and getting the lowest per-day price for it. It follows that if
|
||||
long-term equity anticipation securities (LEAPS) are available on a stock,
|
||||
it is usually best to buy one of those. LEAPS are wonderful tools because,
|
||||
aside from the pricing of time value illustrated in the preceding table, if
|
||||
you find a stock that has undervalued upside potential, you can win from
|
||||
two separate effects:
|
||||
1. The option market prices options as if underlying stocks were ef-
|
||||
ficiently priced when they may not be (e.g., the market thinks that
|
||||
the stock is worth $50 when it’s worth $70). This discrepancy gives
|
||||
rise to the classic value-investor opportunity.
|
||||
2. As long as interest rates are low, the drift term understates the ac-
|
||||
tual, probable drift of the stock market of around 10 percent per
|
||||
year. This effect tends to work for the benefit of a long-tenor call
|
||||
option whether or not the pricing discrepancy is as profound as
|
||||
originally thought.
|
||||
There are a couple of special cases in which this “buy the longest
|
||||
tenor possible” rule of thumb should not be used. First, if you believe
|
||||
that a company may be acquired, it is best to spend as little on time value
|
||||
as possible. I will discuss this case again when I discuss selecting strike
|
||||
prices, but when a company agrees to be acquired by another (and the
|
||||
market does not think there will be another offer and regulatory approv-
|
||||
als will go through), the time value of an option drops suddenly because
|
||||
the expected life of the stock as an independent entity has been short-
|
||||
ened by the acquiring company. This situation can get complicated for
|
||||
stock-based acquisitions (i.e., those that use stocks as the currency of
|
||||
acquisition either partly or completely) because owners of the acquiree’s
|
||||
options receive a stake in the acquirer’s options with strike price adjusted
|
||||
in proportion to the acquisition terms. In this case, the time value on
|
||||
your acquiree options would not disappear after the acquisition but be
|
||||
transferred to the acquirer’s company’s options. The real point is that it
|
||||
is impossible, as far as I know, to guess whether an acquisition will be
|
||||
made in cash or in shares, so the rule of thumb to buy as little time value
|
||||
as possible still holds.
|
||||
@@ -0,0 +1,36 @@
|
||||
194 Part II: Call Option Strategies
|
||||
above 60 for the maximum loss to occur. Even if the stock is at 40 or 60, there is some
|
||||
time premium left in the longer-term option, and the loss is not quite as large as the
|
||||
maximum possible loss of $300.
|
||||
This type of calendar spread has limited profits and relatively large commission
|
||||
costs. It is generally best to establish such a spread 8 to 12 weeks before the near
|
||||
term option expires. If this is done, one is capitalizing on the maximum rate of decay
|
||||
of the near-term option with respect to the longer-term option. That is, when a call
|
||||
has less than 8 weeks of life, the rate of decay of its time value premium increases
|
||||
substantially with respect to the longer-term options on the same stock.
|
||||
THE EFFECT OF VOLATILITY
|
||||
The implied volatility of the options (and hence the actual volatility of the underly
|
||||
ing stock) will have an effect on the calendar spread. As volatility increases, the
|
||||
spread widens; as volatility contracts, the spread shrinks. This is important to know.
|
||||
In effect, buying a calendar spread is an antivolatility strategy: One wants the under
|
||||
lying to remain somewhat unchanged. Sometimes, calendar spreads look especially
|
||||
attractive when the underlying stock is volatile. However, this can be misleading for
|
||||
two reasons. First of all, since the stock is volatile, there is a greater chance that it will
|
||||
move outside of the profit area. Second, if the stock does stabilize and trades in a
|
||||
range near the striking price, the spread will lose value because of the decrease in
|
||||
volatility. That loss may be greater than the gain from time decay!
|
||||
FOLLOW-UP ACTION
|
||||
Ideally, the spreader would like to have the stock be just below the striking price
|
||||
when the near-term call expires. If this happens, he can close the spread with only
|
||||
one commission cost, that of selling out the long call. If the calls are in-the-money at
|
||||
the expiration date, he will, of course, have to pay two commissions to close the
|
||||
spread. As with all spread positions, the order to close the spread should be placed
|
||||
as a single order. "Legging" out of a spread is highly risky and is not recommended.
|
||||
Prior to expiration, the spreader should close the spread if the near-term short
|
||||
call is trading at parity. He does this to avoid assignment. Being called out of spread
|
||||
position is devastating from the viewpoint of the stock commissions involved for the
|
||||
public customer. The near-term call would not normally be trading at parity until
|
||||
quite close to the last day of trading, unless the stock has undergone a substantial rise
|
||||
in price.
|
||||
In the case of an early downside breakout by the underlying stock, the spread
|
||||
er has several choices. He could immediately close the spread and take a small loss
|
||||
@@ -0,0 +1,145 @@
|
||||
Glossary of Common Tickers, Acronyms, Variables, and Math Equations
|
||||
Ticker
|
||||
Full Name
|
||||
SPY
|
||||
SPDR S&P 500
|
||||
XLE
|
||||
Energy Select Sector SPDR Fund
|
||||
GLD
|
||||
SPDR Gold Trust
|
||||
QQQ
|
||||
Invesco QQQ ETF (NASDAQ‐100)
|
||||
TLT
|
||||
iShares 20+ Year Treasury Bond ETF
|
||||
SLV
|
||||
iShares Silver Trust
|
||||
FXE
|
||||
Euro Currency ETF
|
||||
XLU
|
||||
Utilities ETF
|
||||
AAPL
|
||||
Apple Stock
|
||||
GOOGL
|
||||
Google Stock
|
||||
IBM
|
||||
IBM Stock
|
||||
AMZN
|
||||
Amazon Stock
|
||||
TSLA
|
||||
Tesla Stock
|
||||
VIX
|
||||
CBOE Volatility Index (implied volatility for the S&P 500)
|
||||
GVZ
|
||||
CBOE Gold Volatility Index
|
||||
VXAPL
|
||||
CBOE Equity VIX On Apple
|
||||
VXAZN
|
||||
CBOE Equity VIX On Amazon
|
||||
VXN
|
||||
CBOE NASDAQ‐100 Volatility Index
|
||||
Acronym
|
||||
Full Name
|
||||
NYSE
|
||||
New York Stock Exchange
|
||||
ETF
|
||||
Exchange‐Traded Fund
|
||||
DTE
|
||||
Days to Expiration
|
||||
EMH
|
||||
Efficient Market Hypothesis
|
||||
ITM
|
||||
In‐the‐Money
|
||||
OTM
|
||||
Out‐of‐the‐Money
|
||||
ATM
|
||||
At‐the‐Money
|
||||
P/L
|
||||
Profit and Loss
|
||||
IV
|
||||
Implied Volatility
|
||||
VaR
|
||||
Value at Risk
|
||||
CVaR
|
||||
Conditional Value at Risk
|
||||
POP
|
||||
Probability of Profit
|
||||
BPR
|
||||
Buying Power Reduction
|
||||
IVP
|
||||
IV Percentile
|
||||
IVR
|
||||
IV Rank
|
||||
NFT
|
||||
Non‐Fungible Tokens
|
||||
Variable Symbol
|
||||
Variable Name/Definition
|
||||
Spot/stock price: the price of the underlying
|
||||
Contract price: the price of the option, noting that
|
||||
C
|
||||
is used if the contract is a call and
|
||||
P
|
||||
is used in the case of puts
|
||||
Strike price: the price at which the holder of an option can buy or sell an asset on or before a future date
|
||||
Risk‐free rate of return: the theoretical rate of return of a riskless asset
|
||||
Mean: the central tendency of a distribution
|
||||
Standard deviation: the spread of a distribution; also used as a measure of uncertainty or risk
|
||||
Volatility: the standard deviation of log‐returns for an asset; a key input in options pricing
|
||||
Delta: the expected change in an option's price given a $1 increase in the price of the underlying
|
||||
Gamma: the expected change in an option's delta given a $1 change in the price of the underlying
|
||||
Theta: the expected time decay of an option's extrinsic value in dollars per day
|
||||
Beta: the volatility of the stock relative to that of the overall market
|
||||
Beta‐weighted delta: the expected change in an option's price given a $1 change in some reference index
|
||||
Equation Number
|
||||
Equation
|
||||
1.1
|
||||
Simple Returns
|
||||
1.2
|
||||
Log Returns
|
||||
1.3
|
||||
Long Call P/L
|
||||
1.4
|
||||
Long Put P/L
|
||||
1.5
|
||||
Population Mean
|
||||
1.6
|
||||
Expected Value
|
||||
1.7
|
||||
Population Variance
|
||||
1.8
|
||||
Variance
|
||||
1.9
|
||||
Skew
|
||||
1.15
|
||||
Delta
|
||||
1.16
|
||||
Gamma
|
||||
1.17
|
||||
Theta
|
||||
1.18
|
||||
Population Covariance
|
||||
1.19
|
||||
Covariance
|
||||
1.20
|
||||
Correlation Coefficient
|
||||
1.21
|
||||
Additive Property of Variance
|
||||
1.22
|
||||
Beta
|
||||
2.1
|
||||
±1σ Expected Range Approximation (%)
|
||||
2.2
|
||||
±1σ Expected Range Approximation ($)
|
||||
3.1
|
||||
IV Percentile (IVP)
|
||||
3.2
|
||||
IV Rank (IVR)
|
||||
4.1
|
||||
Short Put BPR
|
||||
4.2
|
||||
Short Call BPR
|
||||
4.3
|
||||
Short Strangle BPR
|
||||
5.1
|
||||
Short Iron Condor BPR
|
||||
8.1
|
||||
Approximate Kelly Allocation Percentage
|
||||
@@ -0,0 +1,37 @@
|
||||
84 Part II: Call Option Strategies
|
||||
Example: An investor previously entered a covered writing situation in which he
|
||||
wrote five January 30 calls against 500 XYZ common. The following prices exist cur
|
||||
rently, l month before expiration:
|
||||
XYZ common, 29¼;
|
||||
January 30 call,¼; and
|
||||
April 30 call, 2¼.
|
||||
The writer can only make ¼ a point more of time premium on this covered write for
|
||||
the time remaining until expiration. It is possible that his money could be put to bet
|
||||
ter use by rolling forward to the April 30 call. Commissions for rolling forward must
|
||||
be subtracted from the April 30's premium to present a true comparison.
|
||||
By remaining in the January 30, the writer could make, at most, $250 for the 30
|
||||
days remaining until January expiration. This is a return of $8.33 per day. The com
|
||||
missions for rolling forward would be approximately $100, including both the buy
|
||||
back and the new sale. Since the current time premium in the April 30 call is $250
|
||||
per option, this would mean that the writer would stand to make 5 times $250 less
|
||||
the $100 in commissions during the 120-day period until April expiration; $1,150
|
||||
divided by 120 days is $9.58 per day. Thus, the per-day return is higher from the April
|
||||
30 than from the January 30, after commissions are included. The writer should roll
|
||||
forward to the April 30 at this time.
|
||||
Rolling forward, since it involves a positive cash flow ( that is, it is a credit trans
|
||||
action) simultaneously increases the writer's maximum profit potential and lowers the
|
||||
break-even point. In the example above, the credit for rolling forward is 2 points, so
|
||||
the break-even point will be lowered by 2 points and the maximum profit potential
|
||||
is also increased by the 2-point credit.
|
||||
A simple calculator can provide one with the return-per-day calculation neces
|
||||
sary to make the decision concerning rolling forward. The preceding analysis is only
|
||||
directly applicable to rolling forward at the same striking price. Rolling-up or rolling
|
||||
down decisions at expiration, since they involve different striking prices, cannot be
|
||||
based solely on the differential returns in time premium values offered by the options
|
||||
in question.
|
||||
In the earlier discussion concerning rolling up, it was mentioned that at or near
|
||||
expiration, one may have no choice but to write the next higher striking price if he
|
||||
wants to retain his stock. This does not necessarily involve a debit transaction, how
|
||||
ever. If the stock is volatile enough, one might even be able to roll up for even money
|
||||
or a slight credit at expiration. Should this occur, it would be a desirable situation and
|
||||
should always be taken advantage of.
|
||||
@@ -0,0 +1,211 @@
|
||||
CHAPTER 8
|
||||
Dividends and Option Pricing
|
||||
Much of this book studies how to break down and trade certain components of option prices. This chapter examines the role of dividends in the pricing structure. There is no greek symbol that measures an option’s sensitivity to changes in the dividend. And in most cases, dividends are not “traded” by means of options in the same way that volatility, interest, and other option price influences are. Dividends do, though, affect option prices, and therefore a trader’s P&(L), so they deserve attention.
|
||||
There are some instances where dividends provide ample opportunity to the option trader, and there some instances where a change in dividend policy can have desirable, or undesirable, effects on the bottom line. Despite the fact that dividends do not technically involve greeks, they need to be monitored in much the same way as do delta, gamma, theta, vega, and rho.
|
||||
Dividend Basics
|
||||
Let’s start at the beginning. When a company decides to pay a dividend, there are four important dates the trader must be aware of:
|
||||
1. Declaration date
|
||||
2. Ex-dividend date
|
||||
3. Record date
|
||||
4. Payable date
|
||||
The first date chronologically is the declaration date. This date is when the company formally declares the dividend. It’s when the company lets its shareholders know when and in what amount it will pay the dividend. Active traders, however, may buy and sell the same stock over and over again. How does the corporation know exactly who collects the dividend when it is opening up its coffers?
|
||||
Dividends are paid to shareholders of record who are on the company’s books as owning the stock at the opening of business on another important date: the record date. Anyone long the stock at this moment is entitled to the dividend. Anyone with a short stock position on the opening bell on the record date is required to make payment in the amount of the dividend. Because the process of stock settlement takes time, the important date is actually not the record date. For all intents and purposes, the key date is two days before the record date. This is called the ex-dividend date, or the ex-date.
|
||||
Traders who have earned a dividend by holding a stock in their account on the morning of the ex-date have one more important date they need to know—the date they get paid. The date that the dividend is actually paid is called the payable date. The payable date can be a few weeks after the ex-date.
|
||||
Let’s walk through an example. ABC Corporation announces on March 21 (the declaration date) that it will pay a 25-cent dividend to shareholders of record on April 3 (the record date), payable on April 23 (the payable date). This means market participants wishing to receive the dividend must own the stock on the open on April 1 (the ex-date). In practice, they must buy the stock before the closing bell rings on March 31 in order to have it for the open the next day.
|
||||
This presents a potential quandary. If a trader only needs to have the stock on the open on the ex-date, why not buy the stock just before the close on the day before the ex-date, in this case March 31, and sell it the next morning after the open? Could this be an opportunity for riskless profit?
|
||||
Unfortunately, no. There are a couple of problems with that strategy. First, as far as the riskless part is concerned, stock prices can and often do change overnight. Yesterday’s close and today’s open can sometimes be significantly different. When they are, it is referred to as a gap open. Whenever a stock is held (long or short), there is risk. The second problem with this strategy to earn riskless profit is with the profit part. On the ex-date, the opening stock price reflects the dividend. Say ABC is trading at $50 at the close on March 31. If the market for the stock opens unchanged the next morning—that is, a zero net change on the day on—ABC will be trading at $49.75 ($50 minus the $0.25 dividend). Alas, the quest for riskless profit continues.
|
||||
Dividends and Option Pricing
|
||||
The preceding discussion demonstrated how dividends affect stock traders. There’s one problem: we’re option traders! Option holders or writers do not receive or pay dividends, but that doesn’t mean dividends aren’t relevant to the pricing of these securities. Observe the behavior of a conversion or a reversal before and after an ex-dividend date. Assuming the stock opens unchanged on the ex-date, the relationship of the price of the synthetic stock to the actual stock price will change. Let’s look at an example to explore why.
|
||||
At the close on the day before the ex-date of a stock paying a $0.25 dividend, a trader has an at-the-money (ATM) conversion. The stock is trading right at $50 per share. The 50 puts are worth 2.34, and the 50 calls are worth 2.48. Before the ex-date, the trader is
|
||||
Long 100 shares at $50
|
||||
Long one 50 put at 2.34
|
||||
Short one 50 call at 2.48
|
||||
Here, the trader is long the stock at $50 and short stock synthetically at $50.14—50 + (2.48 − 2.34). The trader is synthetically short $0.14 over the price at which he is long the stock.
|
||||
Assume that the next morning the stock opens unchanged. Since this is the ex-date, that means the stock opens at $49.75—$0.25 lower than the previous day’s close. The theoretical values of the options will change very little. The options will be something like 2.32 for the put and 2.46 for the call.
|
||||
After the ex-date, the trader is
|
||||
Long 100 shares at $49.75
|
||||
Long one 50 put at 2.32
|
||||
Short one 50 call at 2.46
|
||||
Each option is two cents lower. Why? The change in the option prices is due to theta. In this case, it’s $0.02 for each option. The synthetic stock is still short from an effective price of $50.14. With the stock at $49.75, the synthetic short price is now $0.39 over the stock. Incidentally, $0.39 is $0.25 more than the $0.14 difference before the ex-date.
|
||||
Did the trader who held the conversion overnight from before the ex-date to after it make or lose money? Neither. Before the ex-date, he had an asset worth $50 per share (the stock) and he shorted the asset synthetically at $50.14. After the ex-date, he still has assets totaling $50 per share—the stock at $49.75 plus the 0.25 dividend—and he is still synthetically short the stock at $50.14. Before the ex-date, the $0.14 difference between the synthetic and the stock is interest minus the dividend. After the ex-date, the $0.39 difference is all interest.
|
||||
Dividends and Early Exercise
|
||||
As the ex-date approaches, in-the-money (ITM) calls on equity options can often be found trading at parity, regardless of the dividend amount and regardless of how far off expiration is. This seems counterintuitive. What about interest? What about dividends? Normally, these come into play in option valuation.
|
||||
But option models designed for American options take the possibility of early exercise into account. It is possible to exercise American-style calls and exchange them for the underlying stock. This would give traders, now stockholders, the right to the dividend—a right for which they would not be eligible as call holders. Because of the impending dividend, the call becomes an exercise just before the ex-date. For this reason, the call can trade for parity before the ex-date.
|
||||
Let’s look at an example of a reversal on a $70 stock that pays a $0.40 dividend. The options in this reversal have 24 days until expiration, which makes the interest on the 60 strike roughly $0.20, given a 5 percent interest rate. The day before the ex-date, a trader has the following position at the stated prices:
|
||||
Short 100 shares at $70
|
||||
Long one 60 call at 10.00
|
||||
Short one 60 put at 0.05
|
||||
To understand how American calls work just before the ex-date, it is helpful first to consider what happens if the trader holds the position until the ex-date. Making the assumption that the stock is unchanged on the ex-dividend date, it will open at $69.60, lower by the amount of the dividend—in this case, $0.40. The put, being so far out-of-the-money (OTM) as to have a negligible delta, will remain unchanged. But what about the call? With no dividend left in the stock, the put call-parity states
|
||||
In this case,
|
||||
Before the ex-date, the model valued the call at parity. Now it values the same call at $0.25 over parity (9.85 − [69.60 − 60]). Another way to look at this is that the time value of the call is now made up of the interest plus the put premium. Either way, that’s a gain of $0.25 on the call. That sounds good, but because the trader is short stock, if he hasn’t exercised, he will owe the $0.40 dividend—a net loss of $0.15. The new position will be
|
||||
Short 100 shares at $69.60
|
||||
Owe $0.40 dividend
|
||||
Long one 60 call at 9.85
|
||||
Short one 60 put at 0.05
|
||||
At the end of the trading day before the ex-date, this trader must exercise the call to capture the dividend. By doing so, he closes two legs of the trade—the call and the stock. The $10 call premium is forfeited, the stock that is short at $70 is bought at $60 (from the call exercise) for a $10 profit. The transaction leads to neither a profit nor a loss. The purpose of exercising is to avoid the $0.15 loss ($0.25 gain in call time value minus the $0.40 loss in dividends owed).
|
||||
The other way the trader could achieve the same ends is to sell the long call and buy in the short stock. This is tactically undesirable because the trader may have to sell the bid in the call and buy the offer in the stock. Furthermore, when legging a trade in this manner, there is the risk of slippage. If the call is sold first, the stock can move before the trader has a chance to buy it at the necessary price. It is generally better and less risky to exercise the call rather than leg out of the trade.
|
||||
In this transaction, the trader begins with a fairly flat position (short stock/long synthetic stock) and ends with a short put that is significantly out-of-the-money. For all intents and purposes, exercising the call in this trade is like synthetically selling the put. But at what price? In this case, it’s $0.15. This again is the cost benefit of saving $0.40 by avoiding the dividend obligation versus the $0.25 gain in call time value. Exercising the call is effectively like selling the put at 0.15 in this example. If the dividend is lower or the interest is higher, it may not be worth it to the trader to exercise the call to capture the dividend. How do traders know if their calls should be exercised?
|
||||
The traders must do the math before each ex-dividend date in option classes they trade. The traders have to determine if the benefit from exercising—or the price at which the synthetic put is essentially being sold—is more or less than the price at which they can sell the put. The math used here is adopted from put-call parity:
|
||||
This shows the case where the traders can effectively synthetically sell the put (by exercising) for more than the current put value. Tactically, it’s appropriate to use the bid price for the put in this calculation since that is the price at which the put can be sold.
|
||||
In this case, the traders would be inclined to not exercise. It would be theoretically more beneficial to sell the put if the trader is so inclined.
|
||||
Here, the traders, from a valuation perspective, are indifferent as to whether or not to exercise. The question then is simply: do they want to sell the put at this price?
|
||||
Professionals and big retail traders who are long (ITM) calls—whether as part of a reversal, part of another type of spread, or because they are long the calls outright—must do this math the day before each ex-dividend date to maximize profits and minimize losses. Not exercising, or forgetting to exercise, can be a costly mistake. Traders who are short ITM dividend-paying calls, however, can reap the benefits of those sleeping on the job. It works both ways.
|
||||
Traders who are long stock and short calls at parity before the ex-date may stand to benefit if some of the calls do not get assigned. Any shares of long stock remaining on the ex-date will result in the traders receiving dividends. If the dividends that will be received are greater in value than the interest that will subsequently be paid on the long stock, the traders may stand reap an arbitrage profit because of long call holders’ forgetting to exercise.
|
||||
Dividend Plays
|
||||
The day before an ex-dividend date in a stock, option volume can be unusually high. Tens of thousands of contracts sometimes trade in names that usually have average daily volumes of only a couple thousand. This spike in volume often has nothing to do with the market’s opinion on direction after the dividend. The heavy trading has to do with the revaluation of the relationship of exercisable options to the underlying expected to occur on the ex-dividend date.
|
||||
Traders that are long ITM calls and short ITM calls at another strike just before an ex-dividend date have a potential liability and a potential benefit. The potential liability is that they can forget to exercise. This is a liability over which the traders have complete control. The potential benefit is that some of the short calls may not get assigned. If traders on the other side of the short calls (the longs) forget to exercise, the traders that are short the call make out by not having to pay the dividend on short stock.
|
||||
Professionals and big retail traders who have very low transaction costs will sometimes trade ITM call spreads during the afternoon before an ex-dividend date. This consists of buying one call and selling another call with a different strike price. Both calls in the dividend-play strategy are ITM and have corresponding puts with little or no value (to be sure, the put value is less than the dividend minus the interest). The traders trade the spreads, fairly indifferent as to whether they buy or sell the spreads, in hope of skating—or not getting assigned—on some of their short calls. The more they don’t get assigned the better.
|
||||
This usually occurs in options that have high open interest, meaning there are a lot of outstanding contracts already. The more contracts in existence, the better the possibility of someone forgetting to exercise. The greatest volume also tends to occur in the front month.
|
||||
Strange Deltas
|
||||
Because American calls become an exercise possibility when the ex-date is imminent, the deltas can sometimes look odd. When the calls are trading at parity, they have a 1.00 delta. They are a substitute for the stock. They, in fact, will be stock if and when they are exercised just before the ex-date. But if the puts still have some residual time value, they may also have a small delta, of 0.05 or perhaps more.
|
||||
In this unique scenario, the delta of the synthetic can be greater than +1.00 or less than −1.00. It is not uncommon to see the absolute values of the call and put deltas add up to 1.07 or 1.08. When the dividend comes out of the options model on the ex-date, synthetics go back to normal. The delta of the synthetic again approaches 1.00. Because of the out-of-whack deltas, delta-neutral traders need to take extra caution in their analytics when ex-dates are near. A little common sense should override what the computer spits out.
|
||||
Inputting Dividend Data into the Pricing Model
|
||||
Often dividend payments are regular and predictable. With many companies, the dividend remains constant quarter after quarter. Some corporations have a track record of incrementally increasing their dividends every year. Some companies pay dividends in a very irregular fashion, by paying special dividends that are often announced as a surprise to investors. In a truly capitalist society, there are no restrictions and no rules on when, whether, or how corporations pay dividends to their shareholders. Unpredictability of dividends, though, can create problems in options valuation.
|
||||
When a company has a constant, reasonably predictable dividend, there is not a lot of guesswork. Take Exelon Corp. (EXC). From November 2008 to the time of this writing, Exelon has paid a regular quarterly dividend of $0.525. During that period, a trader has needed simply to enter 0.525 into the pricing calculator for all expected future dividends to generate the theoretical value. Based on recent past performance, the trader could feel confident that the computed analytics were reasonably accurate. If the trader believed the company would continue its current dividend policy, there would be little options-related dividend risk—unless things changed.
|
||||
When there is uncertainty about when future dividends will be paid in what amounts, the level of dividend-related risk begins to increase. The more uncertainty, the more risk. Let’s examine an interesting case study: General Electric (GE).
|
||||
For a long time, GE was a company that has had a history of increasing its dividends at fairly regular intervals. In fact, there was more than a 30-year stretch in which GE increased its dividend every year. During most of the first decade of the 2000s, increases in GE’s dividend payments were around one to six cents and tended to occur toward the end of December, after December expiration. The dividends were paid four times per year but not exactly quarterly. For several years, the ex-dates were in February, June, September, and December. Option traders trading GE options had a pretty easy time estimating their future dividend streams, and consequently evaded valuation problems that could result from using wrong dividend data. Traders would simply adjust the dividend data in the model to match their expectations for predictably increasing future dividends in order to achieve an accurate theoretical value. Let’s look back at GE to see how a trader might have done this.
|
||||
The following shows dividend-history data for GE.
|
||||
Ex-Date
|
||||
Dividend
|
||||
*
|
||||
12/27/02
|
||||
$0.19
|
||||
02/26/03
|
||||
$0.19
|
||||
06/26/03
|
||||
$0.19
|
||||
09/25/03
|
||||
$0.19
|
||||
12/29/03
|
||||
$0.20
|
||||
02/26/04
|
||||
$0.20
|
||||
06/24/04
|
||||
$0.20
|
||||
09/23/04
|
||||
$0.20
|
||||
12/22/04
|
||||
$0.22
|
||||
02/24/05
|
||||
$0.22
|
||||
06/23/05
|
||||
$0.22
|
||||
09/22/05
|
||||
$0.22
|
||||
12/22/05
|
||||
$0.25
|
||||
02/23/06
|
||||
$0.25
|
||||
06/22/06
|
||||
$0.25
|
||||
09/21/06
|
||||
$0.25
|
||||
12/21/06
|
||||
$0.28
|
||||
02/22/07
|
||||
$0.28
|
||||
06/21/07
|
||||
$0.28
|
||||
*
|
||||
These data are taken from the following Web page on GE’s web site:
|
||||
www.ge.com/investors/stock_info/dividend_history.html
|
||||
.
|
||||
At the end of 2006, GE raised its dividend from $0.25 to $0.28. A trader trading GE options at the beginning of 2007 would have logically anticipated the next increase to occur again in the following December unless there was reason to believe otherwise. Options expiring before this anticipated next dividend increase would have the $0.28 dividend priced into their values. Options expiring after December 2007 would have a higher dividend priced into them—possibly an additional three cents to 0.31 (which indeed it was). Calls would be adversely affected by this increase, and puts would be favorably affected. A typical trader would have anticipated those changes. The dividend data a trader pricing GE options would have entered into the model in January 2007 would have looked something like this.
|
||||
Ex-Date
|
||||
Dividend
|
||||
*
|
||||
02/22/07
|
||||
$0.28
|
||||
06/21/07
|
||||
$0.28
|
||||
09/20/07
|
||||
$0.28
|
||||
12/20/07
|
||||
$0.31
|
||||
02/21/08
|
||||
$0.31
|
||||
06/19/08
|
||||
$0.31
|
||||
09/18/08
|
||||
$0.31
|
||||
*
|
||||
These data are taken from the following Web page on GE’s web site:
|
||||
www.ge.com/investors/stock_info/dividend_history.html
|
||||
.
|
||||
The trader would have entered the anticipated future dividend amount in conjunction with the anticipated ex-dividend date. This trader projection goes out to February 2008, which would aid in valuing options expiring in 2007 as well as the 2008 LEAPS. Because the declaration dates had yet to occur, one could not know with certainty when the dividends would be announced or in what amount. Certainly, there would be some estimation involved for both the dates and the amount. But traders would probably get it pretty close—close enough.
|
||||
Then, something particularly interesting happened. Instead of raising the dividend going into December 2008 as would be a normal pattern, GE kept it the same. As shown, the 12/24/08 ex-dated dividend remained $0.31.
|
||||
Ex-Date
|
||||
Dividend
|
||||
*
|
||||
02/22/07
|
||||
$0.28
|
||||
06/21/07
|
||||
$0.28
|
||||
09/20/07
|
||||
$0.28
|
||||
12/20/07
|
||||
$0.31
|
||||
02/21/08
|
||||
$0.31
|
||||
06/19/08
|
||||
$0.31
|
||||
09/18/08
|
||||
$0.31
|
||||
12/24/08
|
||||
$0.31
|
||||
*
|
||||
These data are taken from the following Web page on GE’s web site:
|
||||
www.ge.com/investors/stock_info/dividend_history.html
|
||||
.
|
||||
The dividend stayed at $0.31 until the June 2009 dividend, which held another jolt for traders pricing options. Around this time, GE’s stock price had taken a beating. It fell from around $42 a share in the fall of 2007 ultimately to about $6 in March 2009. GE had its first dividend cut in more than three decades. The dividend with the ex-date of 06/18/09 was $0.10.
|
||||
12/24/08
|
||||
$0.31
|
||||
02/19/09
|
||||
$0.31
|
||||
06/18/09
|
||||
$0.10
|
||||
09/17/09
|
||||
$0.10
|
||||
12/23/09
|
||||
$0.10
|
||||
02/25/10
|
||||
$0.10
|
||||
06/17/10
|
||||
$0.10
|
||||
09/16/10
|
||||
$0.12
|
||||
12/22/10
|
||||
$0.14
|
||||
02/24/11
|
||||
$0.14
|
||||
06/16/11
|
||||
$0.15
|
||||
09/15/11
|
||||
$0.15
|
||||
Though the company gave warnings in advance, the drastic dividend change had a significant impact on option prices. Call prices were helped by the dividend cut (or anticipated dividend cut) and put prices were hurt.
|
||||
The break in the pattern didn’t stop there. The dividend policy remained $0.10 for five quarters until it rose to $0.12 in September 2010, then to $0.14 in December 2010, then to $0.15 in June 2011. These irregular changes in the historically predictable dividend policy made it tougher for traders to attain accurate valuations. If the incremental changes were bigger, the problem would have been even greater.
|
||||
Good and Bad Dates with Models
|
||||
Using an incorrect date for the ex-date in option pricing can lead to unfavorable results. If the ex-dividend date is not known because it has yet to be declared, it must be estimated and adjusted as need be after it is formally announced. Traders note past dividend history and estimate the expected dividend stream accordingly. Once the dividend is declared, the ex-date is known and can be entered properly into the pricing model. Not executing due diligence to find correct known ex-dates can lead to trouble. Using a bad date in the model can yield dubious theoretical values that can be misleading or worse—especially around the expiration.
|
||||
Say a call is trading at 2.30 the day before the ex-date of a $0.25 dividend, which happens to be thirty days before expiration. The next day, of course, the stock may have moved higher or lower. Assume for illustrative purposes, to compare apples to apples as it were, that the stock is trading at the same price—in this case, $76.
|
||||
If the trader is using the correct date in the model, the option value will adjust to take into account the effect of the dividend expiring, or reaching its ex-date, when the number of days to expiration left changes from 30 to 29. The call trading postdividend will be worth more relative to the same stock price. If the dividend date the trader is using in the model is wrong, say one day later than it should be, the dividend will still be an input of the theoretical value. The calculated value will be too low. It will be wrong.
|
||||
Exhibit 8.1
|
||||
compares the values of a 30-day call on the ex-date given the right and the wrong dividend.
|
||||
EXHIBIT 8.1
|
||||
Comparison of 30-day call values
|
||||
At the same stock price of $76 per share, the call is worth $0.13 more after the dividend is taken out of the valuation. Barring any changes in implied volatility (IV) or the interest rate, the market prices of the options should reflect this change. A trader using an ex-date in the model that is farther in the future than the actual ex-date will still have the dividend as part of the generated theoretical value. With the ex-date just one day later, the call would be worth 2.27. The difference in option value is due to the effect of theta—in this case, $0.03.
|
||||
With a bad date, the value of 2.27 would likely be significantly below market price, causing the market value of the option to look more expensive than it actually is. If the trader did not know the date was wrong, he would need to raise IV to make the theoretical value match the market. This option has a vega of 0.08, which translates into a difference of about two IV points for the theoretical values 2.43 and 2.27. The trader would perceive the call to be trading at an IV two points higher than the market indicates.
|
||||
Dividend Size
|
||||
It’s not just the date but also the size of the dividend that matters. When companies change the amount of the dividend, options prices follow in step. In 2004, when Microsoft (MSFT) paid a special dividend of $3 per share, there were unexpected winners and losers in the Microsoft options. Traders who were long calls or short puts were adversely affected by this change in dividend policy. Traders with short calls or long puts benefited. With long-term options, even less anomalous changes in the size of the dividend can have dramatic effects on options values.
|
||||
Let’s study an example of how an unexpected rise in the quarterly dividend of a stock affects a long call position. Extremely Yellow Zebra Corp. (XYZ) has been paying a quarterly dividend of $0.10. After a steady rise in stock price to $61 per share, XYZ declares a dividend payment of $0.50. It is expected that the company will continue to pay $0.50 per quarter. A trader, James, owns the 528-day 60-strike calls, which were trading at 9.80 before the dividend increase was announced.
|
||||
Exhibit 8.2
|
||||
compares the values of the long-term call using a $0.10 quarterly dividend and using a $0.50 quarterly dividend.
|
||||
EXHIBIT 8.2
|
||||
Effect of change in quarterly dividend on call value.
|
||||
This $0.40 dividend increase will have a big effect on James’s calls. With 528 days until expiration, there will be six dividends involved. Because James is long the calls, he loses 1.52 per option. If, however, he were short the calls, 1.52 would be his profit on each option.
|
||||
Put traders are affected as well. Another trader, Marty, is long the 60-strike XYZ puts. Before the dividend announcement, Marty was running his values with a $0.10 dividend, giving his puts a value of 5.42.
|
||||
Exhibit 8.3
|
||||
compares the values of the puts with a $0.10 quarterly dividend and with a $0.50 quarterly dividend.
|
||||
EXHIBIT 8.3
|
||||
Effect of change in quarterly dividend on put value.
|
||||
When the dividend increase is announced, Marty will benefit. His puts will rise because of the higher dividend by $0.66 (all other parameters held constant). His long-term puts with six quarters of future expected dividends will benefit more than short-term XYZ puts of the same strike would. Of course, if he were short the puts, he would lose this amount.
|
||||
The dividend inputs to a pricing model are best guesses until the dates and amounts are announced by the company. How does one find dividend information? Regularly monitoring the news and press releases on the companies one trades is a good way to stay up to date on dividend information, as well as other company news. Dividend announcements are widely disseminated by the major news services. Most companies also have an investor-relations phone number and section on their web sites where dividend information can be found.
|
||||
@@ -0,0 +1,38 @@
|
||||
621
|
||||
This lowering of the call price continues as more dividends are paid, until it finally
|
||||
reaches the final call price at maturity. The PERCS holder should not be confused
|
||||
this sliding scale of call prices. The sliding call feature is designed to ensure that
|
||||
PERC S holder is compensated for not receiving all his "promised" dividends if the
|
||||
PERCS should be called prior to maturity.
|
||||
Example: As before, XYZ issues a PERCS when the common is at 35. The PERCS
|
||||
pays an annual dividend of $2.50 per share as compared to $1 per share on the com
|
||||
mon stock. The PERCS has a final call price of 39 dollars per share in three years.
|
||||
If XYZ stock should undergo a sudden price advance and rise dramatically in a
|
||||
very short period of time, it is possible that the PERCS could be called before any
|
||||
dividends are paid at all. In order to compensate the PERCS holder for such an
|
||||
c>ecurrence, the initial call price would be set at 43.50 per share. That is, the PERCS
|
||||
can't be called unless XYZ trades to a price over 43.50 dollars per share. Notice that
|
||||
the difference between the eventual call price of 39 and the initial call price of 43.50
|
||||
is 4.50 points, which is also the amount of additional dividends that the PERCS
|
||||
would pay over the three-year period. The PER CS pays $2.50 per year and the com
|
||||
mon $1 per year, so the difference is $1.50 per year, or $4.50 over three years.
|
||||
Once the PERCS dividends begin to be paid, the call price will be reduced to
|
||||
reflect that fact. For example, after one year, the call price would be 42, reflecting
|
||||
the fact that if the PERCS were not called until a year had passed, the PERCS hold
|
||||
er would be losing $3 of additional dividends as compared to the common stock
|
||||
($1.50 per year for the remaining two years). Thus, the call price after one year is set
|
||||
at the eventual call price, 39, plus the $3 of potential dividend loss, for a total call
|
||||
price of 42.
|
||||
This example shows how the company uses the sliding call price to compensate
|
||||
the PERCS holder for potential dividend loss if the PERCS is called before the
|
||||
three-year time to maturity has elapsed. Thus, the PER CS holder will make the same
|
||||
dollars of profit - dividends and price appreciation combined - no matter when the
|
||||
PERCS is called. In the case of the XYZ PERCS in the example, that total dollar
|
||||
profit is $11.50 (see the prior example). Notice that the investor's annualized rate of
|
||||
return would be much higher if he were called prior to the eventual maturity date.
|
||||
One final point: The call price §lides on a scale as set forth in the prospectus for
|
||||
the PERCS. It may be every time a dividend is paid, but more likely it will be daily!
|
||||
That is, the present worth of the remaining dividends is added to the final call price
|
||||
to calculate the sliding call price daily. Do not be overwhelmed by this feature.
|
||||
Remember that it is just a means of giving the PERCS holder his entire "dividend
|
||||
premium" if the PERCS is called before maturity.
|
||||
@@ -0,0 +1,35 @@
|
||||
Chapter 14: Diagonalizing a Spread 231
|
||||
bull spread would be similar except that one would buy a longer-tenn call at the lower
|
||||
strike and would sell a near-tenn call at the higher strike. The number of calls long
|
||||
and short would still be the same. By diagonalizing the spread, the position is hedged
|
||||
somewhat on the downside in case the stock does not advance by near-term expira
|
||||
tion. Moreover, once the near-term option expires, the spread can often be reestab
|
||||
lished by selling the call with the next maturity.
|
||||
Example: The following prices exist:
|
||||
Strike April Ju~ October Stock Price
|
||||
XYZ 30 3 4 5 32
|
||||
XYZ 35 11/2 2 32
|
||||
A vertical bull spread could be established in any of the expiration series by buying
|
||||
the call with 30 strike and selling the call with 35 strike. A diagonal bull spread would
|
||||
consist of buying the July 30 or October 30 and selling the April 35. To compare a
|
||||
vertical bull spread with a diagonal spread, the following two spreads will be used:
|
||||
Vertical bull spread: buy the April 30 call, sell the April 35 - 2 debit
|
||||
Diagonal bull spread: buy the July 30 call, sell the April 35 3 debit
|
||||
The vertical bull spread has a 3-point potential profit if XYZ is above 35 at April expi
|
||||
ration. The maximum risk in the normal bull spread is 2 points (the original debit) if
|
||||
XYZ is anywhere below 30 at April expiration. By diagonalizing the spread, the strate
|
||||
gist lowers his potential profit slightly at April expiration, but also lowers the proba
|
||||
bility of losing 2 points in the position. Table 14-1 compares the two types of spreads
|
||||
at April expiration. The price of the July 30 call is estimated in order to derive the
|
||||
estimated profits or losses from the diagonal bull spread at that time. If the underly
|
||||
ing stock drops too far - to 20, for example - both spreads will experience nearly a
|
||||
total loss at April expiration. However, the diagonal spread will not lose its entire
|
||||
value if XYZ is much above 24 at expiration, according to Table 14-1. The diagonal
|
||||
spread actually has a smaller dollar loss than the normal spread between 27 and 32
|
||||
at expiration, despite the fact that the diagonal spread was more expensive to estab
|
||||
lish. On a percentage basis, the diagonal spread has an even larger advantage in this
|
||||
range. If the stock rallies aboye 35 by expiration, the normal spread will provide a
|
||||
larger profit. There is an interesting characteristic of the diagonal spread that is
|
||||
shown in Table 14-1. If the stock advances substantially and all the calls come to par
|
||||
ity, the profit on the diagonal spread is limited to 2 points. However, if the stock is
|
||||
near 35 at April expiration, the long call will have some time premium in it and the
|
||||
@@ -0,0 +1,37 @@
|
||||
832 Part VI: Measuring and Trading Volatility
|
||||
moved two or three times that far with great frequency. Finally, there is a continu
|
||||
ity to the points on the histogram: There are some y-axis data points at almost all
|
||||
points on the x-axis (between the minimum and maximum x-axis points). That is
|
||||
good, because it shows that there has not been a clustering of movements by XYZ
|
||||
that might have dominated past activity.
|
||||
As for what is not a "good" histogram, we would not be so enamored of a his
|
||||
togram that showed a huge cluster of points near and between the "-1" and 'T' points
|
||||
on the X-axis. We want the stock to have shown an ability to move farther than just the
|
||||
break-even distance, if possible. As an example, see Figure 39-5, which shows a stock
|
||||
whose movements rarely exceed the "-1" or "+l" points, and even when they do, they
|
||||
don't exceed it by much. Most of these would be losing trades because, even though
|
||||
the stock might have moved the required percentage, that was its maximum move
|
||||
during the 10-month period, and there is no way that a trader would know to take
|
||||
profits exactly at that time. The straddles described by the histogram in Figure 39-5
|
||||
should not be bought, regardless of what the previous analyses might have shown.
|
||||
Nor would it be desirable for the histogram to show a large number of move
|
||||
ments above the "+3" level on the histogram, with virtually nothing below that. Such
|
||||
a histogram would most likely be reflective of the spiky, Internet-type stock activity
|
||||
that was referred to earlier as being unreasonable to expect that it might repeat itself.
|
||||
In a general sense, one doesn't want to see too many open spaces on the histogram's
|
||||
X-axis; continuity is desired.
|
||||
If the histogram is a favorable one, then the volatility analysis is complete. One
|
||||
would have found mispriced options, with a good theoretical probability of profit,
|
||||
whose past stock movements verify that such movements are feasible in the future.
|
||||
ANOTHER APPROACH?
|
||||
After having considered the descriptions of all of these analyses, one other approach
|
||||
comes to mind: Use the past movements exclusively and ignore the other analyses
|
||||
altogether. This sounds somewhat radical, but it is certainly a valid approach. It's
|
||||
more like giving some rigor to the person who "knows" IBM can move 18 points and
|
||||
who therefore wants to buy the straddle. If the histogram (study of past movements)
|
||||
tells us that IBM does, indeed, have a good chance of moving 18 points, what do we
|
||||
really care about the relationship of implied and historical volatility, or about the cur
|
||||
rent percentiles of either type of volatility, or what a theoretical probability calcula
|
||||
tor might say? In some sense, this is like comparing implied volatility (the price of the
|
||||
straddle) with historical volatility (the history of stock price movements) in a strictly
|
||||
practical sense, not using statistics.
|
||||
@@ -0,0 +1,34 @@
|
||||
Chapter 24: Ratio Spreads Using Puts 361
|
||||
down. Rather, one should be able to close the position with the puts close to parity if
|
||||
the stock breaks below the downside break-even point. The spreader may want to buy
|
||||
in additional long puts, as was described for call spreads in Chapter 11, but this is not
|
||||
as advantageous in the put spread because of the time value premium shrinkage.
|
||||
This strategy may prove psychologically pleasing to the less experienced
|
||||
investor because he will not lose money on an upward move by the underlying stock.
|
||||
Many of the ratio strategies that involve call options have upside risk, and a large
|
||||
number of investors do not like to lose money when stocks move up. Thus, although
|
||||
these investors might be attracted to ratio strategies because of the possibility of col
|
||||
lecting the profits on the sale of multiple out-of-the-money options, they may often
|
||||
prefer ratio put spreads to ratio call spreads because of the small upside risk in the
|
||||
put strategy.
|
||||
USING DELTAS
|
||||
The "delta spread" concept can also be used for establishing and adjusting neutral
|
||||
ratio put spreads. The delta spread was first described in Chapter 11. A neutral put
|
||||
spread can be constructed by using the deltas of the two put options involved in the
|
||||
spread. The neutral ratio is determined by dividing the delta of the put at the higher
|
||||
strike by the delta of the put at the lower strike. Referring to the previous example,
|
||||
suppose the delta of the January 45 put is -.30 and the delta of the January 50 put is
|
||||
-.50. Then a neutral ratio would be 1.67 (-.50 divided by -.30). That is, 1.67 puts
|
||||
would be sold for each put bought. One might thus sell 5 January 45 puts and buy 3
|
||||
January 50 puts.
|
||||
This type of spread would not change much in price for small fluctuations in the
|
||||
underlying stock price. However, as time passes, the preponderance of time value
|
||||
premium sold via the January 45 puts would begin to tum a profit. As the underlying
|
||||
stock moves up or down by more than a small distance, the neutral ratio between the
|
||||
two puts will change. The spreader can adjust his position back into a neutral one by
|
||||
selling more January 45's or buying more January 50's.
|
||||
THE RATIO PUT CALENDAR SPREAD
|
||||
The ratio put calendar spread consists of buying a longer-term put and selling a larg
|
||||
er quantity of shorter-term puts, all with the same striking price. The position is gen
|
||||
erally established with out-of-the-money puts that is, the stock is above the striking
|
||||
price - so that there is a greater probability that the near-term puts will expire worth-
|
||||
@@ -0,0 +1,44 @@
|
||||
758 Part VI: Measuring and Trading Volatility
|
||||
direct manner. That is, an increase in implied volatility will cause the option price to
|
||||
rise, while a decrease in volatility will cause a decline in the option price. That piece
|
||||
of information is the most important one of all, for it imparts what an option trader
|
||||
needs to know: An explosion in implied volatility is a boon to an option owner, but
|
||||
can be a devastating detriment to an option seller, especially a naked option seller.
|
||||
A couple of examples might demonstrate more clearly just how powerful the
|
||||
effect of implied volatility is, even when there isn't much time remaining in the life
|
||||
of an option. One should understand the notion that an increase in implied volatility
|
||||
can overcome days, even weeks, of time decay. This first example attempts to quan
|
||||
tify that statement somewhat.
|
||||
Example: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3-
|
||||
month call with striking price of 100. Furthermore, suppose that implied volatility is
|
||||
currently at 20%. Given these assumptions, the Black-Scholes model tells us that the
|
||||
call would be trading at a price of 4.64.
|
||||
Stock Price:
|
||||
Strike Price:
|
||||
Time Remaining:
|
||||
Implied Volatility:
|
||||
Theoretical Call Value:
|
||||
100
|
||||
100
|
||||
3 months
|
||||
20%
|
||||
4.64
|
||||
Now, suppose that a month passes. If implied volatility remained the same
|
||||
(20% ), the call would lose nearly a point of value due to time decay. However, how
|
||||
much would implied volatility have had to increase to completely counteract the
|
||||
effect of that time decay? That is, after a month has passed, what implied volatility
|
||||
will yield a call price of 4.64? lt turns out to be just under 26%.
|
||||
Stock Price:
|
||||
Strike Price:
|
||||
Time Remaining:
|
||||
Implied Volatility:
|
||||
Theoretical Call Value:
|
||||
100
|
||||
100
|
||||
2 months
|
||||
25.9%
|
||||
4.64
|
||||
What would happen after another month passes? There is, of course, some
|
||||
implied volatility at which the call would still be worth 4.64, but is it so high as to be
|
||||
unreasonable? Actually, it turns out that if implied volatility increases to about 38%,
|
||||
the call will still be worth 4.64, even with only one month of life remaining:
|
||||
@@ -0,0 +1,23 @@
|
||||
ler 20: The Sale of a Straddle
|
||||
GURE 20-2.
|
||||
ked straddle sale.
|
||||
307
|
||||
Stock Price at Expiration
|
||||
the stock at 52. If, however, he is planning to take other action that might involve
|
||||
staying with the position if the stock goes to 55 or 56, he should allow enough collat
|
||||
eral to be able to finance that action. If the stock never gets that high, he will have
|
||||
excess collateral while the position is in place.
|
||||
SELECTING A STRADDLE WRITE
|
||||
Ideally, one would like to receive a premium for the straddle write that produces a
|
||||
profit range that is wide in relation to the volatility of the underlying stock. In the
|
||||
example above, the profit range is 38 to 52. This may or may not be extraordinarily
|
||||
wide, depending on the volatility of XYZ. This is a somewhat subjective measure
|
||||
ment, although one could construct a simple straddle writer's index that ranked strad
|
||||
dles based on the following simple formula:
|
||||
I d Straddle time value premium n ex= _______ ..._ ___ _
|
||||
Stock price x Volatility
|
||||
Refinements would have to be made to such a ranking, such as eliminating cases in
|
||||
which either the put or the call sells for less than ¼ point ( or even 1 point, if a more
|
||||
restrictive requirement is desired) or cases in which the in-the-money time premium
|
||||
is small. Furthermore, the index would have to be annualized to be able to compare
|
||||
straddles for different expiration months. More advanced selection criteria, in the
|
||||
@@ -0,0 +1,209 @@
|
||||
CHAPTER 9
|
||||
Vertical Spreads
|
||||
Risk—it is the focal point around which all trading revolves. It may seem as if profit should be occupying this seat, as most important to trading options, but without risk, there would be no profit! As traders, we must always look for ways to mitigate, eliminate, preempt, and simply avoid as much risk as possible in our pursuit of success without diluting opportunity. Risk must be controlled. Trading vertical spreads takes us one step further in this quest.
|
||||
The basic strategies discussed in Chapters 4 and 5 have strengths when compared with pure linear trading in the equity markets. But they have weaknesses, too. Consider the covered call, one of the most popular option strategies.
|
||||
A covered call is best used as an augmentation to an investment plan. It can be used to generate income on an investment holding, as an entrance strategy into a stock, or as an exit strategy out of a stock. But from a trading perspective, one can often find better ways to trade such a forecast.
|
||||
If the forecast on a stock is neutral to moderately bullish, accepting the risk of stock ownership is often unwise. There is always the chance that the stock could collapse. In many cases, this is an unreasonable risk to assume.
|
||||
To some extent, we can make the same case for the long call, short put, naked call, and the like. In certain scenarios, each of these basic strategies is accompanied with unwanted risks that serve no beneficial purpose to the trader but can potentially cause harm. In many situations, a vertical spread is a better alternative to these basic spreads. Vertical spreads allow a trader to limit potential directional risk, limit theta and vega risk, free up margin, and generally manage capital more efficiently.
|
||||
Vertical Spreads
|
||||
Vertical spreads involve buying one option and selling another. Both are on the same underlying and expire the same month, and both are either calls or puts. The difference is in the strike prices of the two options. One is higher than the other, hence the name
|
||||
vertical spread
|
||||
. There are four vertical spreads: bull call spread, bear call spread, bear put spread, and bull put spread. These four spreads can be sliced and diced into categories a number of ways: call spreads and put spreads, bull spreads and bear spreads, debit spreads and credit spreads. There is overlap among the four verticals in how and when they are used. The end of this chapter will discuss how the spreads are interrelated.
|
||||
Bull Call Spread
|
||||
A bull call spread is a long call combined with a short call that has a higher strike price. Both calls are on the same underlying and share the same expiration month. Because the purchased call has a lower strike price, it costs more than the call being sold. Establishing the trade results in a debit to the trader’s account. Because of this debit, it’s called a debit spread.
|
||||
Below is an example of a bull call spread on Apple Inc. (AAPL):
|
||||
In this example, Apple is trading around $391. With 40 days until February expiration, the trader buys the 395–405 call spread for a net debit of $4.40, or $440 in actual cash. Or one could simply say the trader paid $4.40 for the 395–405 call.
|
||||
Consider the possible outcomes if the spread is held until expiration.
|
||||
Exhibit 9.1
|
||||
shows an at-expiration diagram of the bull call spread.
|
||||
EXHIBIT 9.1
|
||||
AAPL bull call spread.
|
||||
Before discussing the greeks, consider the bull call spread from an at-expiration perspective. Unlike the long call, which has two possible outcomes at expiration—above or below the strike—this spread has three possibilities: below both strikes, between the strikes, or above both strikes.
|
||||
In this example, if Apple is below $395 at expiration, both calls expire worthless. The rights and obligations of the options are gone, as is the cash spent on the trade. In this case, the entire debit of $4.40 is lost.
|
||||
If Apple is between the strikes at expiration, the 405-strike call expires worthless. The trader is long stock at an effective price of $399.40. This is the $395-strike price at which the stock would be purchased if the call is exercised, plus the $4.40 premium spent on the spread. The break-even price of the trade is $399.40. If Apple is above $399.40 at expiration, the trade is profitable; below $399.40, it is a loser. The aptly named bull call spread requires the stock to rise to reach its profit potential. But unlike an outright long call, profits are capped with the spread.
|
||||
If Apple is above $405 at expiration, both calls are in-the-money (ITM). If the 395-strike calls are exercised, the trader buys 100 shares of Apple at $395 and these shares, in turn, would be sold at $405 when the 405-strike calls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40 debit spent on the trade and the net profit is $5.60 per share.
|
||||
There are some other differences between the 395–405 call spread and the outright purchase of the 395 call. The absolute risk is lower. To buy the 395-strike call costs 14.60, versus 4.40 for the spread—a big difference. Because the debit is lower, the margin for the spread is lower at most option-friendly brokers, as well.
|
||||
If we dig a little deeper, we find some other differences between the bull call spread and the outright call. Long options are haunted by the specter of time. Because the spread involves both a long and a short option, the time-decay risk is lower than that associated with owning an option outright. Implied volatility (IV) risk is lower, too.
|
||||
Exhibit 9.2
|
||||
compares the greeks of the long 395 call with those of the 395–405 call spread.
|
||||
EXHIBIT 9.2
|
||||
Apple call versus bull call spread (Apple @ $391).
|
||||
395 Call
|
||||
395–405 Call
|
||||
Delta
|
||||
0.484
|
||||
0.100
|
||||
Gamma
|
||||
0.0097
|
||||
0.0001
|
||||
Theta
|
||||
−0.208
|
||||
−0.014
|
||||
Vega
|
||||
0.513
|
||||
0.020
|
||||
The positive deltas indicate that both positions are bullish, but the outright call has a higher delta. Some of the 395 call’s directional sensitivity is lost when the 405 call is sold to make a spread. The negative delta of the 405 call somewhat offsets the positive delta of the 395 call. The spread delta is only about 20 percent of the outright call’s delta. But for a trader wanting to focus on trading direction, the smaller delta can be a small sacrifice for the benefit of significantly reduced theta and vega. Theta spread’s risk is about 7 percent that of the outright. The spread’s vega risk is also less than 4 percent that of the outright 395 call. With the bull call spread, a trader can spread off much of the exposure to the unwanted risks and maintain a disproportionately higher greeks in the wanted exposure (delta).
|
||||
These relationships change as the underlying moves higher. Remember, at-the-money (ATM) options have the greatest sensitivity to theta and vega. With Apple sitting at around the long strike, gamma and vega have their greatest positive value, and theta has its most negative value.
|
||||
Exhibit 9.3
|
||||
shows the spread greeks given other underlying prices.
|
||||
EXHIBIT 9.3
|
||||
AAPL 395–405 bull call spread.
|
||||
As the stock moves higher toward the 405 strike, the 395 call begins to move away from being at-the-money, and the 405 call moves toward being at-the-money. The at-the-money is the dominant strike when it comes to the characteristics of the spread greeks. Note the greeks position when the underlying is directly between the two strike prices: The long call has ceased to be the dominant influence on these metrics. Both calls influence the analytics pretty evenly. The time-decay risk has been entirely spread off. The volatility risk is mostly spread off. Gamma remains a minimal concern. When the greeks of the two calls balance each other, the result is a directional play.
|
||||
As AAPL continues to move closer to the 405-strike, it becomes the at-the-money option, with the dominant greeks. The gamma, theta, and vega of the 405 call outweigh those of the ITM 395 call. Vega is more negative. Positive theta now benefits the trade. The net gamma of the spread has turned negative. Because of the negative gamma, the delta has become smaller than it was when the stock was at $400. This means that the benefit of subsequent upward moves in the stock begins to wane. Recall that there is a maximum profit threshold with a vertical spread. As the stock rises beyond $405, negative gamma makes the delta smaller and time decay becomes less beneficial. But at this point, the delta has done its work for the trader who bought this spread when the stock was trading around $395. The average delta on a move in the stock from $395 to $405 is about 0.10 in this case.
|
||||
When the stock is at the 405 strike, the characteristics of the trade are much different than they are when the stock is at the 395 strike. Instead of needing movement upward in the direction of the delta to combat the time decay of the long calls, the position can now sit tight at the short strike and reap the benefits of option decay. The key with this spread, and with all vertical spreads, is that the stock needs to move in the direction of the delta to the short strike.
|
||||
Strengths and Limitations
|
||||
There are many instances when a bull call spread is superior to other bullish strategies, such as a long call, and there are times when it isn’t. Traders must consider both price and time.
|
||||
A bull call spread will always be cheaper than the outright call purchase. That’s because the cost of the long-call portion of the spread is partially offset by the premium of the higher-strike short call. Spending less for the same exposure is always a better choice, but the exposure of the vertical is not exactly the same as that of the long call. The most obvious trade-off is the fact that profit is limited. For smaller moves—up to the price of the short strike—vertical spreads tend to be better trades than outright call purchases. Beyond the strike? Not so much.
|
||||
But time is a trade-off, too. There have been countless times that I have talked with new traders who bought a call because they thought the stock was going up. They were right and still lost money. As the adage goes, timing is everything. The more time that passes, the more advantageous the lower-theta vertical spread becomes. When held until expiration, a vertical spread can be a better trade than an outright call in terms of percentage profit.
|
||||
In the previous example, when Apple is at $391 with 40 days until expiration, the 395 call is worth 14.60 and the spread is worth 4.40. If Apple were to rise to be trading at $405 at expiration, the call rises to be worth 10, for a loss of 4.60 on the 14.60 debit paid. The spread also is worth 10. It yields a gain of about 127 percent on the initial $4.40 per share debit.
|
||||
But look at this same trade if the move occurs before expiration. If Apple rallies to $405 after only a couple weeks, the outcome is much different. With four weeks still left until expiration, the 395 call is worth 19.85 with the underlying at $405. That’s a 36 percent gain on the 14.60. The spread is worth 5.70. That’s a 30 percent gain. The vertical spread must be held until expiration to reap the full benefits, which it accomplishes through erosion of the short option.
|
||||
The long-call-only play (with a significantly larger negative theta) is punished severely by time passing. The long call benefits more from a quick move in the underlying. And of course, if the stock were to rise to a price greater than $405, in a short amount of time—the best of both worlds for the outright call—the outright long 395 call would be emphatically superior to the spread.
|
||||
Bear Call Spread
|
||||
The next type of vertical spread is called a
|
||||
bear call spread
|
||||
. A bear call spread is a short call combined with a long call that has a higher strike price. Both calls are on the same underlying and share the same expiration month. In this case, the call being sold is the option of higher value. This call spread results in a net credit when the trade is put on and, therefore, is called a credit spread.
|
||||
The bull call spread and the bear call spread are two sides of the same coin. The difference is that with the bull call spread, one is buying the call spread, and with the bear call spread, one is selling the call spread. An example of a bear call spread can be shown using the same trade used earlier.
|
||||
Here we are selling one AAPL February (40-day) 395 call at 14.60 and buying the 405 call at 10.20. We are selling the 395–405 call at $4.40 per share, or $440.
|
||||
Exhibit 9.4
|
||||
is an at-expiration diagram of the trade.
|
||||
EXHIBIT 9.4
|
||||
Apple bear call spread.
|
||||
The same three at-expiration outcomes are possible here as with the bull call spread: the stock can be above both strikes, between both strikes, or below both strikes. If the stock is below both strikes at expiration, both calls will expire worthless. The rights and obligations cease to exist. In this case, the entire credit of $440 is profit.
|
||||
If AAPL is between the two strike prices at expiration, the 395-strike call will be in-the-money. The short call will get assigned and result in a short stock position at expiration. The break-even price falls at $399.40—the short strike plus the $4.40 net premium. This is the price at which the stock will effectively be sold if assignment occurs.
|
||||
If Apple is above both strikes at expiration, it means both calls are in-the-money. Stock is sold at $395 because of assignment and bought back at $405 through exercise. This leads to a loss of $10 per share on the negative scalp. Factoring in the $4.40-per-share credit makes the net loss only $5.60 per share with AAPL above $405 at February expiration.
|
||||
Just as the at-expiration diagram is the same but reversed, the greeks for this call spread will be similar to those in the bull call spread example except for the positive and negative signs. See
|
||||
Exhibit 9.5
|
||||
.
|
||||
EXHIBIT 9.5
|
||||
Apple 395–405 bear call spread.
|
||||
A credit spread is commonly traded as an income-generating strategy. The idea is simple: sell the option closer-to-the-money and buy the more out-of-the-money (OTM) option—that is, sell volatility—and profit from nonmovement (above a certain point). In this example, with Apple at $391, a neutral to slightly bearish trader would think about selling this spread at 4.40 in hopes that the stock will remain below $395 until expiration. The best-case scenario is that the stock is below $395 at expiration and both options expire, resulting in a $4.40-per-share profit.
|
||||
The strategy profits as long as Apple is under its break-even price, $399.40, at expiration. But this is not so much a bearish strategy as it is a nonbullish strategy. The maximum gain with a credit spread is the premium received, in this case $4.40 per share. Traders who thought AAPL was going to decline sharply would short it or buy a put. If they thought it would rise sharply, they’d use another strategy.
|
||||
From a greek perspective, when the trade is executed it’s very close to its highest theta price point—the 395 short strike price. This position theoretically collects $0.90 a day with Apple at around $395. As time passes, that theta rises. The key is that the stock remains at around $395 until the short option is just about worthless. The name of the game is sit and wait.
|
||||
Although the delta is negative, traders trading this spread to generate income want the spread to expire worthless so they can pocket the $4.40 per share. If Apple declines, profits will be made on delta, and theta profits will be foregone later. All that matters is the break-even point. Essentially, the idea is to sell a naked call with a maximum potential loss. Sell the 395s and buy the 405s for protection.
|
||||
If the underlying decreases enough in the short term and significant profits from delta materialize, it is logical to consider closing the spread early. But it often makes more sense to close part of the spread. Consider that the 405-strike call is farther out-of-the-money and will lose its value before the 395 call.
|
||||
Say that after two weeks a big downward move occurs. Apple is trading at $325 a share; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at 0.55. At this point, the lion’s share of the profits can be taken early. A trader can do so by closing only the 395 calls. Closing the 395s to eliminate the risk of negative delta and gamma makes sense. But does it make sense to close the 405s for 0.05? Usually not. Recouping this residual value accomplishes little. It makes more sense to leave them in your position in case the stock rebounds. If the stock proves it can move down $70; it can certainly move up $70. Because the majority of the profits were taken on the 395 calls, holding on to the 405s is like getting paid to own calls. In scenarios where a big move occurs and most of the profits can be taken early, it’s often best to hold the long calls, just in case. It’s a win-win situation.
|
||||
Credit and Debit Spread Similarities
|
||||
The credit call spread and the debit call spread appear to be exactly opposite in every respect. Many novice traders perceive credit spreads to be fundamentally different from debit spreads. That is not necessarily so. Closer study reveals that these two are not so different after all.
|
||||
What if Apple’s stock price was higher when the trade was put on? What if the stock was at $405? First, the spread would have had more value. The 395 and 405 calls would both be worth more. A trader could have sold the spread for a $5.65-per-share credit. The at-expiration diagram would look almost the same. See
|
||||
Exhibit 9.6
|
||||
.
|
||||
EXHIBIT 9.6
|
||||
Apple bear call spread initiated with Apple at $405.
|
||||
Because the net premium is much higher in this example, the maximum gain is more—it is $5.65 per share. The breakeven is $400.65. The price points on the at-expiration diagram, however, have nothing to do with the greeks. The analytics from
|
||||
Exhibit 9.5
|
||||
are the same either way.
|
||||
The motivation for a trader selling this call spread, which has both options in-the-money, is different from that for the typical income generator. When the spread is sold in this context, the trader is buying volatility. Long gamma, long vega, negative theta. The trader here has a trade more like the one in the bull call spread example—except that instead of needing a rally, the trader needs a rout. The only difference is that the bull call spread has a bullish delta, and the bear call spread has a bearish delta.
|
||||
Bear Put Spread
|
||||
There is another way to take a bearish stance with vertical spreads: the bear put spread. A bear put spread is a long put plus a short put that has a lower strike price. Both puts are on the same underlying and share the same expiration month. This spread, however, is a debit spread because the more expensive option is being purchased.
|
||||
Imagine that a stock has had a good run-up in price. The chart shows a steady march higher over the past couple of months. A study of technical analysis, though, shows that the run-up may be pausing for breath. An oscillator, such as slow stochastics, in combination with the relative strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing.
|
||||
For traders looking for a small pullback, a bear put spread can be an excellent strategy. The goal is to see the stock drift down to the short strike. So, like the other members of the vertical spread family, strike selection is important.
|
||||
Let’s look at an example of ExxonMobil (XOM). After the stock has rallied over a two-month period to $80.55, a trader believes there will be a short-term temporary pullback to $75. Instead of buying the June 80 puts for 1.75, the trader can buy the 75–80 put spread of the same month for 1.30 because the 75 put can be sold for 0.45.
|
||||
1
|
||||
In this example, the June put has 40 days until expiration.
|
||||
Exhibit 9.7
|
||||
illustrates the payout at expiration.
|
||||
EXHIBIT 9.7
|
||||
ExxonMobil bear put spread.
|
||||
If the trader is wrong and ExxonMobil is still above 80 at expiry, both puts expire and the 1.30 premium is lost. If ExxonMobil is between the two strikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are OTM and expire. The net effect is short stock at an effective price of $78.70. The effective sale price is found by taking the price at which the short stock is established when the puts are exercised—$80—minus the net 1.30 paid for the spread. This is the spread’s breakeven at expiration.
|
||||
If the trader is right and ExxonMobil is below both strikes at expiration, both puts are ITM, and the result is a 3.70 profit and no position. Why a 3.70 profit? The 80 puts are exercised, making the trader short at $80, and the 75 puts are assigned, so the short is bought back at $75 for a positive stock scalp of $5. Including the 1.30 debit for the spread in the profit and loss (P&(L)), the net profit is $3.70 per share when the stock is below both strikes at expiration.
|
||||
This is a bearish trade. But is the bear put spread necessarily a better trade than buying an outright ATM put? No. The at-expiration diagram makes this clear. Profits are limited to $3.70 per share. This is an important difference. But because in this particular example, the trader expects the stock to retrace only to around $75, the benefits of lower cost and lower theta and vega risk can be well worth the trade-off of limited profit. The trader’s objectives are met more efficiently by buying the spread. The goal is to profit from the delta move down from $80 to $75.
|
||||
Exhibit 9.8
|
||||
shows the differences between the greeks of the outright put and the spread when the trade is put on with ExxonMobil at $80.55.
|
||||
EXHIBIT 9.8
|
||||
ExxonMobil put vs. bear put spread (ExxonMobil @ $80.55).
|
||||
80 Put
|
||||
75–80 Put
|
||||
Delta
|
||||
−0.445
|
||||
−0.300
|
||||
Gamma
|
||||
+0.080
|
||||
+0.041
|
||||
Theta
|
||||
−0.018
|
||||
−0.006
|
||||
Vega
|
||||
+0.110
|
||||
+0.046
|
||||
As in the call-spread examples discussed previously, the spread delta is smaller than the outright put’s. It appears ironic that the spread with the smaller delta is a better trade in this situation, considering that the intent is to profit from direction. But it is the relative differences in the greeks besides delta that make the spread worthwhile given the trader’s goal. Gamma, theta, and vega are proportionately much smaller than the delta in the spread than in the outright put. While the spread’s delta is two thirds that of the put, its gamma is half, its theta one third, and its vega around 42 percent of the put’s.
|
||||
Retracements such as the one called for by the trader in this example can happen fast, sometimes over the course of a week or two. It’s not necessarily bad if this move occurs quickly. If ExxonMobil drops by $5 right away, the short delta will make the position profitable.
|
||||
Exhibit 9.9
|
||||
shows how the spread position changes as the stock declines from $80 to $75.
|
||||
EXHIBIT 9.9
|
||||
75–80 bear put spread as ExxonMobil declines.
|
||||
The delta of this trade remains negative throughout the stock’s descent to $75. Assuming the $5 drop occurs in one day, a delta averaging around −0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36 times $5 times 100). This is still a far cry from the spread’s $3.70 potential profit. Although the stock is at $75, the maximum profit potential has yet to be reached, and it won’t be until expiration. How does the rest of the profit materialize? Time decay.
|
||||
The price the trader wants the stock to reach is $75, but the assumption here is that the move happens very fast. The trade went from being a long-volatility play—long gamma and vega—to a short-vol play: short gamma and vega. The trader wanted movement when the stock was at $80 and wants no movement when the stock is at $75. When the trade changes characteristics by moving from one strike to another, the trader has to reconsider the stock’s outlook. The question is: if I didn’t have this position on, would I want it now?
|
||||
The trader has a choice to make: take the $180 profit—which represents a 138 percent profit on the 1.30 debit—or wait for theta to do its thing. The trader looking for a retracement would likely be inclined to take a profit on the trade. Nobody ever went broke taking a profit. But if the trader thinks the stock will sit tight for the remaining time until expiration, he will be happy with this income-generating position.
|
||||
Although the trade in the last, overly simplistic example did not reap its full at-expiration potential, it was by no means a bad trade. Holding the spread until expiration is not likely to be part of a trader’s plan. Buying the 80 put outright may be a better play if the trader is expecting a fast move. It would have a bigger delta than the spread. Debit and credit spreads can be used as either income generators or as delta plays. When they’re used as delta plays, however, time must be factored in.
|
||||
Bull Put Spread
|
||||
The last of the four vertical spreads is a bull put spread. A bull put spread is a short put with one strike and a long put with a lower strike. Both puts are on the same underlying and in the same expiration cycle. A bull put spread is a credit spread because the more expensive option is being sold, resulting in a net credit when the position is established. Using the same options as in the bear put example:
|
||||
With ExxonMobil at $80.55, the June 80 puts are sold for 1.75 and the June 75 puts are bought at 0.45. The trade is done for a credit of 1.30.
|
||||
Exhibit 9.10
|
||||
shows the payout of this spread if it is held until expiration.
|
||||
EXHIBIT 9.10
|
||||
ExxonMobil bull put spread.
|
||||
The sale of this spread generates a 1.30 net credit, which is represented by the maximum profit to the right of the 80 strike. With ExxonMobil above $80 per share at expiration, both options expire OTM and the premium is all profit. Between the two strike prices, the 80 put expires in the money. If the ITM put is still held at expiration, it will be assigned. Upon assignment, the put becomes long stock, profiting with each tick higher up to $80, or losing with each tick lower to $75. If the 80 put is assigned, the effective price of the long stock will be $78.70. The assignment will “hit your sheets” as a buy at $80, but the 1.30 credit lowers the effective net cost to $78.70.
|
||||
If the stock is below $75 at option expiration, both puts will be ITM. This is the worst case scenario, because the higher-struck put was sold. At expiration, the 80 puts would be assigned, the 75 puts exercised. That’s a negative scalp of $5 on the resulting stock. The initial credit lessens the pain by 1.30. The maximum possible loss with ExxonMobil below both strikes at expiration is $3.70 per spread.
|
||||
The spread in this example is the flip side of the bear put spread of the previous example. Instead of buying the spread, as with the bear put, the spread in this case is sold.
|
||||
Exhibit 9.11
|
||||
shows the analytics for the bull put spread.
|
||||
EXHIBIT 9.11
|
||||
Greeks for ExxonMobil 75–80 bull put spread.
|
||||
Instead of having a short delta, as with the bear spread, the bull spread is long delta. There is negative theta with positive gamma and vega as XOM approaches the long strike—the 75s, in this case. There is also positive theta with negative gamma and vega around the short strike—the 80s.
|
||||
Exhibit 9.11
|
||||
shows the characteristics that define the vertical spread. If one didn’t know which particular options were being traded here, this could almost be a table of greeks for either a 75–80 bull put spread or a 75–80 bull call spread.
|
||||
Like the other three verticals, this spread can be a delta play or a theta play. A bullish trader may sell the spread if both puts are in-the-money. Imagine that XOM is trading at around $75. The spread will have a positive 0.364 delta, positive gamma, and negative theta. The spread as a whole is a decaying asset. It needs the underlying to rally to combat time decay.
|
||||
A bullish trader may also sell this spread if XOM is between the two strikes. In this case, with XOM at, say, $77, the delta is +0.388, and all other greeks are negligible. At this particular price point in the underlying, the trader has almost pure leveraged delta exposure. But this trade would be positioned for only a small move, not much above $80. A speculator wanting to trade direction for a small move while eliminating theta and vega risks achieves her objectives very well with a vertical spread.
|
||||
A bullish-to-neutral trader would be inclined to sell this spread if ExxonMobil were around $80 or higher. Day by day, the 1.30 premium would start to come in. With 40 days until expiration, theta would be small, only 0.004. But if the stock remained at $80, this ATM put would begin decaying faster and faster. The objective of trading this spread for a neutral trader is selling future realized volatility—selling gamma to earn theta. A trader can also trade a vertical spread to profit from IV.
|
||||
Verticals and Volatility
|
||||
The IV component of a vertical spread, although small compared with that of an outright call or put, is still important—especially for large traders with low margin and low commissions who can capitalize on small price changes efficiently. Whether it’s a call spread or a put spread, a credit spread or a debit spread, if the underlying is at the short option’s strike, the spread will have a net negative vega. If the underlying is at the long option’s strike, the spread will have positive vega. Because of this characteristic, there are three possible volatility plays with vertical spreads: speculating on IV changes when the underlying remains constant, profiting from IV changes resulting from movement of the underlying, and special volatility situations.
|
||||
Vertical spreads offer a limited-risk way to speculate on volatility changes when the underlying remains fairly constant. But when the intent of a vertical spread is to benefit from vega, one must always consider the delta—it’s the bigger risk. Chapter 13 discusses ways to manage this risk by hedging with stock, a strategy called delta-neutral trading.
|
||||
Non-delta-neutral traders may speculate on vol with vertical spreads by assuming some delta risk. Traders whose forecast is vega bearish will sell the option with the strike closest to where the underlying is trading—that is, the ATM option—and buy an OTM strike. Traders would lean with their directional bias by choosing either a call spread or a put spread. As risk managers, the traders balance the volatility stance being taken against the additional risk of delta. Again, in this scenario, delta can hurt much more than help.
|
||||
In the ExxonMobil bull put spread example, the trader would sell the 80-strike put if ExxonMobil were around $80 a share. In this case, if the stock didn’t move as time passed, theta would benefit from historical volatility being’s low—that is, from little stock movement. At first, the benefit would be only 0.004 per day, speeding up as expiration nears. And if implied volatility decreased, the trader would profit 0.04 for every 1 percent decline in IV. Small directional moves upward help a little. But in the long run, those profits are leveled off by the fact that theta gets smaller as the stock moves higher above $80—more profit on direction, less on time.
|
||||
For the delta player, bull call spreads and bull put spreads have a potential added benefit that stems from the fact that IV tends to decrease as stocks rise and increase when stocks fall. This offers additional opportunity to the bull spread player. With the bull call spread or the bull put spread, the trader gains on positive delta with a rally. Once the underlying comes close to the short option’s strike, vega is negative. If IV declines, as might be anticipated, there is a further benefit of vega profits on top of delta profits. If the underlying declines, the trader loses on delta. But the pain can potentially be slightly lessened by vega profits. Vega will get positive as the underlying approaches the long strike, which will benefit from the firming of IV that often occurs when the stock drops. But this dual benefit is paid for in the volatility skew. In most stocks or indexes, the lower strikes—the ones being bought in a bull spread—have higher IVs than the higher strikes, which are being sold.
|
||||
Then there are special market situations in which vertical spreads that benefit from volatility changes can be traded. Traders can trade vertical spreads to strategically position themselves for an expected volatility change. One example of such a situation is when a stock is rumored to be a takeover target. A natural instinct is to consider buying calls as an inexpensive speculation on a jump in price if the takeover is announced. Unfortunately, the IV of the call is often already bid up by others with the same idea who were quicker on the draw. Buying a call spread consisting of a long ITM call and a short OTM call can eliminate immediate vega risk and still provide wanted directional exposure.
|
||||
Certainly, with this type of trade, the trader risks being wrong in terms of direction, time, and volatility. If and when a takeover bid is announced, it will likely be for a specific price. In this event, the stock price is unlikely to rise above the announced takeover price until either the deal is consummated or a second suitor steps in and offers a higher price to buy the company. If the takeover is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in a very tight range below the takeover price for a long time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will let the trader profit from collapsing IV through negative vega.
|
||||
Say XYZ stock, trading at $52 a share, is a rumored takeover target at $60. When the rumors are first announced, the stock will likely rise, to say $55, with IV rising as well. Buying the 50–60 call spread will give a trader a positive delta and a negligible vega. If the rumors are realized and a cash takeover deal is announced at $60, the trade gains on delta, and the spread will now have negative vega. The negative vega at the 60 strike gains on implied volatility declining, and the stock will sit close to $60, producing the benefits of positive theta. Win, win, win.
|
||||
The Interrelations of Credit Spreads and Debit Spreads
|
||||
Many traders I know specialize in certain niches. Sometimes this is because they find something they know well and are really good at. Sometimes it’s because they have become comfortable and don’t have the desire to try anything new. I’ve seen this strategy specialization sometimes with traders trading credit spreads and debit spreads. I’ve had serial credit spread traders tell me credit spreads are the best trades in the world, much better than debit spreads. Habitual debit spread traders have likewise said their chosen spread is the best. But credit spreads and debit spreads are not so different. In fact, one could argue that they are really the same thing.
|
||||
Conventionally, credit-spread traders have the goal of generating income. The short option is usually ATM or OTM. The long option is more OTM. The traders profit from nonmovement via time decay. Debit-spread traders conventionally are delta-bet traders. They buy the ATM or just out-of-the-money option and look for movement away from or through the long strike to the short strike. The common themes between the two are that the underlying needs to end up around the short strike price and that time has to pass to get the most out of either spread.
|
||||
With either spread, movement in the underlying may be required, depending on the relationship of the underlying price to the strike prices of the options. And certainly, with a credit spread or debit spread, if the underlying is at the short strike, that option will have the most premium. For the trade to reach the maximum profit, it will need to decay.
|
||||
For many retail traders, debit spreads and credit spreads begin to look even more similar when margin is considered. Margin requirements can vary from firm to firm, but verticals in retail accounts at option-friendly brokerage firms are usually margined in such a way that the maximum loss is required to be deposited to hold the position (this assumes Regulation T margining). For all intents and purposes, this can turn the trader’s cash position from a credit into a debit. From a cash perspective, all vertical spreads are spreads that require a debit under these margin requirements. Professional traders and retail traders who are subject to portfolio margining are subject to more liberal margin rules.
|
||||
Although margin is an important concern, what we really care about as traders is risk versus reward. A credit call spread and a debit put spread on the same underlying, with the same expiration month, sharing the same strike prices will also share the same theoretical risk profile. This is because call and put prices are bound together by put-call parity.
|
||||
Building a Box
|
||||
Two traders, Sam and Isabel, share a joint account. They have each been studying Johnson & Johnson (JNJ), which is trading at around $63.35 per share. Sam and Isabel, however, cannot agree on direction. Sam thinks Johnson & Johnson will rise over the next five weeks, and Isabel believes it will decline during that period.
|
||||
Sam decides to buy the January 62.50 −65 call spread (January has 38 days until expiration in this example). Sam can buy this spread for 1.28. His maximum risk is 1.28. This loss occurs if Johnson & Johnson is below $62.50 at expiration, leaving both calls OTM. His maximum gain is 1.22, realized if Johnson & Johnson is above $65 (65–62.50–1.28). With Johnson & Johnson at $63.35, Sam’s delta is long 0.29 and his other greeks are about flat.
|
||||
Isabel decides to buy the January 62.50–65 put spread for a debit of 1.22. Isabel’s biggest potential loss is 1.22, incurred if Johnson & Johnson is above $65 a share at expiration, leaving both puts OTM. Her maximum possible profit is 1.28, realized if the stock is below $62.50 at option expiration. With Johnson & Johnson at $63.35, Isabel has a delta that is short around 0.27 and is nearly flat gamma, theta, and vega.
|
||||
Collectively, if both Sam and Isabel hold their trades until expiration, it’s a zero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel profits. She cancels out Sam’s loss by making 1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount, canceling out Sam’s gains. Between the two strikes, Sam has gains on his 62.50 call and Isabel has gains on her 65 put. The gains on the two options will total 2.50, the combined total spent on the spreads—another draw.
|
||||
EXHIBIT 9.12
|
||||
Sam’s long call spread in Johnson & Johnson.
|
||||
62.50–65 Call Spread
|
||||
Delta
|
||||
+0.290
|
||||
Gamma
|
||||
+0.001
|
||||
Theta
|
||||
−0.004
|
||||
Vega
|
||||
+0.006
|
||||
EXHIBIT 9.13
|
||||
Isabel’s long put spread in Johnson & Johnson.
|
||||
62.50–65 Put Spread
|
||||
Delta
|
||||
−0.273
|
||||
Gamma
|
||||
−0.001
|
||||
Theta
|
||||
+0.005
|
||||
Vega
|
||||
−0.006
|
||||
These two spreads were bought for a combined total of 2.50. The collective position, composed of the four legs of these two spreads, forms a new strategy altogether.
|
||||
The two traders together have created a box. This box, which is empty of both profit and loss, is represented by greeks that almost entirely offset each other. Sam’s positive delta of 0.29 is mostly offset by Isabel’s −0.273 delta. Gamma, theta, and vega will mostly offset each other, too.
|
||||
Chapter 6 described a box as long synthetic stock combined with short synthetic stock having a different strike price but the same expiration month. It can also be defined, however, as two vertical spreads: a bull (bear) call spread plus a bear (bull) put spread with the same strike prices and expiration month.
|
||||
The value of a box equals the present value of the distance between the two strike prices (American-option models will also account for early exercise potential in the box’s value). This 2.50 box, with 38 days until expiration at a 1 percent interest rate, has less than a penny of interest affecting its value. Boxes with more time until expiration will have a higher interest rate component. If there was one year until expiration, the combined value of the two verticals would equal 2.475. This is simply the distance between the strikes minus interest (2.50–[2.50 × 0.01]).
|
||||
Credit spreads are often made up of OTM options. Traders betting against a stock rising through a certain price tend to sell OTM call spreads. For a stock at $50 per share, they might sell the 55 calls and buy the 60 calls. But because of the synthetic relationship that verticals have with one another, the traders could buy an ITM put spread for the same exposure, after accounting for interest. The traders could buy the 60 puts and sell the 55 puts. An ITM call (put) spread is synthetically equal to an OTM put (call) spread.
|
||||
Verticals and Beyond
|
||||
Traders who want to take full advantage of all that options have to offer can do so strategically by trading spreads. Vertical spreads truncate directional risk compared with strategies like the covered call or single-legged option trades. They also reduce option-specific risk, as indicated by their lower gamma, theta, and vega. But lowering risk both in absolute terms and in the greeks has a trade-off compared with buying options: limited profit potential. This trade-off can be beneficial, depending on the trader’s forecast. Debit spreads and credit spreads can be traded interchangeably to achieve the same goals. When a long (short) call spread is combined with a long (short) put spread, the product is a box. Chapter 10 describes other ways vertical spreads can be combined to form positions that achieve different trading objectives.
|
||||
Note
|
||||
1
|
||||
. Note that it is customary when discussing the purchase or sale of spreads to state the lower strike first, regardless of which is being bought or sold. In this case, the trader is buying the 75–80 put spread.
|
||||
@@ -0,0 +1,51 @@
|
||||
740 Part VI: Measuring and Trading Volatility
|
||||
FIGURE 36-5.
|
||||
Implied versus historical volatility of a stock.
|
||||
150
|
||||
140
|
||||
130
|
||||
120
|
||||
110
|
||||
100
|
||||
90
|
||||
80
|
||||
70
|
||||
60
|
||||
50
|
||||
40
|
||||
30
|
||||
20
|
||||
10
|
||||
oi--""""'""""',,,.....""' -10
|
||||
-20
|
||||
-30 "O
|
||||
-40 ct!
|
||||
-50 ~
|
||||
-80 0.
|
||||
-701'-'-=CIJ+---+---+--+;
|
||||
-80
|
||||
1999
|
||||
FIGURE 36-6.
|
||||
Implied minus Actual
|
||||
The price graph of the stock.
|
||||
. . .
|
||||
•• , •••••••• ,. •••••••• .,. ••• + ••••••••••• ••••• -~······ •••••• ,. ••••••••••• ·t . ······ . . . ... ["
|
||||
·· · ·· ·· ··· ·· · · · Stock Price · ·· · : ·· ·· I
|
||||
~ !'"Y"d"'il~tilirrs::•of'T!
|
||||
' ' .· ............ ; ·--·•·····! ............ · ................ : ............... : ...........•.. :.
|
||||
············•·:••············•:•···········•;••·············(·········•: Implied Volatility
|
||||
98 0 N D J F M A M 99
|
||||
29.000
|
||||
27.000
|
||||
25.000
|
||||
23.000
|
||||
21.000
|
||||
19.000
|
||||
17.000
|
||||
15.000
|
||||
13.000
|
||||
11.000
|
||||
9.000
|
||||
7.000
|
||||
5.000
|
||||
Date
|
||||
@@ -0,0 +1,37 @@
|
||||
Chapter 39: Volatility Trading Techniques 833
|
||||
In reality, one would have to be mindful of not buying overly expensive options ( or
|
||||
selling overly cheap ones), because implied volatility cannot be ignored. However, the
|
||||
price of the straddle itself, which is what determines the x-axis on the histogram, does
|
||||
reflect option prices, and therefore implied volatility, in a nontechnical sense. This author
|
||||
suspects that a list of volatility trading candidates generated only by using past movements
|
||||
would be a rather long list. Therefore, as a practical matter, it may not be useful.
|
||||
MORE THOUGHTS ON SELLING VOLATILITY
|
||||
Earlier, it was promised that another, more complex volatility selling strategy would
|
||||
be discussed. An option strategist is often faced with a difficult choice when it comes
|
||||
to selling (overpriced) options in a neutral manner - in other words, "selling volatili
|
||||
ty." Many traders don't like to sell naked options, especially naked equity options, yet
|
||||
many forms of spreads designed to limit risk seem to force the strategist into a direc
|
||||
tional (bullish or bearish) strategy that he doesn't really want. This section addresses
|
||||
the more daunting prospect of trying to sell volatility with protection in the equity
|
||||
and futures option markets.
|
||||
The quandary in trying to sell volatility is in trying to find a neutral strategy that
|
||||
allows one to benefit from the sale of expensive options without paying too much for
|
||||
a hedge - the offsetting purchase of equally expensive options. The simple strategy
|
||||
that most traders first attempt is the credit spread. Theoretically, if implied volatility
|
||||
were to fall during the time the credit spread position is in place, a profit might be
|
||||
realized. However, after commissions on four different options in and possibly out
|
||||
(assuming one sold both out-of-the-money put and call spreads), there probably
|
||||
wouldn't be any real profit left if the position were closed out early. In sum, there is
|
||||
nothing really wrong with the credit spread strategy, but it just doesn't seem like any
|
||||
thing to get too excited about. What other strategy can be used that has limited risk
|
||||
and would benefit from a decline in implied volatility? The highest-priced options are
|
||||
the longer-term ones. If implied volatility is high, then if one can sell options such as
|
||||
these and hedge them, that might be a good strategy.
|
||||
The simplest strategy that has the desired traits is selling a calendar spread
|
||||
that is, sell a longer-term option and hedge it by buying a short-term option at the
|
||||
same strike. True, both are expensive (and the near-term option might even have a
|
||||
slightly higher implied volatility than the longer-term one). But the longer-term one
|
||||
trades with a far greater absolute price, so if both become cheaper, the longer-term
|
||||
one can decline quite a bit farther in points than the near-term one. That is, the vega
|
||||
of the longer-term option is greater than the vega of the shorter-term one. When one
|
||||
sells a calendar spread, it is called a reverse calendar spread. The strategy was
|
||||
@@ -0,0 +1,39 @@
|
||||
816 Part VI: Measuring and Trading Volatility
|
||||
600 days of implied volatility history for the purpose of determining percentiles, but
|
||||
a case could be made for other lengths of time. The purpose is to use enough implied
|
||||
volatility history to give one a good perspective. Then, a reading of the 10th per
|
||||
centile or the 90th percentile will truly be significant and would therefore be a good
|
||||
starting point in determining whether the options are cheap or expensive.
|
||||
In addition to the actual percentile, the trader should also be aware of the width
|
||||
of the implied volatility distribution. This was discussed in an earlier chapter, but
|
||||
essentially the concept is this: If the first percentile is an implied volatility of 40% and
|
||||
the 100th percentile is an implied volatility of 45%, then that entire range is so nar
|
||||
row as to be meaningless in terms of whether one could classify the options as cheap
|
||||
or expensive.
|
||||
The advantage of buying options in a low percentile of implied volatility is to
|
||||
give oneself two ways to make money: one, via movement in the underlying (if a
|
||||
straddle were owned, for example), and two, by an increase in implied volatility. That
|
||||
is, if the options were to return to the 50th percentile of implied volatility, the volatil
|
||||
ity trader who has bought "cheap" options should expect to make money from that
|
||||
movement as well. That can only happen if the 50th percentile and the 10th per
|
||||
centile are sufficiently far apart to allow for an increase in the price of the option to
|
||||
be meaningful. Perhaps a good rule of thumb is this: If the option rises from the cur
|
||||
rent (low) percentile reading to the 50th percentile in a month, will the increase in
|
||||
implied volatility be equal to or greater than the time decay over that period?
|
||||
Alternatively stated, with all other things being equal, will the option be trading at
|
||||
the same or a greater price in a month, if implied volatility rises to the 50th percentile
|
||||
at the end of that time? If so, then the width of the range of implied volatilities is
|
||||
great enough to produce the desired results.
|
||||
The attractiveness to this method for determining if implied volatility is out of
|
||||
line is that the trader is "forced" to buy options that are cheap ( or to sell options that
|
||||
are expensive), on a relative basis. Even though historical volatility has not been taken
|
||||
into consideration, it will be later on when the probability calculators are brought to
|
||||
bear. There is no guarantee, of course, that implied volatility will move toward the
|
||||
50th percentile while the position is in place, but if it does, that will certainly be an
|
||||
aid to the position.
|
||||
In effect this method is measuring what the option trading public is "thinking"
|
||||
about volatility and comparing it with what they've thought in the past. Since the pub
|
||||
lic is wrong (about prices as well as volatility) at major turning points, it is valid to want
|
||||
to be long volatility when "everyone else" has pushed it down to depressed levels. The
|
||||
converse may not necessarily be true: that we would want to be short volatility when
|
||||
everyone else has pushed it up to extremely high levels. The caveat in that case is that
|
||||
@@ -0,0 +1,30 @@
|
||||
The Retail Trader versus the Pro
|
||||
Iron condors are very popular trades among retail traders. These days one
|
||||
can hardly go to a cocktail party and mention the word options without
|
||||
hearing someone tell a story about an iron condor on which he’s made a
|
||||
bundle of money trading. Strangely, no one ever tells stories about trades in
|
||||
which he has lost a bundle of money.
|
||||
Two of the strengths of this strategy that attract retail traders are its
|
||||
limited risk and high probability of success. Another draw of this type of
|
||||
strategy is that the iron condor and the other wing spreads offer something
|
||||
truly unique to the retail trader: a way to profit from stocks that don’t move.
|
||||
In the stock-trading world, the only thing that can be traded is direction—
|
||||
that is, delta. The iron condor is an approachable way for a nonprofessional
|
||||
to dabble in nonlinear trading. The iron condor does a good job in
|
||||
eliminating delta—unless, of course, the stock moves and gamma kicks in.
|
||||
It is efficient in helping income-generating retail traders accomplish their
|
||||
goals. And when a loss occurs, although it can be bigger than the potential
|
||||
profits, it is finite.
|
||||
But professional option traders, who have access to lots of capital and
|
||||
have very low commissions and margin requirements, tend to focus their
|
||||
efforts in other directions: they tend to trade volatility. Although iron
|
||||
condors are well equipped for profiting from theta when the stock
|
||||
cooperates, it is also possible to trade implied volatility with this strategy.
|
||||
The examples of iron condors, condors, iron butterflies, and butterflies
|
||||
presented in this chapter so far have for the most part been from the
|
||||
perspective of the neutral trader: selling the guts and buying the wings. A
|
||||
trader focusing on vega in any of these strategies may do just the opposite
|
||||
—buy the guts and sell the wings—depending on whether the trader is
|
||||
bullish or bearish on volatility.
|
||||
Say a trader, Joe, had a bullish outlook on volatility in Salesforce.com
|
||||
(CRM). Joe could sell the following condor 100 times.
|
||||
@@ -0,0 +1,42 @@
|
||||
Cl,opter 19: The Sale of a Put
|
||||
TABLE 19-1.
|
||||
Results from the sale of an uncovered put.
|
||||
XYZ Price at Put Price at
|
||||
Expiration Expiration (Parity)
|
||||
30 20
|
||||
40 10
|
||||
46 4
|
||||
50 0
|
||||
60 0
|
||||
70 0
|
||||
f IGURE 19-1.
|
||||
Uncovered sale of a put.
|
||||
$400
|
||||
C
|
||||
0
|
||||
~ ·5.
|
||||
X
|
||||
w
|
||||
'lii
|
||||
(/l $0 (/l
|
||||
.3 50
|
||||
0
|
||||
~ a.
|
||||
Stock Price at Expiration
|
||||
293
|
||||
Put Sale
|
||||
Profit
|
||||
-$1,600
|
||||
600
|
||||
0
|
||||
+ 400
|
||||
+ 400
|
||||
+ 400
|
||||
for a total of $1,400. If the stock were above the striking price, the striking price dif
|
||||
forential would be subtracted from the requirement. The minimum requirement is
|
||||
I 0% of the put' s striking price, plus the put premium, even if the computation above
|
||||
yields a smaller result.
|
||||
The uncovered put writing strategy is similar in many ways to the covered call
|
||||
writing strategy. Note that the profit graphs have the same shape; this means that the
|
||||
two strategies are equivalent. It may be helpful to the reader to describe the aspects
|
||||
of naked put writing by comparing them to similar aspects of covered call writing.
|
||||
@@ -0,0 +1,38 @@
|
||||
642 Part V: Index Options and Futures
|
||||
exercise it; or is there too great a chance that OEX will rally and wipe out his dis
|
||||
count?
|
||||
If he buys this put when there is very little time left in the trading day, it might
|
||||
be enough of a discount. Recall that a one-point move in OEX is roughly equivalent
|
||||
to 15 points on the Dow (while a one-point move in SPX is about 7.5 Dow points).
|
||||
Thus, this O EX discount of 0.4 7 is about equal to 7 Dow points. Obviously, this is not
|
||||
a lot of cushion, because the Dow can easily move that far in a short period of time,
|
||||
so it would be sufficient only if there are just a few minutes of trading left and there
|
||||
were not previous indications oflarge orders to buy "market on close."
|
||||
However, if this situation were presented to the discounter at an earlier time in
|
||||
the trading day, he might defer because he would have to hedge his position and that
|
||||
might not be worth the trouble. If there were several hours left in the trading day,
|
||||
even a discount of a full point would not be enough to allow him to remain unhedged
|
||||
(one full OEX point is about 15 Dow points). Rather, he would, for example, buy
|
||||
futures, buy OEX calls, or sell puts on another index. At the end of the day, he could
|
||||
exercise the puts he bought at a discount and reverse the hedge in the open market.
|
||||
CONVERSIONS AND REVERSALS
|
||||
Conversions and reversals in cash-based options are really the market basket hedges
|
||||
(index arbitrage) described in Chapter 30. That is, the underlying security is actually
|
||||
all the stocks in the index. However, the more standard conversions and reversals can
|
||||
be executed with futures and futures options.
|
||||
Since there is no credit to one's account for selling a future and no debit for buy
|
||||
ing one, most futures conversions and reversals trade very nearly at a net price equal
|
||||
to the strike. That is, the value of the out-of-the-money futures option is equal to the
|
||||
time premium of the in-the-money option that is its counterpart in the conversion or
|
||||
reversal.
|
||||
Example: An index future is trading at 179.00. If the December 180 call is trading
|
||||
for 5.00, then the December 180 put should be priced near 6.00. The time value pre
|
||||
mium of the in-the-money put is 5.00 (6.00 + 179.00 - 180.00), which is equal to the
|
||||
price of the out-of-the-money call at the same strike.
|
||||
If one were to attempt to do a conversion or reversal with these options, he
|
||||
would have a position with no risk of loss but no possibility of gain: A reversal would
|
||||
be established, for example, at a "net price" of 180. Sell the future at 179, add the
|
||||
premium of the put, 6.00, and subtract the cost of the call, 5.00: 179 + 6.00 - 5.00 =
|
||||
180.00. As we know from Chapter 27 on arbitrage, one unwinds a conversion or
|
||||
reversal for a "net price" equal to the strike. Hence, there would be no gain or loss
|
||||
from this futures reversal.
|
||||
@@ -0,0 +1,33 @@
|
||||
Finding Mispriced Options • 155
|
||||
can extend indefinitely into the future and that is probably a lot closer to
|
||||
representing actual market expectations for the forward volatility (and, by
|
||||
extension, the range of future prices for a stock). Once we have this BSM
|
||||
cone—with its high-low ranges spelled out for us—we can compare it with
|
||||
the best- and worst-case valuations we derived as part of the company
|
||||
analysis process.
|
||||
Let’s look at this process in the next section, where I spell out, step by
|
||||
step, how to compare an intelligent valuation range with that implied by
|
||||
the option market.
|
||||
Note: Data used for Oracle graphing example:
|
||||
Expiration Date Lower Middle Upper
|
||||
7/25/2013 29.10 31.86 32.75
|
||||
8/16/2013 22.00 32.00 33.50
|
||||
9/20/2013 19.00 32.00 35.00
|
||||
12/20/2013 20.00 32.50 37.00
|
||||
1/17/2014 19.00 32.50 37.20
|
||||
1/16/2015 23.00 32.30 42.00
|
||||
Here I have eyeballed (and sometimes done a quick extrapolation) to try
|
||||
to get the price that is closest to the 84-delta, 50-delta, and 16-delta marks,
|
||||
respectively. Of course, you could calculate these more carefully and get
|
||||
exact numbers, but the point of this is to get a general idea of how likely the
|
||||
market thinks a particular future stock price is going to be.
|
||||
Comparing an Intelligent Valuation
|
||||
Range with a BSM Range
|
||||
The point of this book is to teach you how to be an intelligent option investor
|
||||
and not how to do stochastic calculus or how to program a computer to
|
||||
calculate the BSM. As such, I’m not going to explain how to mathematically
|
||||
derive the BSM cone. Instead, on my website I have an application that will
|
||||
allow you to plug in a few numbers and create a graphic representation of a
|
||||
BSM cone and carry out the comparison process described in this section.
|
||||
The only thing you need to know is what numbers to plug into this web
|
||||
application!
|
||||
@@ -0,0 +1,47 @@
|
||||
271Chapter seventeen: A summary an d concluding comments
|
||||
3. Enable processing of a hitherto unimaginable degree. An unlimited number of stocks
|
||||
may be analyzed. Choosing those to trade with a computer will be dealt with in
|
||||
Chapter 21, Selection of Stocks to Chart.
|
||||
4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no
|
||||
pit traders or locals to fiddle with prices.
|
||||
Advancements in investment technology, part 1:
|
||||
developments in finance theory and practice
|
||||
Numerous pernicious and useless inventions, services, and products litter the internet
|
||||
and the financial industry marketplace; but modern finance theory and technology are
|
||||
important and must be taken into consideration by the general investor. This chapter will
|
||||
explore the minimum the moderately advanced investor needs to know about advances
|
||||
in theory and practice. And it will point the reader to further resources if he desires to
|
||||
continue more advanced study.
|
||||
Instruments of limited (or non) availability during the time of Edwards and Magee
|
||||
included exchange traded options on stocks, futures on averages and indexes, options
|
||||
on futures and indexes, and securitized indexes and averages, as a partial list of only the
|
||||
most important instruments. Undoubtedly, one of the most important developments of
|
||||
the modern era is the creation of trading instruments that allow the investor to trade and
|
||||
hedge the major indexes. Of these, the instruments created by the Chicago Board of Trade
|
||||
(CBOT
|
||||
®) are of singular importance. These are the CBOT® DJIASM Futures and the CBOT®
|
||||
DJIASM Futures Options, which are discussed in greater detail at the end of this chapter.
|
||||
(EN9: Not so singular, perhaps. Probably of greater importance to readers of this book are the AMEX
|
||||
iShares, particularly DIA, SPY, and QQQ, which are instruments (ETFs) that offer the investor
|
||||
direct participation in the major indexes as though they were stocks.)
|
||||
General developments of great importance in finance theory and practice are found in
|
||||
the following sections.
|
||||
Options
|
||||
From the pivotal moment in 1973 when Fischer Black (friend and college classmate) and his
|
||||
partner, Myron Scholes, published their—excuse the usage—paradigm-setting Model, the
|
||||
options and derivatives markets have grown from negligible to trillions of dollars a year.
|
||||
The investor who is not informed about options is playing with half a deck. The subject,
|
||||
however, is beyond the scope of this book, which hopes only to offer some perspective on
|
||||
the subject and guides to the further study necessary for most traders and many investors.
|
||||
Something in the neighborhood of 30% or more of options expire worthless. This is
|
||||
probably the most important fact to know about options. (There is a rule of thumb about
|
||||
options called the 60–30–10 rule: 60% are closed out before expiration, 30% are “long at
|
||||
expiration,” meaning they are worthless, and 10% are exercised.) Another fact to know
|
||||
about options occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on
|
||||
October 16 were worth hundreds of dollars on October 19—if you could get the broker to
|
||||
pick up the telephone and trade them. (The editor had a client at Options Research, Inc.
|
||||
during that time who lost $57 million in three days and almost brought down a major
|
||||
Chicago bank; he had sold too many naked puts.)
|
||||
The most sophisticated and skilled traders in the world make their livings (quite
|
||||
sumptuous livings, thank you) trading options. Educated estimates have been made that
|
||||
as many as 90% of retail options traders lose money. That combined with the fact that by far
|
||||
@@ -0,0 +1,36 @@
|
||||
800 Part VI: Measuring and Trading Volatility
|
||||
of success. If it turns out that volatility is higher during the life of the position, that
|
||||
will be an added benefit to this position consisting of long options. So, in this exam
|
||||
ple, he should use the 20-day historical volatility because it is the lowest of the four
|
||||
choices that he has.
|
||||
Similarly, if one is considering the sale of options or is taking a position with a
|
||||
negative vega ( one that will be harmed if volatility increases), then he should use the
|
||||
highest historical volatility when making his probability projections. By so doing, he
|
||||
is again being conservative. If the strategy in question still looks good, even under an
|
||||
assumption of high volatility, then he can figure that he won't be unpleasantly sur
|
||||
prised by a higher volatility during the life of the position.
|
||||
There have been times when a 100-day lookback period was not sufficient for
|
||||
determining historical volatility. That is, the underlying has been performing in an
|
||||
erratic or unusual manner for over 100 days. In reality, its true nature is not described
|
||||
by its movements over the past 100 days. Some might say that 100 days is not enough
|
||||
time to determine the historical volatility in any case, although most of the time the
|
||||
four volatility measures shown above will be a sufficient guide for volatility.
|
||||
When a longer lookback period is required, there is another method that can be
|
||||
used: Go back in a historical database of prices for the underlying and compute the
|
||||
20-day, 50-day, and l 00-day historic volatilities for all the time periods in the data
|
||||
base, or at least during a fairly large segment of the past prices. Then use the medi
|
||||
an of those calculations for your volatility estimates.
|
||||
Example: XYZ has been behaving erratically for several months, due to overall mar
|
||||
ket volatility being high as well as to a series of chaotic news events that have been
|
||||
affecting XYZ. A trader wants to trade XYZ's options, but needs a good estimate of
|
||||
the "true" volatility potential of XYZ, for he thinks that the news events are out of the
|
||||
way now. At the current time, the historical volatility readings are:
|
||||
20-day historical: 130%
|
||||
50-day historical l 00%
|
||||
100-day historical 80%
|
||||
However, when the trader looks farther back in XYZ's trading history, he sees
|
||||
that it is not normally this volatile. Since he suspects that XYZ's recent trading histo
|
||||
ry is not typical of its true long-term performance, what volatility should he use in
|
||||
either an option model or a probability calculator?
|
||||
Rather than just using the maximum or minimum of the above three numbers
|
||||
(depending on whether one is buying or selling options), the trader decides to look
|
||||
@@ -0,0 +1,40 @@
|
||||
294 Part Ill: Put Option Strategies
|
||||
In either strategy, one needs to be somewhat bullish, or at least neutral, on the
|
||||
underlying stock. If the underlying stock moves upward, the uncovered put writer
|
||||
will make a profit, possibly the entire amount of the premium received. If the under
|
||||
lying stock should be unchanged at expiration - a neutral situation - the put writer
|
||||
will profit by the amount of the time value premium received when he initially wrote
|
||||
the put. This could represent the maximum profit if the put was out-of-the-money
|
||||
initially, since that would mean that the entire put premium was composed of time
|
||||
value premium. For an in-the-money put, however, the time value premium would
|
||||
represent something less than the entire value of the option. These are similar qual
|
||||
ities to those inherent in covered call writing. If the stock moves up, the covered call
|
||||
writer can make his maximum profit. However, if the stock is unchanged at expira
|
||||
tion, he will make his maximum profit only if the stock is above the call's striking
|
||||
price. So, in either strategy, if the position is established with the stock above the
|
||||
striking price, there is a greater probability of achieving the maximum profit. This
|
||||
represents the less aggressive application: writing an out-of-the-money put initially,
|
||||
which is equivalent to the covered write of an in-the-money call.
|
||||
The more aggressive application of naked put writing is to write an in-the
|
||||
money put initially. The writer will receive a larger amount of premium dollars for
|
||||
the in-the-money put and, if the underlying stock advances far enough, he will thus
|
||||
make a large profit. By increasing his profit potential in this manner, he assumes
|
||||
more risk. If the underlying stock should fall, the in-the-money put writer will lose
|
||||
money more quickly than one who initially wrote an out-of-the-money put. Again,
|
||||
these facts were demonstrated much earlier with covered call writing. An in-the
|
||||
money covered call write affords more downside protection but less profit potential
|
||||
than does an out-of-the-money covered call write.
|
||||
It is fairly easy to summarize all of this by noting that in either the naked put
|
||||
writing strategy or the covered call writing strategy, a less aggressive position is estab
|
||||
lished when the stock is higher than the striking price of the written option. If the
|
||||
stock is below the striking price initially, a more aggressive position is created.
|
||||
There are, of course, some basic differences between covered call writing and
|
||||
naked put writing. First, the naked put write will generally require a smaller invest
|
||||
ment, since one is only collateralizing 20% of the stock price plus the put premium,
|
||||
as opposed to 50% for the covered call write on margin. Also, the naked put writer is
|
||||
not actually investing cash; collateral is used, so he may finance his naked put writing
|
||||
through the value of his present portfolio, whether it be stocks, bonds, or government
|
||||
securities. However, any losses would create a debit and might therefore cause him
|
||||
to disturb a portion of this portfolio. It should be pointed out that one can, ifhe wish
|
||||
es, write naked puts in a cash account by depositing cash or cash equivalents equal to
|
||||
the striking price of the put. This is called "cash-based put writing." The covered call
|
||||
@@ -0,0 +1,36 @@
|
||||
888 Part VI: Measuring and Trading Vo/atillty
|
||||
Stock
|
||||
Price P&L Delta Gamma Theta Vega
|
||||
54.46 1905 - 7.40 1.62 0.94 - 1.57
|
||||
55.79 1077 - 4.90 2.07 1.18 - 1.96
|
||||
57.16 606 1.97 2.13 1.53 - 2.90
|
||||
58.56 528 0.74 1.65 2.00 -4.62
|
||||
60.00 771 2.38 0.56 2.63 -7.22
|
||||
61.47 1127 2.07 - 1.01 3.38 -10.63
|
||||
62.98 1252 - 0.87 - 2.85 4.22 -14.56
|
||||
64.52 702 - 6.73 - 4.67 5.07 -18.61
|
||||
66.11 - 1019 -15.42 - 6.21 5.85 -22.31
|
||||
In a similar manner, the position would have the following characteristics after
|
||||
14 days had passed:
|
||||
Stock
|
||||
Price P&L Delto Gamma Theta Vega
|
||||
52.31 4221 - 9.10 0.69 0.55 - 0.98
|
||||
54.14 2731 - 6.93 1.69 0.75 - 0.89
|
||||
56.02 1782 - 2.87 2.51 1.06 - 1.21
|
||||
57.98 1717 2.17 2.44 1.61 - 2.69
|
||||
60.00 2577 5.85 1.00 2.51 -6.00
|
||||
62.09 3839 5.29 - 1.63 3.73 -11.05
|
||||
64.26 4361 - 1.55 - 4.61 5.09 -16.90
|
||||
66.50 2631 -14.80 - 7.02 6.31 -22.17
|
||||
68.82 - 2799 -32.83 - 8.32 7.18 -25.72
|
||||
The same information will be presented graphically in Figure 40-13 so that
|
||||
those who prefer pictures instead of columns of numbers can follow the discussions
|
||||
easily.
|
||||
First, the profitability of the spread can be examined. This profit picture
|
||||
assumes that the volatility of XYZ remains unchanged. Note that in 7 days, there is a
|
||||
small profit if the stock remains unchanged. This is to be expected, since theta was
|
||||
positive, and therefore time is working in favor of this spread. Likewise, in 14 days,
|
||||
there is an even bigger profit if XYZ remains relatively unchanged - again due to the
|
||||
positive theta. Overall, there is an expected profit of $800 in 7 days, or $2,600 in 14
|
||||
days, from this position. This indicates that it is an attractive situation statistically, but,
|
||||
of course, it does not mean that one cannot lose money.
|
||||
@@ -0,0 +1,36 @@
|
||||
88 Part II: Call Option Strategies
|
||||
return concept - is described that has great appeal to large stockholders, both indi
|
||||
viduals and institutions.
|
||||
COVERED WRITING AGAINST A CONVERTIBLE SECURITY
|
||||
It may be more advantageous to buy a security that is convertible into common stock
|
||||
than to buy the stock itself, for covered call writing purposes. Convertible bonds and
|
||||
convertible preferred stocks are securities commonly used for this purpose. One
|
||||
advantage of using the convertible security is that it often has a higher yield than does
|
||||
the common stock itself.
|
||||
Before describing the covered write, it may be beneficial to review the basics of
|
||||
convertible securities. Suppose XYZ common stock has an XYZ convertible Preferred
|
||||
A stock that is convertible into 1.5 shares of common. The number of shares of com
|
||||
mon that the convertible security converts into is an important piece of information
|
||||
that the writer must know. It can be found in a Standard & Poor's Stock Guide (or
|
||||
Bond Guide, in the case of convertible bonds).
|
||||
The writer also needs to determine how many shares of the convertible securi
|
||||
ty must be owned in order to equal 100 shares of the common stock. This is quickly
|
||||
determined by dividing 100 by the conversion ratio - 1.5 in our XYZ example. Since
|
||||
100 divided by 1.5 equals 66.666, one must own 67 shares of XYZ cv Pfd A to cover
|
||||
the sale of one XYZ option for 100 shares of common. Note that neither the market
|
||||
prices of XYZ common nor the convertible security are necessary for this computa
|
||||
tion.
|
||||
When using a convertible bond, the conversion information is usually stated in
|
||||
a form such as, "converts into 50 shares at a price of 20." The price is irrelevant. What
|
||||
is important is the number of shares that the bond converts into - 50 in this case.
|
||||
Thus, if one were using these bonds for covered writing of one call, he would need
|
||||
two (2,000) bonds to own the equivalent of 100 shares of stock.
|
||||
Once one knows how much of the convertible security must be purchased, he
|
||||
can use the actual prices of the securities, and their yields, to determine whether a
|
||||
covered write against the common or the convertible is more attractive.
|
||||
Example: The following information is known:
|
||||
XYZ common, 50;
|
||||
XYZ CV Pfd A, 80;
|
||||
XYZ July 50 call, 5;
|
||||
XYZ dividend, 1.00 per share annually; and
|
||||
XYZ cv Pfd A dividend, 5.00 per share annually.
|
||||
@@ -0,0 +1,32 @@
|
||||
the time value of the option. The time value reflects the possibility that
|
||||
exercise will become more profitable if the futures price moves farther
|
||||
away from the strike price. Generally, the more time until expiration, the
|
||||
greater the time value of the option because the likelihood of the option
|
||||
becoming profitable to exercise is greater. At expiration, the time value is
|
||||
zero and the option price equals the intrinsic value.
|
||||
Volatility
|
||||
The degree of fluctuation in the price of the underlying futures contract is
|
||||
known as “volatility” (see Appendix B, Resources, for the formula). The
|
||||
greater the volatility of the futures, the higher the option premium. The
|
||||
price of a futures option is a function of the futures price, the strike price,
|
||||
the time left to expiration, the money market rate, and the volatility of the
|
||||
futures price. Of these variables, volatility is the only one that cannot be
|
||||
observed directly. Considering all the other variables are known, however, it
|
||||
is possible to infer from option prices an estimate of how the market is
|
||||
gauging volatility. This estimate is called the “implied volatility” of the
|
||||
option. It measures the market's average expectation of what the volatility
|
||||
of the underlying futures return will be until the expiration of the option.
|
||||
Implied volatility is usually expressed in annualized terms. The significance
|
||||
and use of implied volatility is potentially complex and confusing for the
|
||||
general investor, professionals having a decided edge in this area. Their
|
||||
edge can be removed by serious study.
|
||||
Exercising the option
|
||||
At expiration, the rules of optimal exercise are clear. The call owner should
|
||||
exercise the option if the strike price is less than the underlying futures
|
||||
price. The value of the exercised call is the difference between the futures
|
||||
price and the strike price. Conversely, the put owner should exercise the
|
||||
option if the strike price is greater than the futures price. The value of the
|
||||
exercised put is the difference between the strike price and the futures price.
|
||||
To illustrate, if the price of the expiring futures contract is 7,600, a call
|
||||
struck at 7,500 should be exercised, but a put at the same or lower strike
|
||||
price should not. The value of the exercised call is $1,000. The value of the
|
||||
@@ -0,0 +1,35 @@
|
||||
766 Part VI: Measuring and Trading Volatility
|
||||
(2) Put TVP = Put price - Strike price + Stock price
|
||||
The arbitrage equation, (1), can be rewritten as:
|
||||
(3) Put price - Strike price+ Stock price= Call price+ Dividends - Carrying cost
|
||||
and substituting equation (2) for the terms in equation (3), one arrives at:
|
||||
( 4) Put TVP = Call price + Dividends - Carrying cost
|
||||
In other words, the time value premium of an in-the-money put is the same as the
|
||||
(out-of-the-money) call price, plus any dividends to be ea med until expiration, less
|
||||
any carrying costs over that same time period.
|
||||
Assuming that the dividend is small or zero (as it is for most stocks), one can see
|
||||
that an in-the-money put would lose its time value premium whenever carrying costs
|
||||
exceed the value of the out-of-the-money call. Since these carrying costs can be rel
|
||||
atively large ( the carrying cost is the interest being paid on the entire debit of the
|
||||
position - and that debit is approximately equal to the strike price), they can quickly
|
||||
dominate the price of an out-of-the-money call. Hence, the time value premium of
|
||||
an in-the-money put disappears rather quickly.
|
||||
This is important information for put option buyers, because they must under
|
||||
stand that a put won't appreciate in value as much as one might expect, even when
|
||||
the stock drops, since the put loses its time value premium quickly. It's even more
|
||||
important information for put sellers: A short put is at risk of assignment as soon as
|
||||
there is no time value premium left in the put. Thus, a put can be assigned well in
|
||||
advance of expiration even a LEAPS put!
|
||||
Now, returning to the main topic of how implied volatility affects a position, one
|
||||
can ask himself how an increase or decrease in implied volatility would affect equa
|
||||
tion ( 4) above. If implied volatility increases, the call price would increase, and if the
|
||||
increase were great enough, might impart some time value premium to the put.
|
||||
Hence, an increase in implied volatility also may increase the price of a put, but if the
|
||||
put is too far in-the-nwney, a modest increase in implied volatility still won't budge
|
||||
the put. That is, an increase in implied volatility would increase the value of the call,
|
||||
but until it increases enough to be greater than the carrying costs, an in-the-money
|
||||
put will remain at parity, and thus a short put would still remain at risk of assignment.
|
||||
STRADDLE OR STRANGLE BUYING AND SELLING
|
||||
Since owning a straddle involves owning both a put and a call with the same terms,
|
||||
it is fairly evident that an increase in implied volatility will be very beneficial for a
|
||||
straddle buyer. A sort of double benefit occurs if implied volatility rises, for it will
|
||||
@@ -0,0 +1,79 @@
|
||||
CHAPTER 17
|
||||
Putting the Greeks into Action
|
||||
This book was intended to arm the reader with the knowledge of the greeks needed to make better trading decisions. As the preface stated, this book is not so much a how-to guide as a how-come tutorial. It is step one in a three-step learning process:
|
||||
Step One: Study
|
||||
. First, aspiring option traders must learn as much as possible from books such as this one and from other sources, such as articles, both in print and online, and from classes both in person and online. After completing this book, the reader should have a solid base of knowledge of the greeks.
|
||||
Step Two: Paper Trade
|
||||
. A truly deep understanding requires practice, practice, and more practice! Fortunately, much of this practice can be done without having real money on the line. Paper trading—or simulated trading—in which one trades real markets but with fake money is step two in the learning process. I highly recommend paper trading to kick the tires on various types of strategies and to see how they might work differently in reality than you thought they would in theory.
|
||||
Step Three: Showtime
|
||||
! Even the most comprehensive academic study or windfall success with paper profits doesn’t give one a true feel for how options work in the real world. There are some lessons that must be learned from the black and the blue. When there’s real money on the line, you will trade differently—at least in the beginning. It’s human nature to be cautious with wealth. This is not a bad thing. But emotions should not override sound judgment. Start small—one or two lots per trade—until you can make rational decisions based on what you have learned, keeping emotions in check.
|
||||
This simple three-step process can take years of diligent work to get it right. But relax. Getting rich quick is truly a poor motivation for trading options. Option trading is a beautiful thing! It’s about winning. It’s about beating the market. It’s about being smart. Don’t get me wrong—wealth can be a nice by-product. I’ve seen many people who have made a lot of money trading options, but it takes hard work. For every successful option trader I’ve met, I’ve met many more who weren’t willing to put in the effort, who brashly thought this is easy, and failed miserably.
|
||||
Trading Option Greeks
|
||||
Traders must take into account all their collective knowledge and experience with each and every trade. Now that you’re armed with knowledge of the greeks, use it! The greeks come in handy in many ways.
|
||||
Choosing between Strategies
|
||||
A very important use of the greeks is found in selecting the best strategy for a given situation. Consider a simple bullish thesis on a stock. There are plenty of bullish option strategies. But given a bullish forecast, which option strategy should a trader choose? The answer is specific to each unique opportunity. Trading is situational.
|
||||
Example 1
|
||||
Imagine a trader, Arlo, is studying the following chart of Agilent Technologies Inc. (A). See
|
||||
Exhibit 17.1
|
||||
.
|
||||
EXHIBIT 17.1
|
||||
Agilent Technologies Inc. daily candles.
|
||||
Source
|
||||
: Chart courtesy of Livevol
|
||||
®
|
||||
Pro (
|
||||
www.livevol.com
|
||||
)
|
||||
The stock has been in an uptrend for six weeks or so. Close-to-close volatility hasn’t increased much. But intraday volatility has increased greatly as indicated by the larger candles over the past 10 or so trading sessions. Earnings is coming up in a week in this example, however implied volatility has not risen much. It is still “cheap” relative to historical volatility and past implied volatility. Arlo is bullish. But how does he play it? He needs to use what he knows about the greeks to guide his decision.
|
||||
Arlo doesn’t want to hold the trade through earnings, so it will be a short-term trade. Thus, theta is not much of a concern. The low-priced volatility guides his strategy selection in terms of vega. Arlo certainly wouldn’t want a short-vega trade. Not with the prospect of implied volatility potential rising going into earnings. In fact, he’d actually want a big positive vega position. That rules out a naked/cash-secured put, put credit spread and the likes.
|
||||
He can probably rule out vertical spreads all together. He doesn’t need to spread off theta. He doesn’t want to spread off vega. Positive gamma is attractive for this sort of trade. He wouldn’t want to spread that off either. Plus, the inherent time component of spreads won’t work well here. As discussed in Chapter 9, the bulk of vertical spreads profits (or losses) take time to come to fruition. The deltas of a call spread are smaller than an outright call. Profits would come from both delta and theta, if the stock rises to the short strike and positive theta kicks in.
|
||||
The best way for Arlo to play this opportunity is by buying a call. It gives him all the greeks attributes he wants (comparatively big positive delta, gamma and vega) and the detriment (negative theta) is not a major issue.
|
||||
He’d then select among in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) calls and the various available expiration cycles. In this case, because positive gamma is attractive and theta is not an issue, he’d lean toward a front month (in this case, three week) option. The front month also benefits him in terms of vega. Though the vegas are smaller for short-term options, if there is a rise in implied volatility leading up to earnings, the front month will likely rise much more than the rest. Thus, the trader has a possibility for profits from vega.
|
||||
Example 2
|
||||
A trader, Luke, is studying the following chart for United States Steel Corp. (X). See
|
||||
Exhibit 17.2
|
||||
.
|
||||
EXHIBIT 17.2
|
||||
United States Steel Corp. daily candles.
|
||||
Source
|
||||
: Chart courtesy of Livevol
|
||||
®
|
||||
Pro (
|
||||
www.livevol.com
|
||||
)
|
||||
This stock is in a steady uptrend, which Luke thinks will continue. Earnings are out and there are no other expected volatility events on the horizon. Luke thinks that over the next few weeks, United States Steel can go from its current price of around $31 a share to about $34. Volatility is midpriced in this example—not cheap, not expensive.
|
||||
This scenario is different than the previous one. Luke plans to potentially hold this trade for a few weeks. So, for Luke, theta is an important concern. He cares somewhat about volatility, too. He doesn’t necessarily want to be long it in case it falls; he doesn’t want to be short it in case it rises. He’d like to spread it off; the lower the vega, the better (positive or negative). Luke really just wants delta play that he can hold for a few weeks without all the other greeks getting in the way.
|
||||
For this trade, Luke would likely want to trade a debit call spread with the long call somewhat ITM and the short call at the $34 strike. This way, Luke can start off with nearly no theta or vega. He’ll retain some delta, which will enable the spread to profit if United States Steel rises and as it approaches the 34 strike, positive theta will kick in.
|
||||
This spread is superior to a pure long call because of its optimized greeks. It’s superior to an OTM bull put spread in its vega position and will likely produce a higher profit with the strikes structured as such too, as it would have a bigger delta.
|
||||
Integrating greeks into the process of selecting an option strategy must come natural to a trader. For any given scenario, there is one position that best exploits the opportunity. In any option position, traders need to find the optimal greeks position.
|
||||
Managing Trades
|
||||
Once the trade is on, the greeks come in handy for trade management. The most important rule of trading is
|
||||
Know Thy Risk
|
||||
. Knowing your risk means knowing the influences that expose your position to profit or peril in both absolute and incremental terms. At-expiration diagrams reveal, in no uncertain terms, what the bottom-line risk points are when the option expires. These tools are especially helpful with simple short-option strategies and some long-option strategies. Then traders need the greeks. After all, that’s what greeks are: measurements of option risk. The greeks give insight into a trade’s exposure to the other pricing factors. Traders must know the greeks of every trade they make. And they must always know the net-portfolio greeks at all times. These pricing factors ultimately determine the success or failure of each trade, each portfolio, and eventually each trader.
|
||||
Furthermore, always—and I do mean always—traders must know their up and down risk, that is, the directional risk of the market moving up or down certain benchmark intervals. By definition, moves of three standard deviations or more are very infrequent. But they happen. In this business anything can happen. Take the “flash crash of 2010 in which the Dow Jones Industrial Average plunged more than 1,000 points in “a flash.” In my trading career, I’ve seen some surprises. Traders have to plan for the worst.
|
||||
It’s not too hard to tell your significant other, “Sorry I’m late, but I hit unexpected traffic. I just couldn’t plan for it.” But to say, “Sorry, I lost our life savings, and the kids’ college fund, and our house because the market made an unexpected move. I couldn’t plan for it,” won’t go over so well. The fact is, you
|
||||
can
|
||||
plan for it. And as an option trader, you have to. The bottom line is, expect the unexpected because the unexpected will sometimes happen. Traders must use the greeks and up and down risk, instead of relying on other common indicators, such as the HAPI.
|
||||
The HAPI: The Hope and Pray Index
|
||||
So you bought a call spread. At the opening bell the next morning, you find that the market for the underlying has moved lower—a lot lower. You have a loss on your hands. What do you do? Keep a positive attitude? Wear your lucky shirt? Pray to the options gods? When traders finds themselves hoping and praying—I swear I’ll never do that again if I can just get out of this position!—it is probably time for them to take their losses and move on to the next trade. The Hope and Pray Index is a contraindicator. Typically, the higher it is, the worse the trade.
|
||||
There are two numbers a trader can control: the entry price and the exit price. All of the other flashing green and red numbers on the screen are out of the trader’s control. Savvy traders observe what the market does and make decisions on whether and when to enter a position and when to exit. Traders who think about their positions in terms of probability make better decisions at both of these critical moments.
|
||||
In entering a trade, traders must consider their forecast, their assessment of the statistical likelihood of success, the potential payout and loss, and their own tolerance for risk. Having considered these criteria helps the traders stay the course and avoid knee-jerk reactions when the market moves in the wrong direction. Trading is easy when positions make money. It is how traders deal with adverse positions that separates good traders from bad.
|
||||
Good traders are good at losing money. They take losses quickly and let profits run. Accepting, before entering the trade, the statistical nature of trading can help traders trade their positions with less emotion. It then becomes a matter of competent management of those positions based on their knowledge of the factors affecting option values: the greeks. Learning to think in terms of probability is among the most difficult challenges for a new options trader.
|
||||
Chapter 5 discussed my Would I Do It Now? Rule, in which a trader asks himself: if I didn’t currently have this position, would I put it on now at current market prices? This rule is a handy technique to help traders filter out the noise in their heads that clouds judgment and to help them to make rational decisions on whether to hold a position, close it out or adjust it.
|
||||
Adjusting
|
||||
Sometimes the position a trader starts off with is not the position he or she should have at present. Sometimes positions need to be changed, or adjusted, to reflect current market conditions. Adjusting is very important to option traders. To be good at adjusting, traders need to use the greeks.
|
||||
Imagine a trader makes the following trade in Halliburton Company (HAL) when the stock is trading $36.85.
|
||||
Sell 10 February 35–36–38–39 iron condors at 0.45
|
||||
February has 10 days until expiration in this example. The greeks for this trade are as follows:
|
||||
Delta: −6.80
|
||||
Gamma: −119.20
|
||||
Theta: +21.90
|
||||
Vega: −12.82
|
||||
The trader has a neutral outlook, which can be inferred by the near-flat delta. But what if the underlying stock begins to rise? Gamma starts kicking in. The trader can end up with a short-biased delta that loses exponentially if the stock continues to climb. If Halliburton rises (or falls for that matter) the trader needs to recalibrate his outlook. Surely, if the trader becomes bullish based on recent market activity, he’d want to close the trade. If the trader is bearish, he’d probably let the negative delta go in hopes of making back what was lost from negative gamma. But what if the trader is still neutral?
|
||||
A neutral trader needs a position that has greeks which reflect that outlook. The trader would want to get delta back towards zero. Further, depending on how much the stock rises, theta could start to lose its benefit. If Halliburton approaches one of the long strikes, theta could move toward zero, negating the benefit of this sort of trade all together. If after the stock rises, the trader is still neutral at the new underlying price level, he’d likely adjust to get delta and theta back to desired territory.
|
||||
A common adjustment in this scenario is to roll the call-credit-spread legs of the iron condor up to higher strikes. The trader would buy ten 38 calls and sell ten 39 calls to close the credit spread. Then the trader would buy 10 of the 39 calls as sell 10 of the 40 calls to establish an adjusted position that is short a 10 lot of the February 35–36–39–40 iron condor.
|
||||
This, of course, is just one possible adjustment a trader can make. But the common theme among all adjustments is that the trader’s greeks must reflect the trader’s outlook. The position greeks best describe what the position is—that is, how it profits or loses. When the market changes it affects the dynamic greeks of a position. If the market changes enough to make a trader’s position greeks no longer represent his outlook, the trader must adjust the position (adjust the greeks) to put it back in line with expectations.
|
||||
In option trading there are an infinite number of uses for the greeks. From finding trades, to planning execution, to managing and adjusting them, to planning exits; the greeks are truly a trader’s best resource. They help traders see potential and actual position risk. They help traders project potential and actual trade profitability too. Without the greeks, a trader is at a disadvantage in every aspect of option trading. Use the greeks on each and every trade, and exploit trades to their greatest potential.
|
||||
I wish you good luck
|
||||
!
|
||||
For me, trading option greeks has been a labor of love through the good trades and the bad. To succeed in the long run at greeks trading—or any endeavor, for that matter—requires enjoying the process. Trading option greeks can be both challenging and rewarding. And remember, although option trading is highly statistical and intellectual in nature, a little luck never hurt! That said, good luck trading!
|
||||
@@ -0,0 +1,41 @@
|
||||
780 Part VI: Measuring and Trading Volatility
|
||||
A common mistake that calendar spreaders make is to think that such a spread
|
||||
looks overly attractive on a very volatile stock. Consider the same stock as above, still
|
||||
trading at 100, but for some reason implied volatility has skyrocketed to 80% (per
|
||||
haps a takeover rumor is present).
|
||||
Stock: JOO
|
||||
Implied Volatility: 80%
|
||||
Coll
|
||||
May 100 call
|
||||
June 100 call
|
||||
Theoretical Value
|
||||
12.55
|
||||
16.81
|
||||
On the surface, this seems like a very attractive spread. There are two months
|
||||
of life remaining in the May options (and three months in the Junes) and the spread
|
||||
is trading at 4.36. However, both options are completely composed of time value
|
||||
premium, and most certainly the June 100 call would be worth far more than 4.36
|
||||
when the May expires, if the stock is still near 100. The fact that many traders miss
|
||||
when they think of the calendar spread this way is that the June call will only be
|
||||
worth "far more than 4.36" if implied volatility holds up. If implied volatility for this
|
||||
stock is normally something on the order of 40%, say, then it is probably not reason
|
||||
able to expect that the 80% level will hold up. Just for comparison, note that if the
|
||||
stock is at 100 at May expiration - the maximum profit potential for such a calendar
|
||||
spread - the June 100 call, with implied volatility now at 40%, and with one month
|
||||
of life remaining, would be worth only 4. 77. Thus the spread would only have made
|
||||
a profit of a few cents (4.36 to 4.77), and if the underlying stock were farther from
|
||||
the strike price at expiration, there would probably be a loss rather than a profit.
|
||||
The point to be remembered is that a calendar spread is a "long volatility" play
|
||||
(and a reverse calendar spread is just the opposite). Evaluate the position's risk with
|
||||
an eye to what might happen to implied volatility, and not just to where the stock
|
||||
price might go or how much time decay there might be in the position.
|
||||
RATIO SPREADS AND BACKSPREADS
|
||||
The previous descriptions in this chapter describe fairly fully and accurately what
|
||||
the effect of volatility changes are. More complicated strategies are usually nothing
|
||||
more than combinations of the strategies presented earlier, so it is easy to discern
|
||||
the effect that changes in implied volatility would have; just combine the effects on
|
||||
the simpler strategies. For example, a ratio call write is really just the equivalent of
|
||||
a straddle sale - a strategy whose volatility ramifications are fairly simple to under
|
||||
stand.
|
||||
Ratio spreads, on the other hand, might not be as intuitive to interpret, but they
|
||||
are fairly simple nonetheless. A call ratio spread is really just the combination of some
|
||||
@@ -0,0 +1,38 @@
|
||||
926 Part VI: Measuring and Trading Volatillty
|
||||
in-the-money put for this purpose. By so doing, he would be spending as little as pos
|
||||
sible in the way of time value premium for the put option and he would also be lock
|
||||
ing in his gain on the call. The gains and losses from the put and call combination
|
||||
would nearly equal each other from that time forward as the stock moves up or down,
|
||||
unless the stock rallies strongly, thereby exceeding the striking price of the put. This
|
||||
would be a happy event, however, since even larger gains would accrue. The combi
|
||||
nation could be liquidated in the following tax year, thus achieving a gain.
|
||||
Example: On September 1st, an investor bought an XYZ January 40 call for 3 points.
|
||||
The call is due to expire in the following year. XYZ has risen in price by December
|
||||
1st, and the call is selling for 6 points. The call holder might want to take his 3-point
|
||||
gain on the call, but would also like to defer that gain until the following year. He
|
||||
might be able to do this by buying an XYZ January 50 put for 5 points, for example.
|
||||
He would then hold this combination until after the first of the new year. At that
|
||||
time, he could liquidate the entire combination for at least 10 points, since the strik
|
||||
ing price of the put is 10 points greater than that of the call. In fact, if the stock should
|
||||
have climbed to or above 50 by the first of the year, or should have fallen to or below
|
||||
40 by the first of the year, he would be able to liquidate the combination for more
|
||||
than 10 points. The increase in time value premium at either strike would also be a
|
||||
benefit. In any case, he would have a gain - his original cost was 8 points (3 for the
|
||||
call and 5 for the put). Thus, he has effectively deferred taking the gain on the orig
|
||||
inal call holding until the next tax year. The risk that the call holder incurs in this type
|
||||
of transaction is the increased commission charges of buying and selling the put as
|
||||
well as the possible loss of any time value premium in the put itself. The investor
|
||||
must decide for himself whether these risks, although they may be relatively small,
|
||||
outweigh the potential benefit from deferring his tax gain into the next year.
|
||||
Another way in which the call holder might be able to defer his tax gain into the
|
||||
next year would be to sell another XYZ call against the one that he currently holds.
|
||||
That is, he would create a spread. To assure that he retains as much of his current
|
||||
gain as possible, he should sell an in-the-money call. In fact, he should sell an in-the
|
||||
money call with a lower striking price than the call held long, if possible, to ensure
|
||||
that his gain remains intact even if the underlying stock should collapse substantial
|
||||
ly. Once the spread has been established, it could be held until the following tax year
|
||||
before being liquidated. The obvious risk in this means of deferring gain is that one
|
||||
could receive an assignment notice on the short call. This is not a remote possibility,
|
||||
necessarily, since an in-the-money call should be used as protection for the current
|
||||
gain. Such an assignment would result in large commission costs on the resultant pur
|
||||
chase and sale of the underlying stock, and could substantially reduce one's gain.
|
||||
@@ -0,0 +1,49 @@
|
||||
704
|
||||
TABLE 35-3.
|
||||
Profit and loss of crack spread.
|
||||
Contract
|
||||
2 March Crude
|
||||
1 March Unleaded
|
||||
1 March Heating Oil
|
||||
Net Profit (before commissions)
|
||||
Initial
|
||||
Price
|
||||
18.00
|
||||
.6000
|
||||
.5500
|
||||
Part V: Index Options and Futures
|
||||
Subsequent
|
||||
Price
|
||||
18.50
|
||||
.6075
|
||||
.5575
|
||||
Gain in
|
||||
Dollars
|
||||
+ $1,000
|
||||
- $ 315
|
||||
- $ 315
|
||||
+ $ 370
|
||||
One can calculate that the crack spread at the new prices has shrunk to 5.965.
|
||||
Thus, the spreader was correct in predicting that the spread would narrow, and he
|
||||
profited.
|
||||
Margin requirements are also favorable for this type of spread, generally being
|
||||
slightly less than the speculative requirement for two contracts of crude oil.
|
||||
The above examples demonstrate some of the various intermarket spreads that
|
||||
are heavily watched and traded by futures spreaders. They often provide some of the
|
||||
most reliable profit situations without requiring one to predict the actual direction of
|
||||
the market itself. Only the differential of the spread is important.
|
||||
One should not assume that all intermarket spreads receive favorable margin
|
||||
treatment. Only those that have traditional relationships do.
|
||||
USING FUTURES OPTIONS IN FUTURES SPREADS
|
||||
After viewing the above examples, one can see that futures spreads are not the same
|
||||
as what we typically know as option spreads. However, option contracts may be use
|
||||
ful in futures spreading strategies. They can often provide an additional measure of
|
||||
profit potential for very little additional risk. This is true for both intramarket and
|
||||
intermarket spreads.
|
||||
The futures option calendar spread is discussed first. The calendar spread with
|
||||
futures options is not the same as the calendar spread with stock or index options. In
|
||||
fact, it may best be viewed as an alternative to the intramarket futures spread rather
|
||||
than as an option spread strategy.
|
||||
CALENDAR SPREADS
|
||||
A calendar spread with futures options would still be constructed in the familiar
|
||||
manner - buy the May call, sell the March call with the same striking price. However,
|
||||
@@ -0,0 +1,22 @@
|
||||
Gaining Exposure • 189
|
||||
Long Call
|
||||
GREEN
|
||||
Downside: Fairly priced
|
||||
Upside: Undervalued
|
||||
Execute: Buy a call option
|
||||
Risk: Amount equal to premium paid
|
||||
Reward: Unlimited less amount of premium paid
|
||||
The Gist
|
||||
An investor uses this strategy when he or she believes that there is a material
|
||||
chance that the value of a company is much higher than the present market price.
|
||||
The investor must pay a premium to initiate the position, and the proportion of
|
||||
the premium that represents time value should be recognized as a realized loss
|
||||
because it cannot be recovered. If the stock fails to move into the area of exposure
|
||||
before option expiration, there will be no profit to offset this realized loss.
|
||||
In economic terms, this transaction allows an investor to go long an
|
||||
undervalued company without accepting an uncertain risk of loss if the
|
||||
stock falls. Instead of the uncertain risk of loss, one must pay the fixed pre-
|
||||
mium. This strategy obeys the same rules of leverage as discussed earlier
|
||||
in this book, with in-the-money (ITM) call options offering less leverage
|
||||
but being much more forgiving regarding timing than are at-the-money
|
||||
(ATM) or especially out-of-the-money (OTM) options.
|
||||
@@ -0,0 +1,36 @@
|
||||
252 Part Ill: Put Option Strategies
|
||||
Dividend payment dates may also have an effect on the frequency of assign
|
||||
ment. For call options, the writer might expect to receive an assignment on the day
|
||||
the stock goes ex-dividend. The holder of the call is able to collect the dividend by
|
||||
so exercising. Things are slightly different for the writer of puts. He might expect
|
||||
to receive an assignment on the day after the ex-dividend date of the underlying
|
||||
stock. Since the writer of the put is obligated to buy stock, it is unlikely that any
|
||||
one would put the stock to him until after the dividend has been paid. In any case,
|
||||
the writer of the put can use a relatively simple gauge to anticipate assignment near
|
||||
the ex-dividend date. If the time value premium of an in-the-money put is less than
|
||||
the amount of the dividend to be paid, the writer may often anticipate that he will
|
||||
be assigned immediately after the ex-dividend of the stock. An example will show
|
||||
why this is true.
|
||||
Example: XYZ is at 45 and it will pay a $.50 dividend. Furthermore, the XYZ July 50
|
||||
put is selling at 5¼. Note that the time value premium of the July 50 put is ¼ point
|
||||
- less than the amount of the dividend, which is ½ point. An arbitrageur could take
|
||||
the following actions:
|
||||
1. Buy XYZ at 45.
|
||||
2. Buy the July 50 put at 5¼.
|
||||
3. Collect the ½-point dividend (he must hold the stock until the ex-date to collect
|
||||
the dividend).
|
||||
4. Exercise his put to sell XYZ at 50 ( writer would receive assignment on the day
|
||||
after the ex-date).
|
||||
The arbitrageur makes 5 points on the stock trades, buying XYZ at 45 and selling it
|
||||
at 50 via exercise of the put. He also collects the ½-point dividend, making his total
|
||||
intake equal to 5½ points. He loses the 5¼ points that he paid for the put but still
|
||||
has a net profit of ¼ point. Thus, as the ex-dividend date of a stock approaches, the
|
||||
time value premium of all in-the-money puts on that stock will tend to equal or exceed
|
||||
the amount of the dividend payment.
|
||||
This is quite different from the call option. It was shown in Chapter 1 that the
|
||||
call writer only needs to observe whether the call was trading at or below parity,
|
||||
regardless of the amount of the dividend, as the ex-dividend date approaches. The
|
||||
put writer must determine if the time value premium of the put exceeds the amount
|
||||
of the dividend to be paid. If it does, there is a much smaller chance of assignment
|
||||
because of the dividend. In any case, the put writer can anticipate the assignment if
|
||||
he carefully monitors his position.
|
||||
@@ -0,0 +1,35 @@
|
||||
158 Part II: Call Option Strategies
|
||||
FOLLOW-UP ACTION
|
||||
Aside from closing the position completely, there are three reasonable approaches to
|
||||
follow-up action in a ratio writing situation. The first, and most popular, is to roll the
|
||||
written calls up if the stock rises too far, or to roll down if the stock drops too far. A
|
||||
second method uses the delta of the written calls. The third follow-up method is to
|
||||
utilize stops on the underlying stock to alter the ratio of the position as the stock
|
||||
moves either up or down. In addition to these types of defensive follow-up action, the
|
||||
investor must also have a plan in mind for taking profits as the written calls approach
|
||||
expiration. These types of follow-up action are discussed separately.
|
||||
ROLLING UP OR DOWN AS A DEFENSIVE ACTION
|
||||
The reader should already be familiar with the definition of a rolling action: The cur
|
||||
rently written calls are bought back and calls at a different striking price are written.
|
||||
The ratio writer can use rolling actions to his advantage to readjust his position if the
|
||||
underlying stock moves to the edges of his profit range.
|
||||
The reason one of the selection criteria for a ratio write was the availability of
|
||||
both the next higher and next lower striking prices was to facilitate the rolling actions
|
||||
that might become necessary as a follow-up measure. Since an option has its great
|
||||
est time premium when the stock price and the striking price are the same, one
|
||||
would normally want to roll exactly at a striking price.
|
||||
Example: A ratio writer bought 100 XYZ at 49 and sold two October 50 calls at 6
|
||||
points each. Subsequently, the stock drops in price and the following prices exist:
|
||||
XYZ, 40; XYZ October 50, l; and XYZ October 40, 4.
|
||||
One would roll down to the October 40 calls by buying back the 2 October
|
||||
50's that he is short and selling 2 October 40's. In so doing, he would reestablish a
|
||||
somewhat neutral position. His profit on the buy-back of the October 50 calls
|
||||
would be 5 points each - they were originally sold for 6 - and he would realize a
|
||||
10-point gain on the two calls. This 10-point gain effectively reduces his stock cost
|
||||
from 49 to 39, so that he now has the equivalent of the following position: long 100
|
||||
XYZ at 39 and short 2 XYZ October 40 calls at 4. This adjusted ratio write has a
|
||||
profit range of 31 to 49 and is thus a new, neutral position with the stock currently
|
||||
at 40. The investor is now in a position to make profits if XYZ remains near this
|
||||
level, or to take further defensive action if the stock experiences a relatively large
|
||||
change in price again.
|
||||
Defensive action to the upside - rolling up -works in much the same manner.
|
||||
@@ -0,0 +1,41 @@
|
||||
480
|
||||
A Complete Guide to the Futures mArket
|
||||
■ Factors That Determine Option Premiums
|
||||
An option’s premium consists of two components:
|
||||
Premiu mi ntri nsic v aluet imev alue=+
|
||||
The intrinsic value of a call option is the amount by which the current futures price is above the strike
|
||||
price. The intrinsic value of a put option is the amount by which the current futures price is below the
|
||||
strike price. In effect, the intrinsic value is that part of the premium that could be realized if the option were
|
||||
exercised and the futures contract offset at the current market price. For example, if July crude oil futures
|
||||
were trading at $74.60, a call option with a strike price of $70 would have an intrinsic value of $4.60. The
|
||||
intrinsic value serves as a floor price for an option. Why? Because if the premium were less than the intrinsic
|
||||
value, a trader could buy and exercise the option, and immediately offset the resulting futures position,
|
||||
thereby realizing a net gain (assuming this profit would at least cover the transaction costs).
|
||||
Options that have intrinsic value (i.e., calls with strike prices below the current futures price and
|
||||
puts with strike prices above the current futures price) are said to be in-the-money. Options with no
|
||||
intrinsic value are called out-of-the-money options. An option whose strike price equals the futures
|
||||
price is called an at-the-money option. The term at-the-money is also often used less restrictively to refer
|
||||
to the specific option whose strike price is closest to the futures price.
|
||||
An out-of-the-money option, which by definition has an intrinsic value of zero, nonetheless retains
|
||||
some value because of the possibility the futures price will move beyond the strike price prior to the expi-
|
||||
ration date. An in-the-money option will have a value greater than the intrinsic value because a position in
|
||||
the option will be preferred to a position in the underlying futures contract.
|
||||
reason: Both the option and
|
||||
the futures contract will gain equally in the event of favorable price movement, but the option’s maximum
|
||||
loss is limited. The portion of the premium that exceeds the intrinsic value is called the time value.
|
||||
It should be emphasized that because the time value is almost always greater than zero, one should
|
||||
avoid exercising an option before the expiration date. Almost invariably, the trader who wants to
|
||||
offset his option position will realize a better return by selling the option, a transaction that will yield
|
||||
the intrinsic value plus some time value, as opposed to exercising the option, an action that will yield
|
||||
only the intrinsic value.
|
||||
The time value depends on four quantifiable factors
|
||||
7:
|
||||
1. the relationship between the strike price and the current futures price. As illus-
|
||||
trated in Figure 34.1, the time value will decline as an option moves more deeply in-the-money
|
||||
or out-of-the-money.
|
||||
deeply out-of-the-money options will have little time value, since it is
|
||||
unlikely the futures will move to (or beyond) the strike price prior to expiration. deeply in-
|
||||
the-money options have little time value because these options offer very similar positions to
|
||||
the underlying futures contracts—both will gain and lose equivalent amounts for all but an
|
||||
extreme adverse price move. In other words, for a deeply in-the-money option, the fact that the
|
||||
7 Theoretically, the time value will also be influenced by price expectations, which are a non-quantifiable factor.
|
||||
@@ -0,0 +1,214 @@
|
||||
CHAPTER 11
|
||||
Calendar and Diagonal Spreads
|
||||
Option selling is a niche that attracts many retail and professional traders because it’s possible to profit from the passage of time. Calendar and diagonal spreads are practical strategies to limit risk while profiting from time. But these spreads are unique in many ways. In order to be successful with them, it is important to understand their subtle qualities.
|
||||
Calendar Spreads
|
||||
Definition
|
||||
: A calendar spread, sometimes called a
|
||||
time spread
|
||||
or a
|
||||
horizontal spread
|
||||
, is an option strategy that involves buying one option and selling another option with the same strike price but with a different expiration date.
|
||||
At-expiration diagrams do a calendar-spread trader little good. Why? At the expiration of the short-dated option, the trader is left with another option that may have time value. To estimate what the position will be worth when the short-term option expires, the value of the long-term option must be analyzed using the greeks. This is true of the variants of the calendar—double calendars, diagonals, and double diagonals—as well. This chapter will show how to analyze strategies that involve options with different expirations and discuss how and when to use them.
|
||||
Buying the Calendar
|
||||
The calendar spread and all its variations are commonly associated with income-generating spreads. Using calendar spreads as income generators is popular among retail and professional traders alike. The process involves buying a longer-term at-the-money option and selling a shorter-term at-the-money (ATM) option. The options must be either both calls or both puts. Because this transaction results in a net debit—the longer-term option being purchased has a higher premium than the shorter-term option being sold—this is referred to as buying the calendar.
|
||||
The main intent of buying a calendar spread for income is to profit from the positive net theta of the position. Because the shorter-term ATM option decays at a faster rate than the longer-term ATM option, the net theta is positive. As for most income spreads, the ideal outcome occurs when the underlying is at the short strike (in this case, shared strike) when the shorter-term option expires. At this strike price, the long option has its highest value, while the short option expires without the trader’s getting assigned. As long as the underlying remains close to the strike price, the value of the spread rises as time passes, because the short option decreases in value faster than the long option.
|
||||
For example, a trader, Richard, watches Bed Bath & Beyond Inc. (BBBY) on a regular basis. Richard believes that Bed Bath & Beyond will trade in a range around $57.50 a share (where it is trading now) over the next month. Richard buys the January–February 57.50 call calendar for 0.80. Assuming January has 25 days until expiration and February has 53 days, Richard will execute the following trade:
|
||||
Richard’s best-case scenario occurs when the January calls expire at expiration and the February calls retain much of their value.
|
||||
If Richard created an at-expiration P&(L) diagram for his position, he’d have trouble because of the staggered expiration months. A general representation would look something like
|
||||
Exhibit 11.1
|
||||
.
|
||||
EXHIBIT 11.1
|
||||
Bed Bath & Beyond January–February 57.50 calendar.
|
||||
The only point on the diagram that is drawn with definitive accuracy is the maximum loss to the downside at expiration of the January call. The maximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit paid for the spread. If Bed Bath & Beyond is below $57.50 at January expiration, the January 57.50 call expires worthless, and the February 57.50 call may or may not have residual value. If Bed Bath & Beyond declines enough, the February 57.50 call can lose all of its value, even with residual time until expiration. If the stock falls enough, the entire 0.80 debit would be a loss.
|
||||
If Bed Bath & Beyond is above $57.50 at January expiration, the January 57.50 call will be trading at parity. It will be a negative-100-delta option, imitating short stock. If Bed Bath & Beyond is trading high enough, the February 57.50 call will become a positive-100-delta option trading at parity plus the interest calculated on the strike. The February deep-in-the-money option would imitate long stock. At a 2 percent interest rate, interest on the 57.50 strike is about 0.17. Therefore, Richard would essentially have a short stock position from $57.50 from the January 57.50 call and would be essentially long stock from $57.50 plus 0.28 from the February call. The maximum loss to the upside is about 0.63 (0.80 − 0.17).
|
||||
The maximum loss if Bed Bath & Beyond is trading over $57.50 at expiration is only an estimate that assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations.
|
||||
The maximum profit is gained if Bed Bath & Beyond is at $57.50 at expiration. At this price, the February 57.50 call is worth the most it can be worth without having the January 57.50 call assigned and creating negative deltas to the upside. But how much precisely is the maximum profit? Richard would have to know what the February 57.50 call would be worth with Bed Bath & Beyond stock trading at $57.50 at February expiration before he can know the maximum profit potential. Although Richard can’t know for sure at what price the calls will be trading, he can use a pricing model to estimate the call’s value.
|
||||
Exhibit 11.2
|
||||
shows analytics at January expiration.
|
||||
EXHIBIT 11.2
|
||||
Bed Bath & Beyond January–February 57.50 call calendar greeks at January expiration.
|
||||
With an unchanged implied volatility of 23 percent, an interest rate of two percent, and no dividend payable before February expiration, the February 57.50 calls would be valued at 1.53 at January expiration. In this best-case scenario, therefore, the spread would go from 0.80, where Richard purchased it, to 1.53, for a gain of 91 percent. At January expiration, with Bed Bath & Beyond at $57.50, the January call would expire; thus, the spread is composed of just the February 57.50 call.
|
||||
Let’s now go back in time and see how Richard figured this trade.
|
||||
Exhibit 11.3
|
||||
shows the position when the trade is established.
|
||||
EXHIBIT 11.3
|
||||
Bed Bath & Beyond January–February 57.50 call calendar.
|
||||
A small and steady rise in the stock price with enough time to collect theta is the recipe for success in this trade. As time passes, delta will flatten out if Bed Bath & Beyond is still right at-the-money. The delta of the January call that Richard is short will move closer to exactly −0.50. The February call delta moves toward exactly +0.50.
|
||||
Gamma and theta will both rise if Bed Bath & Beyond stays around the strike. As expiration approaches, there is greater risk if there is movement and greater reward if there is not.
|
||||
Vega is positive because the long-term option with the higher vega is the long leg of the spread. When trading calendars for income, implied volatility (IV) must be considered as a possible threat. Because it is Richard’s objective to profit from Bed Bath & Beyond being at $57.50 at expiration, he will try to avoid vega risk by checking that the implied volatility of the February call is in the lower third of the 12-month range. He will also determine if there are any impending events that could cause IV to change. The less likely IV is to drop, the better.
|
||||
If there is an increase in IV, that may benefit the profitability of the trade. But a rise in IV is not really a desired outcome for two reasons. First, a rise in IV is often more pronounced in the front month than in the months farther out. If this happens, Richard can lose more on the short call than he makes on the long call. Second, a rise in IV can indicate anxiety and therefore a greater possibility for movement in the underlying stock. Richard doesn’t want IV to rock the boat. “Buy low, stay low” is his credo.
|
||||
Rho is positive also. A rise in interest rates benefits the position because the long-term call is helped by the rise more than the short call is hurt. With only a one-month difference between the two options, rho is very small. Overall, rho is inconsequential to this trade.
|
||||
There is something curious to note about this trade: the gamma and the vega. Calendar spreads are the one type of trade where gamma can be negative while vega is positive, and vice versa. While it appears—at least on the surface—that Richard wants higher IV, he certainly wants low realized volatility.
|
||||
Bed Bath & Beyond January–February 57.50 Put Calendar
|
||||
Richard’s position would be similar if he traded the January–February 57.50 put calendar rather than the call calendar.
|
||||
Exhibit 11.4
|
||||
shows the put calendar.
|
||||
EXHIBIT 11.4
|
||||
Bed Bath & Beyond January–February 57.50 put calendar.
|
||||
The premium paid for the put spread is 0.75. A huge move in either direction means a loss. It is about the same gamma/theta trade as the 57.50 call calendar. At expiration, with Bed Bath & Beyond at $57.50 and IV unchanged, the value of the February put would be 1.45—a 93 percent gain. The position is almost exactly the same as the call calendar. The biggest difference is that the rho is negative, but that is immaterial to the trade. As with the call spread, being short the front-month option means negative gamma and positive theta; being long the back month means positive vega.
|
||||
Managing an Income-Generating Calendar
|
||||
Let’s say that instead of trading a one-lot calendar, Richard trades it 20 times. His trade in this case is
|
||||
His total cash outlay is $1,600 ($80 times 20). The greeks for this trade, listed in
|
||||
Exhibit 11.5
|
||||
, are also 20 times the size of those in
|
||||
Exhibit 11.3
|
||||
.
|
||||
EXHIBIT 11.5
|
||||
20-Lot Bed Bath & Beyond January–February 57.50 call calendar.
|
||||
Note that Richard has a +0.18 delta. This means he’s long the equivalent of about 18 shares of stock—still pretty flat. A gamma of −0.72 means that if Bed Bath & Beyond moves $1 higher, his delta will be starting to get short; and if it moves $1 lower he will be longer, long 90 deltas.
|
||||
Richard can use the greeks to get a feel for how much the stock can move before negative gamma causes a loss. If Bed Bath & Beyond starts trending in either direction, Richard may need to react. His plan is to cover his deltas to continue the position.
|
||||
Say that after one week Bed Bath & Beyond has dropped $1 to $56.50. Richard will have collected seven days of theta, which will have increased slightly from $18 per day to $20 per day. His average theta during that time is about $19, so Richard’s profit attributed to theta is about $133.
|
||||
With a big-enough move in either direction, Richard’s delta will start working against him. Since he started with a delta of +0.18 on this 20-lot spread and a gamma of −0.72, one might think that his delta would increase to 0.90 with Bed Bath & Beyond a dollar lower (18 − [−0.072 × 1.00]). But because a week has passed, his delta would actually get somewhat more positive. The shorter-term call’s delta will get smaller (closer to zero) at a faster rate compared to the longer-term call because it has less time to expiration. Thus, the positive delta of the long-term option begins to outweigh the negative delta of the short-term option as time passes.
|
||||
In this scenario, Richard would have almost broken even because what would be lost on stock price movement, is made up for by theta gains. Richard can sell about 100 shares of Bed Bath & Beyond to eliminate his immediate directional risk and stem further delta losses. The good news is that if Bed Bath & Beyond declines more after this hedge, the profit from the short stock offsets losses from the long delta. The bad news is that if BBBY rebounds, losses from the short stock offset gains from the long delta.
|
||||
After Richard’s hedge trade is executed, his delta would be zero. His other greeks remain unchanged. The idea is that if Bed Bath & Beyond stays at its new price level of $56.50, he reaps the benefits of theta increasing with time from $18 per day. Richard is accepting the new price level and any profits or losses that have occurred so far. He simply adjusts his directional exposure to a zero delta.
|
||||
Rolling and Earning a “Free” Call
|
||||
Many traders who trade income-generating strategies are conservative. They are happy to sell low IV for the benefits afforded by low realized volatility. This is the problem-avoidance philosophy of trading. Due to risk aversion, it’s common to trade calendar spreads by buying the two-month option and selling the one-month option. This can allow traders to avoid buying the calendar in earnings months, and it also means a shorter time horizon, signifying less time for something unwanted to happen.
|
||||
But there’s another school of thought among time-spread traders. There are some traders who prefer to buy a longer-term option—six months to a year—while selling a one-month option. Why? Because month after month, the trader can roll the short option to the next month. This is a simple tactic that is used by market makers and other professional traders as well as savvy retail traders. Here’s how it works.
|
||||
XYZ stock is trading at $60 per share. A trader has a neutral outlook over the next six months and decides to buy a calendar. Assuming that July has 29 days until expiration and December has 180, the trader will take the following position:
|
||||
The initial debit here is 2.55. The goal is basically the same as for any time spread: collect theta without negative gamma spoiling the party. There is another goal in these trades as well: to roll the spread.
|
||||
At the end of month one, if the best-case scenario occurs and XYZ is sitting at $60 at July expiration, the July 60 call expires. The December 60 call will then be worth 3.60, assuming all else is held constant. The positive theta of the short July call gives full benefits as the option goes from 1.45 to zero. The lower negative theta of the December call doesn’t bite into profits quite as much as the theta of a short-term call would.
|
||||
The profit after month one is 1.05. Profit is derived from the December call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if a short-term, less expensive August 60 call were the long leg of this spread.
|
||||
Rolling the Spread
|
||||
The July–December spread is different from short-term spreads, however. When the Julys expire, the August options will have 29 days until expiration. If volatility is still the same, XYZ is still at $60, and the trader’s forecast is still neutral, the 29-day August 60 calls can be sold for 1.45. The trader can either wait until the Monday after July expiration and then sell the August 60s, or when the Julys are offered at 0.05 or 0.10, he can buy the Julys and sell the Augusts as a spread. In either case, it is called rolling the spread. When the August expires, he can sell the Septembers, and so on.
|
||||
The goal is to get a credit month after month. At some point, the aggregate credit from the call sales each month is greater than the price initially paid for the long leg of the spread, thus eliminating the original net debit.
|
||||
Exhibit 11.6
|
||||
shows how the monthly credits from selling the one-month calls aggregate over time.
|
||||
EXHIBIT 11.6
|
||||
A “free” call.
|
||||
After July has expired, 1.45 of premium is earned. After August expiration, the aggregate increases to 2.90. When the September calls, which have 36 days until expiration, are sold, another 1.60 is added to the total premium collected. Over three months—assuming the stock price, volatility, and the other inputs don’t change—this trader collects a total of 4.50. That’s 0.50 more than the price originally paid for the December 60 call leg of the spread.
|
||||
At this point, he effectively owns the December call for free. Of course, this call isn’t really free; it’s earned. It’s paid for with risk and maybe a few sleepless nights. At this point, even if the stock and, consequently, the December call go to zero, the position is still a profitable trade because of the continued month-to-month rolling. This is now a no-lose situation.
|
||||
When the long call of the spread has been paid for by rolling, there are three choices moving forward: sell it, hold it, or continue writing calls against it. If the trader’s opinion calls for the stock to decline, it’s logical to sell the December call and take the residual value as profit. In this case, over three months the trade will have produced 4.50 in premium from the sale of three consecutive one-month calls, which is more than the initial purchase price of the December call. At September expiration, the premium that will be received for selling the December call is all profit, plus 0.50, which is the aggregate premium minus the initial cost of the December call.
|
||||
If the outlook is for the underlying to rise, it makes sense to hold the call. Any appreciation in the value of the call resulting from delta gains as the underlying moves higher is good—$0.50 plus whatever the call can be sold for.
|
||||
If the forecast is for XYZ to remain neutral, it’s logical to continue selling the one-month call. Because the December call has been financed by the aggregate short call premiums already, additional premiums earned by writing calls are profit with “free” protection. As long as the short is closed at its expiration, the risk of loss is eliminated.
|
||||
This is the general nature of rolling calls in a calendar spread. It’s a beautiful plan when it works! The problem is that it is incredibly unlikely that the stock will stay right at $60 per share for five months. It’s almost inevitable that it will move at some point. It’s like a game of Russian roulette. At some point it’s going to be a losing proposition—you just don’t know when. The benefit of rolling is that if the trade works out for a few months in a row, the long call is paid for and the risk of loss is covered by aggregate profits.
|
||||
If we step outside this best-case theoretical world and consider what is really happening on a day-to-day basis, we can gain insight on how to manage this type of trade when things go wrong. Effectively, a long calendar is a typical gamma/theta trade. Negative gamma hurts. Positive theta helps.
|
||||
If we knew which way the stock was going, we would simply buy or sell stock to adjust to get long or short deltas. But, unfortunately, we don’t. Our only tool is to hedge by buying or selling stock as mentioned above to flatten out when gamma causes the position delta to get more positive or negative.
|
||||
1
|
||||
The bottom line is that if the effect of gamma creates unwanted long deltas but the theta/gamma is still a desirable position, selling stock flattens out the delta. If the effect of gamma creates unwanted short deltas, buying stock flattens out the delta.
|
||||
Trading Volatility Term Structure
|
||||
There are other reasons for trading calendar spreads besides generating income from theta. If there is skew in the term structure of volatility, which was discussed in Chapter 3, a calendar spread is a way to trade volatility. The tactic is to buy the “cheap” month and sell the “expensive” month.
|
||||
Selling the Front, Buying the Back
|
||||
If for a particular stock, the February ATM calls are trading at 50 volatility and the May ATM calls are trading at 35 volatility, a vol-calendar trader would buy the Mays and sell the Februarys. Sounds simple, right? The devil is in the details. We’ll look at an example and then discuss some common pitfalls with vol-trading calendars.
|
||||
George has been studying the implied volatility of a $164.15 stock. George notices that front-month volatility has been higher than that of the other months for a couple of weeks. There is nothing in the news to indicate immediate risk of extraordinary movement occurring in this example.
|
||||
George sees that he can sell the 22-day July 165 calls at a 45 percent IV and buy the 85-day September 165 calls at a 38 percent IV. George would like to buy the calendar spread, because he believes the July ATM volatility will drop down to around 38, where the September is trading. If he puts on this trade, he will establish the following position:
|
||||
What are George’s risks? Because he would be selling the short-term ATM option, negative gamma could be a problem. The greeks for this trade, shown in
|
||||
Exhibit 11.7
|
||||
, confirm this. The negative gamma means each dollar of stock price movement causes an adverse change of about 0.09 to delta. The spread’s delta becomes shorter when the stock rises and longer when the stock falls. Because the position’s delta is long 0.369 from the start, some price appreciation may be welcomed in the short term. The stock advance will yield profits but at a diminishing rate, as negative gamma reduces the delta.
|
||||
EXHIBIT 11.7
|
||||
10-lot July–September 165 call calendar.
|
||||
But just looking at the net position greeks doesn’t tell the whole story. It is important to appreciate the fact that long calendar spreads such as this have long vegas. In this case, the vega is +1.522. But what does this number really mean? This vega figure means that if IV rises or falls in both the July and the September calls by the same amount, the spread makes or loses $152 per vol point.
|
||||
George’s plan, however, is to see the July’s volatility decline to converge with the September’s. He hopes the volatilities of the two months will move independently of each other. To better gauge his risk, he needs to look at the vega of each option. With the stock at $164.15 the vegas are as follows:
|
||||
If George is right and July volatility declines 8 points, from 46 to 38, he will make $1,283 ($1.604 × 100 × 8).
|
||||
There are a couple of things that can go awry. First, instead of the volatilities converging, they can diverge further. Implied volatility is a slave to the whims of the market. If the July IV continues to rise while the September IV stays the same, George loses $160 per vol point.
|
||||
The second thing that can go wrong is the September IV declining along with the July IV. This can lead George into trouble, too. It depends the extent to which the September volatility declines. In this example, the vega of the September leg is about twice that of the July leg. That means that if the July volatility loses eight points while the September volatility declines four points, profits from the July calls will be negated by losses from the September calls. If the September volatility falls even more, the trade is a loser.
|
||||
IV is a common cause of time-spread failure for market makers. When i in the front month rises, the volatility of the back-months sometimes does as well. When this happens, it’s often because market makers who sold front-month options to retail or institutional buyers buy the back-month options to hedge their short-gamma risk. If the market maker buys enough back-month options, he or she will accumulate positive vega. But when the market sells the front-month volatility back to the market makers, the back months drop, too, because market makers no longer need the back months for a hedge.
|
||||
Traders should study historical implied volatility to avoid this pitfall. As is always the case with long vega strategies, there is a risk of a decline in IV. Buying long-term options with implied volatility in the lower third of the 12-month IV range helps improve the chances of success, since the volatility being bought is historically cheap.
|
||||
This can be tricky, however. If a trader looks back on a chart of IV for an option class and sees that over the past six months it has ranged between 20 and 30 but nine months ago it spiked up to, say, 55, there must be a reason. This solitary spike could be just an anomaly. To eliminate the noise from volatility charts, it helps to filter the data. News stories from that time period and historical stock charts will usually tell the story of why volatility spiked. Often, it is a one-time event that led to the spike. Is it reasonable to include this unique situation when trying to get a feel for the typical range of implied volatility? Usually not. This is a judgment call that needs to be made on a case-by-case basis. The ultimate objective of this exercise is to determine: “Is volatility cheap or expensive?”
|
||||
Buying the Front, Selling the Back
|
||||
All trading is based on the principle of “buy low, sell high”—even volatility trading. With time spreads, we can do both at once, but we are not limited to selling the front and buying the back. When short-term options are trading at a lower IV than long-term ones, there may be an opportunity to sell the calendar. If the IV of the front month is 17 and the back-month IV is 25, for example, it could be a wise trade to buy the front and sell the back. But selling time spreads in this manner comes with its own unique set of risks.
|
||||
First, a short calendar’s greeks are the opposite of those of a long calendar. This trade has negative theta with positive gamma. A sideways market hurts this position as negative theta does its damage. Each day of carrying the position is paid for with time decay.
|
||||
The short calendar is also a short-vega trade. At face value, this implies that a drop in IV leads to profit and that the higher the IV sold in the back month, the better. As with buying a calendar, there are some caveats to this logic.
|
||||
If there is an across-the-board decline in IV, the net short vega will lead to a profit. But an across-the-board drop in volatility, in this case, is probably not a realistic expectation. The front month tends to be more sensitive to volatility. It is a common occurrence for the front month to be “cheap” while the back month is “expensive.”
|
||||
The volatilities of the different months can move independently, as they can when one buys a time spread. There are a couple of scenarios that might lead to the back-month volatility’s being higher than the front month. One is high complacency in the short term. When the market collectively sells options in expectation of lackluster trading, it generally prefers to sell the short-term options. Why? Higher theta. Because the trade has less time until expiration, the trade has a shorter period of risk. Because of this, selling pressure can push down IV in the front-month options more than in the back. Again, the front month is more sensitive to changes in implied volatility.
|
||||
Because volatility has peaks and troughs, this can be a smart time to sell a calendar. The focus here is in seeing the “cheap” front month rise back up to normal levels, not so much in seeing the “expensive” back month fall. This trade is certainly not without risk. If the market doesn’t move, the negative theta of the short calendar leads to a slow, painful death for calendar sellers.
|
||||
Another scenario in which the back-month volatility can trade higher than the front is when the market expects higher movement after the expiration of the short-term option but before the expiration of the long-term option. Situations such as the expectation of the resolution of a lawsuit, a product announcement, or some other one-time event down the road are opportunities for the market to expect such movement. This strategy focuses on the back-month vol coming back down to normal levels, not on the front-month vol rising. This can be a more speculative situation for a volatility trade, and more can go wrong.
|
||||
The biggest volatility risk in selling a time spread is that what goes up can continue to go up. The volatility disparity here is created by hedgers and speculators favoring long-term options, hence pushing up the volatility, in anticipation of a big future stock move. As the likely date of the anticipated event draws near, more buyers can be attracted to the market, driving up IV even further. Realized volatility can remain low as investors and traders lie in wait. This scenario is doubly dangerous when volatility rises and the stock doesn’t move. A trader can lose on negative theta and lose on negative vega.
|
||||
A Directional Approach
|
||||
Calendar spreads are often purchased when the outlook for the underlying is neutral. Sell the short-term ATM option; buy the long-term ATM option; collect theta. But with negative gamma, these trades are never really neutral. The delta is constantly changing, becoming more positive or negative. It’s like a rubber band: at times being stretched in either direction but always demanding a pull back to the strike. When the strike price being traded is not ATM, calendar spreads can be strategically traded as directional plays.
|
||||
Buying a calendar, whether using calls or puts, where the strike price is above the current stock price is a bullish strategy. With calls, the positive delta of the long-term out-of-the-money (OTM) call will be greater than the negative delta of the short-term OTM call. For puts, the positive delta of the short-term in-the-money (ITM) put will be greater than the negative delta of the long-term ITM put.
|
||||
Just the opposite applies if the strike price is below the current stock price. The negative delta of the short-term ITM call is greater than the positive delta of the long-term ITM call. The negative delta of the long-term OTM put is greater than the positive delta of the short-term OTM put.
|
||||
When the position starts out with either a positive or negative delta, movement in the direction of the delta is necessary for the trade to be profitable. Negative gamma is also an important strategic consideration. Stock-price movement is needed, but not too much.
|
||||
Buying calendar spreads is like playing outfield in a baseball game. To catch a fly ball, an outfielder must focus on both distance and timing. He must gauge how far the ball will be hit and how long it will take to get there. With calendars, the distance is the strike price—that’s where the stock needs to be—and the time is the expiration day of the short month’s option: that’s when it needs to be at the target price.
|
||||
For example, with Wal-Mart (WMT) at $48.50, a trader, Pete, is looking for a rise to about $50 over the next five or six weeks. Pete buys the August–September call calendar. In this example, August has 39 days until expiration and September has 74 days.
|
||||
Exactly what does 50 cents buy Pete? The stock price sitting below the strike price means a net positive delta. This long time spread also has positive theta and vega. Gamma is negative.
|
||||
Exhibit 11.8
|
||||
shows the specifics.
|
||||
EXHIBIT 11.8
|
||||
10-lot Wal-Mart August–September 50 call calendar.
|
||||
The delta of this trade, while positive, is relatively small with 39 days left until August expiration. It’s not rational to expect a quick profit if the stock advances faster than expected. But ultimately, a rise in stock price is the goal. In this example, Wal-Mart needs to rise to $50, and timing is everything. It needs to be at that price in 39 days. In the interim, a move too big and too fast in either direction hurts the trade because of negative gamma. Starting with Wal-Mart at $48.50, delta/gamma problems are worse to the downside.
|
||||
Exhibit 11.9
|
||||
shows the effects of stock price on delta, gamma, and theta.
|
||||
EXHIBIT 11.9
|
||||
Stock price movement and greeks.
|
||||
If Wal-Mart moves lower, the delta gets more positive, racking up losses at a higher rate. To add to Pete’s woes, theta becomes less of a benefit as the stock drifts lower. At $47 a share, theta is about flat. With Wal-Mart trading even lower than $47, the positive theta of the August call is overshadowed by the negative theta of the September. Theta can become negative, causing the position to lose value as time passes.
|
||||
A big move to the upside doesn’t help either. If Wal-Mart rises just a bit, the −0.323 gamma only lessens the benefit of the 0.563 delta. But above $50, negative gamma begins to cause the delta to become increasingly negative. Theta begins to wither away at higher stock prices as well.
|
||||
The place to be is right at $50. The delta is flat and theta is highest. As long as Wal-Mart finds its way up to this price by the third Friday of August, life is good for Pete.
|
||||
The In-or-Out Crowd
|
||||
Pete could just as well have traded the Aug–Sep 50 put calendar in this situation. If he’d been bearish, he could have traded either the Aug–Sep 45 call spread or the Aug–Sep 45 put spread. Whether bullish or bearish, as mentioned earlier, the call calendar and the put calendar both function about the same. When deciding which to use, the important consideration is that one of them will be in-the-money and the other will be OTM. Whether you have an ITM spread or an OTM spread has potential implications for the success of the trade.
|
||||
The bid-ask spreads tend to be wider for higher-delta, ITM options. Because of this, it can be more expensive to enter into an ITM calendar. Why? Trading options with wider markets requires conceding more edge. Take the following options series:
|
||||
By buying the May 50 calls at 3.20, a trader gives up 0.10 of theoretical edge (3.20 is 0.10 higher than the theoretical value). Buying the put at 1.00 means buying only 0.05 over theoretical.
|
||||
Because a calendar is a two-legged spread, the double edge given up by trading the wider markets of two in-the-money options can make the out-of-the-money spread a more attractive trade. The issue of wider markets is compounded when rolling the spread. Giving up a nickel or a dime each month can add up, especially on nominally low-priced spreads. It can cut into a high percentage of profits.
|
||||
Early assignment can complicate ITM calendars made up of American options, as dividends and interest can come into play. The short leg of the spread could get assigned before the expiration date as traders exercise calls to capture the dividend. Short ITM puts may get assigned early because of interest.
|
||||
Although assignment is an undesirable outcome for most calendar spread traders, getting assigned on the short leg of the calendar spread may not necessarily create a significantly different trade. If a long put calendar, for example, has a short front-month put that is so deep in-the-money that it is likely to get assigned, it is trading close to a 100 delta. It is effectively a long stock position already. After assignment, when a long stock position is created, the resulting position is long stock with a deep ITM long put—a fairly delta-flat position.
|
||||
Double Calendars
|
||||
Definition
|
||||
: A double calendar spread is the execution of two calendar spreads that have the same months in common but have two different strike prices.
|
||||
Example
|
||||
Sell 1 XYZ February 70 call
|
||||
Buy 1 XYZ March 70 call
|
||||
Sell 1 XYZ February 75 call
|
||||
Buy 1 XYZ March 75 call
|
||||
Double calendars can be traded for many reasons. They can be vega plays. If there is a volatility-time skew, a double calendar is a way to take a position without concentrating delta or gamma/theta risk at a single strike.
|
||||
This spread can also be a gamma/theta play. In that case, there are two strikes, so there are two potential focal points to gravitate to (in the case of a long double calendar) or avoid (in the case of a short double calendar).
|
||||
Selling the two back-month strikes and buying the front-month strikes leads to negative theta and positive gamma. The positive gamma creates favorable deltas when the underlying moves. Positive or negative deltas can be covered by trading the underlying stock. With positive gamma, profits can be racked up by buying the underlying to cover short deltas and subsequently selling the underlying to cover long deltas.
|
||||
Buying the two back-month strikes and selling the front-month strikes creates negative gamma and positive theta, just as in a conventional calendar. But the underlying stock has two target price points to shoot for at expiration to achieve the maximum payout.
|
||||
Often double calendars are traded as IV plays. Many times when they are traded as IV plays, traders trade the lower-strike spread as a put calendar and the higher-strike spread a call calendar. In that case, the spread is sometimes referred to as a
|
||||
strangle swap
|
||||
. Strangles are discussed in Chapter 15.
|
||||
Two Courses of Action
|
||||
Although there may be many motivations for trading a double calendar, there are only two courses of action: buy it or sell it. While, for example, the trader’s goal may be to capture theta, buying a double calendar comes with the baggage of the other greeks. Fully understanding the interrelationship of the greeks is essential to success. Option traders must take a holistic view of their positions.
|
||||
Let’s look at an example of buying a double calendar. In this example, Minnesota Mining & Manufacturing (MMM) has been trading in a range between about $85 and $97 per share. The current price of Minnesota Mining & Manufacturing is $87.90. Economic data indicate no specific reasons to anticipate that Minnesota Mining & Manufacturing will deviate from its recent range over the next month—that is, there is nothing in the news, no earnings anticipated, and the overall market is stable. August IV is higher than October IV by one volatility point, and October implied volatility is in line with 30-day historical volatility. There are 38 days until August expiration, and 101 days until October expiration.
|
||||
The Aug–Oct 85–90 double calendar can be traded at the following prices:
|
||||
Much like a traditional calendar spread, the price points cannot be definitively plotted on a P&(L) diagram. What is known for certain is that at August expiration, the maximum loss is $3,200. While it’s comforting to know that there is limited loss, losing the entire premium that was paid for the spread is an outcome most traders would like to avoid. We also know the maximum gains occur at the strike prices; but not exactly what the maximum profit can be.
|
||||
Exhibit 11.10
|
||||
provides an alternative picture of the position that is useful in managing the trade on a day-to-day basis.
|
||||
EXHIBIT 11.10
|
||||
10-lot Minnesota Mining & Manufacturing Aug–Oct 85–90 double call calendar.
|
||||
These numbers are a good representation of the position’s risk. Knowing that long calendars and long double calendars have maximum losses at the expiration of the short-term option equal to the net premiums paid, the max loss in this example is 3.20. Break-even prices are not relevant to this position because they cannot be determined with any certainty. What is important is to get a feel for how much movement can hurt the position.
|
||||
To make $19 a day in theta, a −0.468 gamma must be accepted. In the long run, $1 of movement is irrelevant. In fact, some movement is favorable because the ideal point for MMM to be at, at August expiration is either $85 or $90. So while small moves are acceptable, big moves are of concern. The negative gamma is an illustration of this warning.
|
||||
The other risk besides direction is vega. A positive 1.471 vega means the calendar makes or loses about $147 with each one-point across-the-board change in implied volatility. Implied volatility is a risk in all calendar trades. Volatility was one of the criteria studied when considering this trade. Recall that the August IV was one point higher than the October and that the October IV was in line with the 30-day historical volatility at inception of the trade.
|
||||
Considering the volatility data is part of the due diligence when considering a calendar or a double calendar. First, the (slightly) more expensive options (August) are being sold, and the cheaper ones are being bought (October). A study of the company reveals no news to lead one to believe that Minnesota Mining & Manufacturing should move at a higher realized volatility than it currently is in this example. Therefore, the front month’s higher IV is not a red flag. Because the volatility of the October option (the month being purchased) is in line with the historical volatility, the trader could feel that he is paying a reasonable price for this volatility.
|
||||
In the end, the trade is evaluated on the underlying stock, realized volatility, and IV. The trade should be executed only after weighing all the available data. Trading is both cerebral and statistical in nature. It’s about gaining a statistically better chance of success by making rational decisions.
|
||||
Diagonals
|
||||
Definition
|
||||
: A diagonal spread is an option strategy that involves buying one option and selling another option with a different strike price and with a different expiration date. Diagonals are another strategy in the time spread family.
|
||||
Diagonals enable a trader to exploit opportunities similar to those exploited by a calendar spread, but because the options in a diagonal spread have two different strike prices, the trade is more focused on delta. The name
|
||||
diagonal
|
||||
comes from the fact that the spread is a combination of a horizontal spread (two different months) and a vertical spread (two different strikes).
|
||||
Say it’s 22 days until January expiration and 50 days until February expiration. Apple Inc. (AAPL) is trading at $405.10. Apple has been in an uptrend heading toward the peak of its six-month range, which is around $420. A trader, John, believes that it will continue to rise and hit $420 again by February expiration. Historical volatility is 28 percent. The February 400 calls are offered at a 32 implied volatility and the January 420 calls are bid on a 29 implied volatility. John executes the following diagonal:
|
||||
Exhibit 11.11
|
||||
shows the analytics for this trade.
|
||||
EXHIBIT 11.11
|
||||
Apple January–February 400–420 call diagonal.
|
||||
From the presented data, is this a good trade? The answer to this question is contingent on whether the position John is taking is congruent with his view of direction and volatility and what the market tells him about these elements.
|
||||
John is bullish up to August expiration, and the stock in this example is in an uptrend. Any rationale for bullishness may come from technical or fundamental analysis, but techniques for picking direction, for the most part, are beyond the scope of this book. Buying the lower strike in the February option gives this trade a more positive delta than a straight calendar spread would have. The trader’s delta is 0.255, or the equivalent of about 25.5 shares of Apple. This reflects the trader’s directional view.
|
||||
The volatility is not as easy to decipher. A specific volatility forecast was not stated above, but there are a few relevant bits of information that should be considered, whether or not the trader has a specific view on future volatility. First, the historical volatility is 28 percent. That’s lower than either the January or the February calls. That’s not ideal. In a perfect world, it’s better to buy below historical and sell above. To that point, the February option that John is buying has a higher volatility than the January he is selling. Not so good either. Are these volatility observations deal breakers?
|
||||
A Good Ex-Skews
|
||||
It’s important to take skew into consideration. Because the January calls have a higher strike price than the February calls, it’s logical for them to trade at a lower implied volatility. Is this enough to justify the possibility of selling the lower volatility? Consider first that there is some margin for error. The bid-ask spreads of each of the options has a volatility disparity. In this case, both the January and February calls are 10 cents wide. That means with a January vega of 0.34 the bid-ask is about 0.29 vol points wide. The Februarys have a 0.57 vega. They are about 0.18 vol points wide. That accounts for some of the disparity. Natural vertical skew accounts for the rest of the difference, which is acceptable as long as the skew is not abnormally pronounced.
|
||||
As for other volatility considerations, this diagonal has the rather unorthodox juxtaposition of positive vega and negative gamma seen with other time spreads. The trader is looking for a move upward, but not a big one. As the stock rises and Apple moves closer to the 420 strike, the positive delta will shrink and the negative gamma will increase. In order to continue to enjoy profits as the stock rises, John may have to buy shares of Apple to keep his positive delta. The risk here is that if he buys stock and Apple retraces, he may end up negative scalping stock. In other words, he may sell it back at a lower price than he bought it. Using stock to adjust the delta in a negative-gamma play can be risky business. Gamma scalping is addressed further in Chapter 13.
|
||||
Making the Most of Your Options
|
||||
The trader from the previous example had a time-spread alternative to the diagonal: John could have simply bought a traditional time spread at the 420 strike. Recall that calendars reap the maximum reward when they are at the shared strike price at expiration of the short-term option. Why would he choose one over the other?
|
||||
The diagonal in that example uses a lower-strike call in the February than a straight 420 calendar spread and therefore has a higher delta, but it costs more. Gamma, theta, and vega may be slightly lower with the in-the-money call, depending on how far from the strike price the ITM call is and how much time until expiration it has. These, however, are less relevant differences.
|
||||
The delta of the February 400 call is about 0.57. The February 420 call, however, has only a 0.39 delta. The 0.18 delta difference between the calls means the position delta of the time spread will be only about 0.07 instead of about 0.25 of the diagonal—a big difference. But the trade-off for lower delta is that the February 420 call can be bought for 12.15. That means a lower debit paid—that means less at risk. Conversely, though there is greater risk with the diagonal, the bigger delta provides a bigger payoff if the trader is right.
|
||||
Double Diagonals
|
||||
A double diagonal spread is the simultaneous trading of two diagonal spreads: one call spread and one put spread. The distance between the strikes is the same in both diagonals, and both have the same two expiration months. Usually, the two long-term options are more out-of-the-money than the two shorter-term options. For example
|
||||
Buy 1 XYZ May 70 put
|
||||
Sell 1 XYZ March 75 put
|
||||
Sell 1 XYZ March 85 call
|
||||
Buy 1 XYZ May 90 call
|
||||
Like many option strategies, the double diagonal can be looked at from a number of angles. Certainly, this is a trade composed of two diagonal spreads—the March–May 70–75 put and the March–May 85–90 call. It is also two strangles—buying the May 70–90 strangle and selling the March 75–85 strangle. One insightful way to look at this spread is as an iron condor in which the guts are March options and the wings are May options.
|
||||
Trading a double diagonal like this one, rather than a typically positioned iron condor, can offer a few advantages. The first advantage, of course, is theta. Selling short-term options and buying long-term options helps the trader reap higher rates of decay. Theta is the raison d’être of the iron condor. A second advantage is rolling. If the underlying asset stays in a range for a long period of time, the short strangle can be rolled month after month. There may, in some cases, also be volatility-term-structure discrepancies on which to capitalize.
|
||||
A trader, Paul, is studying JPMorgan (JPM). The current stock price is $49.85. In this example, JPMorgan has been trading in a pretty tight range over the past few months. Paul believes it will continue to do so over the next month. Paul considers the following trade:
|
||||
Paul considers volatility. In this example, the JPMorgan ATM call, the August 50 (which is not shown here), is trading at 22.9 percent implied volatility. This is in line with the 20-day historical volatility, which is 23 percent. The August IV appears to be reasonably in line with the September volatility, after accounting for vertical skew. The IV of the August 52.50 calls is 1.5 points above that of the September 55 calls and the August 47.50 put IV is 1.6 points below the September 45 put IV. It appears that neither month’s volatility is cheap or expensive.
|
||||
Exhibit 11.12
|
||||
shows the trade’s greeks.
|
||||
EXHIBIT 11.12
|
||||
10-lot JPMorgan August–September 45–47.50–52.50–55 double diagonal.
|
||||
The analytics of this trade are similar to those of an iron condor. Immediate directional risk is almost nonexistent, as indicated by the delta. But gamma and theta are high, even higher than they would be if this were a straight September iron condor, although not as high as if this were an August iron condor.
|
||||
Vega is positive. Surely, if this were an August or a September iron condor, vega would be negative. In this example, Paul is indifferent as to whether vega is positive or negative because IV is fairly priced in terms of historical volatility and term structure. In fact, to play it close to the vest, Paul probably wants the smallest vega possible, in case of an IV move. Why take on the risk?
|
||||
The motivation for Paul’s double diagonal was purely theta. The volatilities were all in line. And this one-month spread can’t be rolled. If Paul were interested in rolling, he could have purchased longer-term options. But if he is anticipating a sideways market for only the next month and feels that volatility could pick up after that, the one-month play is the way to go. After August expiration, Paul will have three choices: sell his Septembers, hold them, or turn them into a traditional iron condor by selling the September 47.50s and 52.50s. This depends on whether he is indifferent, expects high volatility, or expects low volatility.
|
||||
The Strength of the Calendar
|
||||
Spreads in the calendar-spread family allow traders to take their trading to a higher level of sophistication. More basic strategies, like vertical spreads and wing spreads, provide a practical means for taking positions in direction, realized volatility, and to some extent implied volatility. But because calendar-family spreads involve two expiration months, traders can take positions in the same market variables as with these more basic strategies and also in the volatility spread between different expiration months. Calendar-family spreads are veritable volatility spreads. This is a powerful tool for option traders to have at their disposal.
|
||||
Note
|
||||
1
|
||||
. Advanced hedging techniques are discussed in subsequent chapters.
|
||||
@@ -0,0 +1,35 @@
|
||||
172 • The Intelligent Option Investor
|
||||
the option’s value. Although everyone (especially fly-by-night investment
|
||||
newsletter editors) likes to tout their percentage returns, we know from
|
||||
our earlier investigations of leverage that percentage returns are only part
|
||||
of the story of successful investing. Let’s see why using the three invest-
|
||||
ments I mentioned earlier—an ITM call struck at $20, an OTM call struck
|
||||
at $39, and a long stock position at $31.
|
||||
I believe that there is a good chance that this stock is worth north of
|
||||
$40—in the $43 range, to be precise (my worst-case valuation was $30, and
|
||||
my best-case valuation was in the mid-$50 range). If I am right, and if this
|
||||
stock hits the $43 mark just as my options expire,
|
||||
2 what do I stand to gain
|
||||
from each of these investments?
|
||||
Let’s take a look.
|
||||
Spent Gross Profit Net Profit Percent Profit
|
||||
$39-strike call 0.18 4.00 3.82 2,122
|
||||
$20-strike call 11.50 23.00 11.50 100
|
||||
Shares 31.25 43.00 11.75 38
|
||||
This table means that in the case of the $20-strike call, we spent
|
||||
$11.50 to win gross proceeds of $23.00 (= $43 − $20) and a profit net of
|
||||
investment of $11.50. Netting $11.50 on an $11.50 investment generates a
|
||||
percentage profit of 100 percent.
|
||||
Looking at this chart, the first thing you are liable to notice is the
|
||||
“Percent Profit” column. That 2,122 percent return looks like something
|
||||
you might see advertised on an option tout service, doesn’t it? Y es, that
|
||||
percentage return is wonderful, until you realize that the absolute value
|
||||
of your dollar winnings will not allow you to buy a latte at Starbuck’s.
|
||||
Likewise, the 100 percent return on the $20-strike options looks heads and
|
||||
shoulders better than the measly 38 percent on the shares, until you again
|
||||
realize that the latter is still giving you more money by a quarter.
|
||||
Recall the definition of leverage as a way of “boosting investment re-
|
||||
turns calculated as a percentage, ” and recall that in my previous discussion
|
||||
of financial leverage, I mentioned that the absolute dollar value is always
|
||||
highest in the unlevered case. The fact is that many people get excited about
|
||||
stratospheric percentage returns, but stratospheric percentage returns only
|
||||
@@ -0,0 +1,36 @@
|
||||
752 Part VI: Measuring and Trading Volatility
|
||||
The above example assumed that the stock was making instantaneous changes
|
||||
in price. In reality, of course, time would be passing as well, and that affects the vega
|
||||
too. Table 37-2 shows how the vega changes when time changes, all other factors
|
||||
being equal.
|
||||
Example: In this example, the following items are held fixed: stock price (50), strike
|
||||
price (50), implied volatility (70%), risk-free interest rate (5%), and dividend\(0). But
|
||||
now, we let time fluctuate.
|
||||
Table 37-2 clearly shows that the passage of time results not only in a decreas
|
||||
ing call price, but in a decreasing vega as well. This makes sense, of course, since one
|
||||
cannot expect an increase in implied volatility to have much of an effect on a very
|
||||
short-term option - certainly not to the extent that it would affect a LEAPS option.
|
||||
Some readers might be wondering how changes in implied volatility itself would
|
||||
affect the vega. This might be called the "vega of the vega," although I've never actu
|
||||
ally heard it referred to in that manner. The next table explores that concept.
|
||||
Example: Again, some factors will be kept constant - the stock price (50), the time
|
||||
to July expiration (3 months), the risk-free interest rate (5%), and the dividend (0).
|
||||
Table 37-3 allows implied volatility to fluctuate and shows what the theoretical price
|
||||
of a July 50 call would be, as well as its vega, at those volatilities.
|
||||
Thus, Table 37-3 shows that vega is surprisingly constant over a wide range of
|
||||
implied volatilities. That's the real reason why no one bothers with "vega of the vega."
|
||||
Vega begins to decline only if implied volatility gets exceedingly high, and implied
|
||||
volatilities of that magnitude are relatively rare.
|
||||
One can also compute the distance a stock would need to rise in order to over
|
||||
come a decrease in volatility. Consider Figure 37-1, which shows the theoretical price
|
||||
TABLE 37-2
|
||||
Implied Time Theoretical
|
||||
Stock Price Volatility Remaining Call Price Vega
|
||||
50 70% One year 14.60 0.182
|
||||
Six months 10.32 0.135
|
||||
Three months 7.25 0.098
|
||||
Two months 5.87 0.080
|
||||
One month 4.16 0.058
|
||||
Two weeks 2.87 0.039
|
||||
One week 1.96 0.028
|
||||
One day 0.73 0.010
|
||||
@@ -0,0 +1,24 @@
|
||||
212 Part II: Call Option Strategies
|
||||
FIGURE 11 • 1.
|
||||
Ratio call spread (2: 1 ).
|
||||
Stock Price at Expiration
|
||||
1. The downside risk or gain is predetermined in the ratio spread at expiration, and
|
||||
therefore the position does not require much monitoring on the downside.
|
||||
2. The margin investment required for a ratio spread is normally smaller than that
|
||||
required for a ratio write, since on the long side one is buying a call rather than
|
||||
buying the common stock itself.
|
||||
For margin purposes, a ratio spread is really the combination of a bull spread
|
||||
and a naked call write. There is no margin requirement for a bull spread other than
|
||||
the net debit to establish the bull spread. The net investment for the ratio spread is
|
||||
thus equal to the collateral required for the naked calls in the spread plus or minus
|
||||
the net debit or credit of the spread. In the example above, there is one naked call.
|
||||
The requirement for the naked call is 20% of the stock price plus the call premium,
|
||||
less the out-of-the-money amount. So the requirement in the example would be 20%
|
||||
of 44, or $880, plus the call premium of $300, less the one point that the stock is
|
||||
below the striking price - a $1,080 requirement for the naked call. Since the spread
|
||||
was established at a credit of one point, this credit can also be applied against the ini
|
||||
tial requirement, thereby reducing that requirement to $980. Since there is a naked
|
||||
call in this spread, there will be a mark to market if the stock moves up. Just as was
|
||||
recommended for the ratio write, it is recommended that the ratio spreader allow at
|
||||
least enough collateral to reach the upside break-even point. Since the upside break
|
||||
even point is 51 in this example, the spreader should allow 20% of 51, or $1,020, plus
|
||||
@@ -0,0 +1,37 @@
|
||||
92 Part II: Call Option Strategies
|
||||
The basic strategy involves, as an initial step, selecting the target price at which
|
||||
the writer is willing to sell his stock.
|
||||
Example: A customer owns 1,000 shares of XYZ, which is currently at 60, and is will
|
||||
ing to sell the stock at 80. In the meantime, he would like to realize a positive cash
|
||||
flow from writing options against his stock. This positive cash flow does not neces
|
||||
sarily result in a realized option gain until the stock is called away. Most likely, with
|
||||
the stock at 60, there would not be options available with a striking price of 80, so one
|
||||
could not write 10 July 80's, for example. This would not be an optimum strategy
|
||||
even if the July 80's existed, for the investor would be receiving so little in option pre
|
||||
miums - perhaps 10 cents per call - that writing might not be worthwhile. The incre
|
||||
mental return strategy allows this investor to achieve his objectives regardless of the
|
||||
existence of options with a higher striking price.
|
||||
The foundation of the incremental return strategy is to write against only a part
|
||||
of the entire stock holding initially, and to write these calls at the striking price near
|
||||
est the current stock price. Then, should the stock move up to the next higher strik
|
||||
ing price, one rolls up for a credit by adding to the number of calls written. Rolling
|
||||
for a credit is mandatory and is the key to the strategy. Eventually, the stock reaches
|
||||
the target price and the stock is called away, the investor sells all his stock at the tar
|
||||
get price, and in addition earns the total credits from all the option transactions.
|
||||
Example: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One
|
||||
might begin by selling three of the longest-term calls at 60 for 7 points apiece. Table
|
||||
2-26 shows how a poor case - one in which the stock climbs directly to the target
|
||||
price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three
|
||||
original calls would be bought back and enough calls at 70 would be sold to produce
|
||||
a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month,
|
||||
the 5 calls would be bought back and the entire position - 10 calls - would be writ
|
||||
ten against the target price.
|
||||
If XYZ remains above 80, the stock will be called away and all 1,000 shares will
|
||||
be sold at the target price of 80. In addition, the investor will earn all the option cred
|
||||
its generated along the way. These amount to $2,800. Thus, the writer obtained the
|
||||
full appreciation of his stock to the target price plus an incremental, positive return
|
||||
from option writing.
|
||||
In a flat market, the strategy is relatively easy to monitor. If a written call loses
|
||||
its time value premium and therefore might be subject to assignment, the writer can
|
||||
roll forward to a more distant expiration series, keeping the quantity of written calls
|
||||
constant. This transaction would generate additional credits as well.
|
||||
@@ -0,0 +1,36 @@
|
||||
974 Glossary
|
||||
Monte Carlo Simulation: a model designed to simulate a real-world event that can
|
||||
not be approximated merely with a mathematical formula. The Monte Carlo sim
|
||||
ulation approximates such an event (the movement of the stock market, for exam
|
||||
ple) and then it is simulated a great number of times. The net result of all the sim
|
||||
ulations is then interpreted as the result, generally expressed as a probability of
|
||||
occurrence. For example, a Monte Carlo simulation can be used to determine how
|
||||
stocks might behave under certain stock price distributions that are different from
|
||||
the lognormal distribution.
|
||||
Naked Option: see Uncovered Option.
|
||||
Narrow-Based: Generally referring to an index, it indicates that the index is com
|
||||
posed of only a few stocks, generally in a specific industry group. Narrow-based
|
||||
indices are not subject to favorable treatment for naked option writers. See also
|
||||
Broad-Based.
|
||||
"Net" Order: see Contingent Order.
|
||||
Neutral: describing an opinion that is neither bearish or bullish. Neutral option
|
||||
strategies are generally designed to perform best if there is little nor no net change
|
||||
in the price of the underlying stock. See also Bearish, Bullish.
|
||||
Non-Equity Option: an option whose underlying entity is not common stock; typi
|
||||
cally refers to options on physical commodities, but may also be extended to
|
||||
include index options.
|
||||
"Not Held": see Market Not Held Order.
|
||||
Notice Period: the time during which the buyer of a futures contract can be called
|
||||
upon to accept delivery. Typically, the 3 to 6 weeks preceding the expiration of the
|
||||
contract.
|
||||
Open Interest: the net total of outstanding open contracts in a particular option
|
||||
series. An opening transaction increases the open interest, while any closing trans
|
||||
action reduces the open interest.
|
||||
Opening Transaction: a trade that adds to the net position of an investor. An open
|
||||
ing buy transaction adds more long securities to the account. An opening sell
|
||||
transaction adds more short securities. See also Closing Transaction.
|
||||
Option Pricing Curve: a graphical representation of the projected price of an
|
||||
option at a fixed point in time. It reflects the amount of time value premium in the
|
||||
option for various stock prices, as well. The curve is generated by using a mathe
|
||||
matical model. The delta ( or hedge ratio) is the slope of a tangent line to the curve
|
||||
at a fixed stock price. See also Delta, Hedge Ratio, Model.
|
||||
@@ -0,0 +1,20 @@
|
||||
Chapter 39: VolatiDty Trading Techniques 845
|
||||
lying instrument. Upon finding such discrepancies, the trader attempts to take
|
||||
advantage by constructing a more or less neutral position, preferring not to predict
|
||||
price so much, but rather attempting to predict volatility.
|
||||
Most volatility traders attempt to buy volatility rather than sell it, for the rea
|
||||
sons that the strategies inherent in doing so have limited risk and large potential
|
||||
rewards, and don't require one to monitor them continuously. If one owns a straddle,
|
||||
any major market movements resulting in gaps in prices are a benefit. Hence, mon
|
||||
itoring of positions as little as just once a day is sufficient, a fact that means that the
|
||||
volatility buyer can have a life apart from watching a trading screen all day long. In
|
||||
addition, volatility buyers of stock options can avail themselves of the chaotic move
|
||||
ments that stocks can make, taking advantage of the occasional fat tail movements.
|
||||
However, since volatility and prices are so unstable, one cannot predict their
|
||||
movements with any certainty. The vagaries of historical volatility as compared to
|
||||
implied volatility, the differences between the implied volatility of short- and long
|
||||
term options, and the difficulty in predicting stock price distributions all compli
|
||||
cate the process of predicting volatility. Hence, volatility trading is not a "lock," but
|
||||
its practitioners normally believe that it is by far the best approach to theoretical
|
||||
option trading available today. Moreover, most option professionals primarily trade
|
||||
volatility rather than directional positions.
|
||||
@@ -0,0 +1,397 @@
|
||||
Index
|
||||
American-exercise options
|
||||
Arbitrageurs
|
||||
At-the-money (ATM)
|
||||
Backspreads
|
||||
Bear call spread
|
||||
Bear put spread
|
||||
Bernanke, Ben
|
||||
Black, Fischer
|
||||
Black-Scholes option-pricing model
|
||||
Boxes
|
||||
building
|
||||
Bull call spread
|
||||
strengths and limitations
|
||||
Bull put spread
|
||||
Butterflies
|
||||
long
|
||||
alternatives
|
||||
example
|
||||
short
|
||||
iron
|
||||
long
|
||||
short
|
||||
Buy-to-close order
|
||||
Calendar spreads
|
||||
buying
|
||||
“free” call, rolling and earning
|
||||
rolling the spread
|
||||
income-generating, managing
|
||||
strength of
|
||||
trading volatility term structure
|
||||
buying the front, selling the back
|
||||
directional approach
|
||||
double calendars
|
||||
ITM or OTM
|
||||
selling the front, buying the back
|
||||
Calls
|
||||
buying
|
||||
covered
|
||||
entering
|
||||
exiting
|
||||
long ATM
|
||||
delta
|
||||
gamma
|
||||
rho
|
||||
theta
|
||||
tweaking greeks
|
||||
vega
|
||||
long ITM
|
||||
long OTM
|
||||
selling
|
||||
Cash settlement
|
||||
Chicago Board Options Exchange (CBOE) Volatility Index
|
||||
®
|
||||
Condors
|
||||
iron
|
||||
long
|
||||
short
|
||||
long
|
||||
short
|
||||
strikes
|
||||
safe landing
|
||||
selectiveness
|
||||
too close
|
||||
too far
|
||||
with high probability of success
|
||||
Contractual rights and obligations
|
||||
open interest and volume
|
||||
opening and closing
|
||||
Options Clearing Corporation (OCC)
|
||||
standardized contracts
|
||||
exercise style
|
||||
expiration month
|
||||
option series, option class, and contract size
|
||||
option type
|
||||
premium
|
||||
quantity
|
||||
strike price
|
||||
Credit call spread
|
||||
Debit call spread
|
||||
Delta
|
||||
dynamic inputs
|
||||
effect of stock price on
|
||||
effect of time on
|
||||
effect of volatility on
|
||||
moneyness and
|
||||
Delta-neutral trading
|
||||
art and science
|
||||
direction neutral vs. direction indifferent
|
||||
gamma, theta, and volatility
|
||||
gamma scalping
|
||||
implied volatility, trading
|
||||
selling
|
||||
portfolio margining
|
||||
realized volatility, trading
|
||||
reasons for
|
||||
smileys and frowns
|
||||
Diagonal spreads
|
||||
double
|
||||
Dividends
|
||||
basics
|
||||
and early exercise
|
||||
dividend plays
|
||||
strange deltas
|
||||
and option pricing
|
||||
pricing model, inputting data into
|
||||
dates, good and bad
|
||||
dividend size
|
||||
Estimation, imprecision of
|
||||
European-exercise options
|
||||
Exchange-traded fund (ETF) options
|
||||
Exercise style
|
||||
Expected volatility
|
||||
CBOE Volatility Index®
|
||||
implied
|
||||
stock
|
||||
Expiration month
|
||||
Ford Motor Company
|
||||
Fundamental analysis
|
||||
Gamma
|
||||
dynamic
|
||||
scalping
|
||||
Greeks
|
||||
adjusting
|
||||
defined
|
||||
delta
|
||||
dynamic inputs
|
||||
effect of stock price on
|
||||
effect of time on
|
||||
effect of volatility on
|
||||
moneyness and
|
||||
gamma
|
||||
dynamic
|
||||
HAPI: Hope and Pray Index
|
||||
managing trades
|
||||
online, caveats with regard to
|
||||
price vs. value
|
||||
rho
|
||||
counterintuitive results
|
||||
effect of time on
|
||||
put-call parity
|
||||
strategies, choosing between
|
||||
theta
|
||||
effect of moneyness and stock price on
|
||||
effects of volatility and time on
|
||||
positive or negative
|
||||
taking the day out
|
||||
trading
|
||||
vega
|
||||
effect of implied volatility on
|
||||
effect of moneyness on
|
||||
effect of time on
|
||||
implied volatility (IV) and
|
||||
where to find
|
||||
Greenspan, Alan
|
||||
HOLDR options
|
||||
Implied volatility (IV)
|
||||
trading
|
||||
selling
|
||||
and vega
|
||||
In-the-money (ITM)
|
||||
Index options
|
||||
Interest, open
|
||||
Interest rate moves, pricing in
|
||||
Intrinsic value
|
||||
Jelly rolls
|
||||
Long-Term Equity AnticiPation Securities® (LEAPS®)
|
||||
Open interest
|
||||
Option, definition of
|
||||
Option class
|
||||
Option prices, measuring incremental changes in factors affecting
|
||||
Option series
|
||||
Options Clearing Corporation (OCC)
|
||||
Out-of-the-money (OTM)
|
||||
Parity, definition of
|
||||
Pin risk
|
||||
borrowing and lending money
|
||||
boxes
|
||||
jelly rolls
|
||||
Premium
|
||||
Price discovery
|
||||
Price vs. value
|
||||
Pricing model, inputting data into
|
||||
dates, good and bad
|
||||
dividend size
|
||||
“The Pricing of Options and Corporate Liabilities” (Black & Scholes)
|
||||
Put-call parity
|
||||
American exercise options
|
||||
essentials
|
||||
dividends
|
||||
synthetic calls and puts, comparing
|
||||
synthetic stock
|
||||
strategies
|
||||
theoretical value and interest rate
|
||||
Puts
|
||||
buying
|
||||
cash-secured
|
||||
long ATM
|
||||
married
|
||||
selling
|
||||
Ratio spreads and complex spreads
|
||||
delta-neutral positions, management by market makers
|
||||
through longs to shorts
|
||||
risk, hedging
|
||||
trading flat
|
||||
multiple-class risk
|
||||
ratio spreads
|
||||
backspreads
|
||||
vertical
|
||||
skew, trading
|
||||
Realized volatility
|
||||
trading
|
||||
Reversion to the mean
|
||||
Rho
|
||||
counterintuitive results
|
||||
effect of time on
|
||||
and interest rates
|
||||
in planning trades
|
||||
interest rate moves, pricing in
|
||||
LEAPS
|
||||
put-call parity
|
||||
and time
|
||||
trading
|
||||
Risk and opportunity, option-specific
|
||||
finding the right risk
|
||||
long ATM call
|
||||
delta
|
||||
gamma
|
||||
rho
|
||||
theta
|
||||
tweaking greeks
|
||||
vega
|
||||
long ATM put
|
||||
long ITM call
|
||||
long OTM call
|
||||
options and the fair game
|
||||
volatility
|
||||
buying and selling
|
||||
direction neutral, direction biased, and direction indifferent
|
||||
Scholes, Myron
|
||||
Sell-to-open transaction
|
||||
Skew
|
||||
term structure
|
||||
trading
|
||||
vertical
|
||||
Spreads
|
||||
calendar
|
||||
buying
|
||||
“free” call, rolling and earning
|
||||
income-generating, managing
|
||||
strength of
|
||||
trading volatility term structure
|
||||
diagonal
|
||||
double
|
||||
ratio and complex
|
||||
delta-neutral positions, management by market makers
|
||||
multiple-class risk
|
||||
ratio
|
||||
skew, trading
|
||||
vertical
|
||||
bear call
|
||||
bear put
|
||||
box, building
|
||||
bull call
|
||||
bull put
|
||||
credit and debit, interrelations of
|
||||
credit and debit, similarities in
|
||||
and volatility
|
||||
wing
|
||||
butterflies
|
||||
condors
|
||||
greeks and
|
||||
keys to success
|
||||
retail trader vs. pro
|
||||
trades, constructing to maximize profit
|
||||
Standard deviation
|
||||
and historical volatility
|
||||
Standard & Poor’s Depositary Receipts (SPDRs or Spiders)
|
||||
Straddles
|
||||
long
|
||||
basic
|
||||
trading
|
||||
short
|
||||
risks with
|
||||
trading
|
||||
synthetic
|
||||
Strangles
|
||||
long
|
||||
example
|
||||
short
|
||||
premium
|
||||
risk, limiting
|
||||
Strategies and At-Expiration Diagrams
|
||||
buy call
|
||||
buy put
|
||||
factors affecting option prices, measuring incremental changes in
|
||||
sell call
|
||||
sell put
|
||||
Strike price
|
||||
Supply and demand
|
||||
Synthetic stock
|
||||
strategies
|
||||
conversion
|
||||
market makers
|
||||
pin risk
|
||||
reversal
|
||||
Technical analysis
|
||||
Teenie buyers
|
||||
Teenie sellers
|
||||
Theta
|
||||
effect of moneyness and stock price on
|
||||
effects of volatility and time on
|
||||
positive or negative
|
||||
risk
|
||||
taking the day out
|
||||
Time value
|
||||
Trading strategies
|
||||
Value
|
||||
Vega
|
||||
effect of implied volatility on
|
||||
effect of moneyness on
|
||||
effect of time on
|
||||
implied volatility (IV) and
|
||||
Vertical spreads
|
||||
bear call
|
||||
bear put
|
||||
box, building
|
||||
bull call
|
||||
bull put
|
||||
credit and debit
|
||||
interrelations of
|
||||
similarities in
|
||||
and volatility
|
||||
Volatility
|
||||
buying and selling
|
||||
teenie buyers
|
||||
teenie sellers
|
||||
calculating data
|
||||
direction neutral, direction biased, and direction indifferent
|
||||
expected
|
||||
CBOE Volatility Index®
|
||||
implied
|
||||
stock
|
||||
historical (HV)
|
||||
standard deviation
|
||||
implied (IV)
|
||||
and direction
|
||||
HV-IV divergence
|
||||
inertia
|
||||
relationship of HV and IV
|
||||
selling
|
||||
supply and demand
|
||||
realized
|
||||
trading
|
||||
skew
|
||||
term structure
|
||||
vertical
|
||||
vertical spreads and
|
||||
Volatility charts, studying
|
||||
patterns
|
||||
implied and realized volatility rise
|
||||
realized volatility falls, implied volatility falls
|
||||
realized volatility falls, implied volatility remains constant
|
||||
realized volatility falls, implied volatility rises
|
||||
realized volatility remains constant, implied volatility falls
|
||||
realized volatility remains constant, implied volatility remains constant
|
||||
realized volatility remains constant, implied volatility rises
|
||||
realized volatility rises, implied volatility falls
|
||||
realized volatility rises, implied volatility remains constant
|
||||
Volatility-selling strategies
|
||||
profit potential
|
||||
covered call
|
||||
covered put
|
||||
gamma-theta relationship
|
||||
greeks and income generation
|
||||
naked call
|
||||
short naked puts
|
||||
similarities
|
||||
Would I Do It Now? Rule
|
||||
Volume
|
||||
Weeklys
|
||||
SM
|
||||
Wing spreads
|
||||
butterflies
|
||||
directional
|
||||
long
|
||||
short
|
||||
iron
|
||||
condors
|
||||
iron
|
||||
long
|
||||
short
|
||||
greeks and
|
||||
keys to success
|
||||
retail trader vs. pro
|
||||
trades, constructing to maximize profit
|
||||
Would I Do It Now? Rule
|
||||
@@ -0,0 +1,38 @@
|
||||
778 Part VI: Measuring and Trading Volatility
|
||||
FIGURE 37-9.
|
||||
Bear put spread profit in 30 days.
|
||||
1000 IV= 30%
|
||||
Assignment
|
||||
Risk
|
||||
Area
|
||||
(/)
|
||||
(/)
|
||||
0
|
||||
...J
|
||||
~ 0
|
||||
e 70 80 110 120 130 140
|
||||
a.
|
||||
ff7
|
||||
IV= 80%
|
||||
-1000
|
||||
'~
|
||||
Stock
|
||||
problem, though, since the spread would have widened to its maximum potential in
|
||||
that case and could just be removed when the risk of early assignment materialized.
|
||||
When implied volatility remains high, though, the spread doesn't widen out
|
||||
much, even when the stock drops a lot after 30 days. Since it is common for implied
|
||||
volatility to rise (even skyrocket) when the underlying drops quickly, the put bear
|
||||
spread probably won't widen out much. That may not be a psychologically pleasing
|
||||
strategy, because one won't make the level of profits that he had hoped to when the
|
||||
underlying fell quickly.
|
||||
Once again, it seems that the outright purchase of an option is probably superi
|
||||
or to a spread. In these cases, it is true with respect to puts, much as it was with call
|
||||
options. Spreading often unnecessarily complicates a trader's outlook.
|
||||
CALENDAR SPREADS
|
||||
In the earlier chapter on calendar spreads, it was mentioned that an increase in
|
||||
implied volatility will cause a calendar spread to widen out. Both options will become
|
||||
more expensive, of course, since the increase in implied volatility affects both of
|
||||
them, but the absolute price change will be greatest in the long-term option.
|
||||
Therefore, the calendar spread will widen. This may seem somewhat counterintu
|
||||
itive, especially where highly volatile stocks are concerned, so some examples may
|
||||
prove useful.
|
||||
@@ -0,0 +1,182 @@
|
||||
CHAPTER 1
|
||||
The Basics
|
||||
To understand how options work, one needs first to understand what an option is. An option is a contract that gives its owner the right to buy or the right to sell a fixed quantity of an underlying security at a specific price within a certain time constraint. There are two types of options: calls and puts. A call gives the owner of the option the right to buy the underlying security. A put gives the owner of the option the right to sell the underlying security. As in any transaction, there are two parties to an option contract—a buyer and a seller.
|
||||
Contractual Rights and Obligations
|
||||
The option buyer is the party who owns the right inherent in the contract. The buyer is referred to as having a long position and may also be called the holder, or owner, of the option. The right doesn’t last forever. At some point the option will expire. At expiration, the owner may exercise the right or, if the option has no value to the holder, let it expire without exercising it. But he need not hold the option until expiration. Options are transferable—they can be traded intraday in much the same way as stock is traded. Because it’s uncertain what the underlying stock price of the option will be at expiration, much of the time this right has value before it expires. The uncertainty of stock prices, after all, is the raison d’être of the option market.
|
||||
A long position in an option contract, however, is fundamentally different from a long position in a stock. Owning corporate stock affords the shareholder ownership rights, which may include the right to vote in corporate affairs and the right to receive dividends. Owning an option represents strictly the right either to buy the stock or to sell it, depending on whether it’s a call or a put. Option holders do not receive dividends that would be paid to the shareholders of the underlying stock, nor do they have voting rights. The corporation has no knowledge of the parties to the option contract. The contract is created by the buyer and seller of the option and made available by being listed on an exchange.
|
||||
The party to the contract who is referred to as the option seller, also called the option writer, has a short position in the option. Instead of having a right to take a position in the underlying stock, as the buyer does, the seller incurs an obligation to potentially either buy or sell the stock. When a trader who is long an option exercises, a trader with a short position gets
|
||||
assigned
|
||||
. Assignment means the trader with the short option position is called on to fulfill the obligation that was established when the contract was sold.
|
||||
Shorting an option is fundamentally different from shorting a stock. Corporations have a quantifiable number of outstanding shares available for trading, which must be borrowed to create a short position, but establishing a short position in an option does not require borrowing; the contract is simply created. The strategy of shorting stock is implemented statistically far less frequently than simply buying stock, but that is not at all the case with options. For every open long-option contract, there is an open short-option contract—they are equally common.
|
||||
Opening and Closing
|
||||
Traders’ option orders are either opening or closing transactions. When traders with no position in a particular option buy the option, they buy to open. If, in the future, the traders wish to eliminate the position by selling the option they own, the traders enter a sell to close order—they are closing the position. Likewise, if traders with no position in a particular option want to sell an option, thereby creating a short position, the traders execute a sell-to-open transaction. When the traders cover the short position by buying back the option, the traders enter a buy-to-close order.
|
||||
Open Interest and Volume
|
||||
Traders use many types of market data to make trading decisions. Two items that are often studied but sometimes misunderstood are volume and open interest. Volume, as the name implies, is the total number of contracts traded during a time period. Often, volume is stated on a one-day basis, but could be stated per week, month, year, or otherwise. Once a new period (day) begins, volume begins again at zero. Open interest is the number of contracts that have been created and remain outstanding. Open interest is a running total.
|
||||
When an option is first listed, there are no open contracts. If Trader A opens a long position in a newly listed option by buying a one-lot, or one contract, from Trader B, who by selling is also opening a position, a contract is created. One contract traded, so the volume is one. Since both parties opened a position and one contract was created, the open interest in this particular option is one contract as well. If, later that day, Trader B closes his short position by buying one contract from Trader C, who had no position to start with, the volume is now two contracts for that day, but open interest is still one. Only one contract exists; it was traded twice. If the next day, Trader C buys her contract back from Trader A, that day’s volume is one and the open interest is now zero.
|
||||
The Options Clearing Corporation
|
||||
Remember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday for a hamburger today.” Did Popeye ever get paid for those burgers? In a contract, it’s very important for each party to hold up his end of the bargain—especially when there is money at stake. How does a trader know the party on the other side of an option contract will in fact do that? That’s where the Options Clearing Corporation (OCC) comes into play.
|
||||
The OCC ultimately guarantees every options trade. In 2010, that was almost 3.9 billion listed-options contracts. The OCC accomplishes this through many clearing members. Here’s how it works: When Trader X buys an option through a broker, the broker submits the trade information to its clearing firm. The trader on the other side of this transaction, Trader Y, who is probably a market maker, submits the trade to his clearing firm. The two clearing firms (one representing Trader X’s buy, the other representing Trader Y’s sell) each submit the trade information to the OCC, which “matches up” the trade.
|
||||
If Trader Y buys back the option to close the position, how does that affect Trader X if he wants to exercise it? It doesn’t. The OCC, acting as an intermediary, assigns one of its clearing members with a customer that is short the option in question to deliver the stock to Trader X’s clearing firm, which in turn delivers the stock to Trader X. The clearing member then assigns one of its customers who is short the option. The clearing member will assign the trader either randomly or first in, first out. Effectively, the OCC is the ultimate counterparty to both the exercise and the assignment.
|
||||
Standardized Contracts
|
||||
Exchange-listed options contracts are standardized, meaning the terms of the contract, or the contract specifications, conform to a customary structure. Standardization makes the terms of the contracts intuitive to the experienced user.
|
||||
To understand the contract specifications in a typical equity option, consider an example:
|
||||
Buy 1 IBM December 170 call at 5.00
|
||||
Quantity
|
||||
In this example, one contract is being purchased. More could have been purchased, but not less—options cannot be traded in fractional units.
|
||||
Option Series, Option Class, and Contract Size
|
||||
All calls or puts of the same class, the same expiration month, and the same strike price are called an
|
||||
option series
|
||||
. For example, the IBM December 170 calls are a series. Options series are displayed in an option chain on an online broker’s user interface. An option chain is a full or partial list of the options that are listed on an underlying.
|
||||
Option class
|
||||
means a group of options that represent the same underlying. Here, the option class is denoted by the symbol IBM—the contract represents rights on International Business Machines Corp. (IBM) shares. Buying one contract usually gives the holder the right to buy or to sell 100 shares of the underlying stock. This number is referred to as
|
||||
contract size
|
||||
. Though this is usually the case, there are times when the contract size is something other than 100 shares of a stock. This situation may occur after certain types of stock splits, spin-offs, or stock dividends, for example. In the minority of cases in which the one contract represents rights on something besides 100 shares, there may be more than one class of options listed on a stock.
|
||||
A fairly unusual example was presented by the Ford Motor Company options in the summer of 2000. In June 2000, Ford spun off Visteon Corporation. Then, in August 2000, Ford offered shareholders a choice of converting their shares into (a) new shares of Ford plus $20 cash per share, (b) new Ford stock plus fractional shares with an aggregate value of $20, or (c) new Ford stock plus a combination of more new Ford stock and cash. There were three classes of options listed on Ford after both of these changes: F represented 100 shares of the new Ford stock; XFO represented 100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24; and FOD represented 100 shares of new Ford, 13 shares of Visteon, and $2,001.24.
|
||||
Sometimes these changes can get complicated. If there is ever a question as to what the underlying is for an option class, the authority is the OCC. A lot of time, money, and stress can be saved by calling the OCC at 888-OPTIONS and clarifying the matter.
|
||||
Expiration Month
|
||||
Options expire on the Saturday following the third Friday of the stated month, which in this case is December. The final trading day for an option is commonly the day before expiration—here, the third Friday of December. There are usually at least four months listed for trading on an option class. There may be a total of six months if Long-Term Equity AnticiPation Securities
|
||||
®
|
||||
or LEAPS
|
||||
®
|
||||
are listed on the class. LEAPS can have one year to about two-and-a-half years until expiration. Some underlyings have one-week options called Weeklys
|
||||
SM
|
||||
listed on them.
|
||||
Strike Price
|
||||
The price at which the option holder owns the right to buy or to sell the underlying is called the strike price, or exercise price. In this example, the holder owns the right to buy the stock at $170 per share. There is method to the madness regarding how strike prices are listed. Strike prices are generally listed in $1, $2.50, $5, or $10 increments, depending on the value of the strikes and the liquidity of the options.
|
||||
The relationship of the strike price to the stock price is important in pricing options. For calls, if the stock price is above the strike price, the call is in-the-money (ITM). If the stock and the strike prices are close, the call is at-the-money (ATM). If the stock price is below the strike price the call is out-of-the-money (OTM). This relationship is just the opposite for puts. If the stock price is below the strike price, the put is in-the-money. If the stock price and the strike price are about the same, the put is at-the-money. And, if the stock price is above the put strike, it is out-of-the-money.
|
||||
Option Type
|
||||
There are two types of options: calls and puts. Calls give the holder the right to buy the underlying and the writer the obligation to sell the underlying. Puts give the holder the right to sell the underlying and the writer the obligation to buy the underlying.
|
||||
Premium
|
||||
The price of an option is called its premium. The premium of this option is $5. Like stock prices, option premiums are stated in dollars and cents per share. Since the option represents 100 shares of IBM, the buyer of this option will pay $500 when the transaction occurs. Certain types of spreads may be quoted in fractions of a penny.
|
||||
An option’s premium is made up of two parts: intrinsic value and time value. Intrinsic value is the amount by which the option is in-the-money. For example, if IBM stock were trading at 171.30, this 170-strike call would be in-the-money by 1.30. It has 1.30 of intrinsic value. The remaining 3.70 of its $5 premium would be time value.
|
||||
Options that are out-of-the-money have no intrinsic value. Their values consist only of time premium. Sometimes options have no time value left. Options that consist of only intrinsic value are trading at what traders call
|
||||
parity
|
||||
. Time value is sometimes called
|
||||
premium over parity
|
||||
.
|
||||
Exercise Style
|
||||
One contract specification that is not specifically shown here is the exercise style. There are two main exercise styles: American and European. American-exercise options can be exercised, and therefore assigned, anytime after the contract is entered into until either the trader closes the position or it expires. European-exercise options can be exercised and assigned only at expiration. Exchange-listed equity options are all American-exercise style. Other kinds of options are commonly European exercise. Whether an option is American or European has nothing to with the country in which it’s listed.
|
||||
ETFs, Indexes, and HOLDRs
|
||||
So far, we’ve focused on equity options—options on individual stocks. But investors have other choices for trading securities options. Options on baskets of stocks can be traded, too. This can be accomplished using options on exchange-traded funds (ETFs), index options, or options on holding company depositary receipts (HOLDRs).
|
||||
ETF Options
|
||||
Exchange-traded funds are vehicles that represent ownership in a fund or investment trust. This fund is made up of a basket of an underlying index’s securities—usually equities. The contract specifications of ETF options are similar to those of equity options. Let’s look at an example.
|
||||
One actively traded optionable ETF is the Standard & Poor’s Depositary Receipts (SPDRs or Spiders). Spider shares and options trade under the symbol SPY. Exercising one SPY call gives the exerciser a long position of 100 shares of Spiders at the strike price of the option. Expiration for ETF options typically falls on the same day as for equity options—the Saturday following the third Friday of the month. The last trading day is the Friday before. ETF options are American exercise. Traders of ETFs should be aware of the relationship between the price of the ETF shares and the value of the underlying index. For example, the stated value of the Spiders is about one tenth the stated value of the S&P 500. The PowerShares QQQ ETF, representing the Nasdaq 100, is about one fortieth the stated value of the Nasdaq 100.
|
||||
Index Options
|
||||
Trading options on the Spiders ETF is a convenient way to trade the Standard & Poor’s (S&P) 500. But it’s not the only way. There are other option contracts listed on the S&P 500. The SPX is one of the major ones. The SPX is an index option contract. There are some very important differences between ETF options like SPY and index options like SPX.
|
||||
The first difference is the underlying. The underlying for ETF options is 100 shares of the ETF. The underlying for index options is the numerical value of the index. So if the S&P 500 is at 1303.50, the underlying for SPX options is 1303.50. When an SPX call option is exercised, instead of getting 100 shares of something, the exerciser gets the ITM cash value of the option times $100. Again, with SPX at 1303.50, if a 1300 call is exercised, the exerciser gets $350—that’s 1303.50 minus 1300, times $100. This is called
|
||||
cash settlement
|
||||
.
|
||||
Many index options are European, which means no early exercise. At expiration, any long ITM options in a trader’s inventory result in an account credit; any short ITMs result in a debit of the ITM value times $100. The settlement process for determining whether a European-style index option is in-the-money at expiration is a little different, too. Often, these indexes are a.m. settled. A.m.-settled index options will have actual expiration on the conventional Saturday following the third Friday of the month. But the final trading day is the Thursday before the expiration day. The final settlement value of the index is determined by the opening prices of the components of the index on Friday morning.
|
||||
HOLDR Options
|
||||
Like ETFs, holding company depositary receipts also represent ownership in a basket of stocks. The main difference is that investors owning HOLDRs retain the ownership rights of the individual stocks in the fund, such as the right to vote shares and the right to receive dividends. Options on HOLDRs, for all intents and purposes, function much like options on ETFs.
|
||||
Strategies and At-Expiration Diagrams
|
||||
One of the great strengths of options is that there are so many different ways to use them. There are simple, straightforward strategies like buying a call. And there are complex spreads with creative names like jelly roll, guts, and iron butterfly. A spread is a strategy that involves combining an option with one or more other options or stock. Each component of the spread is referred to as a leg. Each spread has its own unique risk and reward characteristics that make it appropriate for certain market outlooks.
|
||||
Throughout this book, many different spreads will be discussed in depth. For now, it’s important to understand that all spreads are made up of a combination of four basic option positions: buy call, sell call, buy put, and sell put. Understanding complex option strategies requires understanding these basic positions and their common, practical uses. When learning options, it’s helpful to see what the option’s payout is if it is held until expiration.
|
||||
Buy Call
|
||||
Why buy the right to buy the stock when you can simply buy the stock? All option strategies have trade-offs, and the long call is no different. Whether the stock or the call is preferable depends greatly on the trader’s forecast and motivations.
|
||||
Consider a long call example:
|
||||
Buy 1 INTC June 22.50 call at 0.85.
|
||||
In this example, a trader is bullish on Intel (INTC). He believes Intel will rise at least 20 percent, from $22.25 per share to around $27 by June expiration, about two months from now. He is concerned, however, about downside risk and wants to limit his exposure. Instead of buying 100 shares of Intel at $22.25—a total investment of $2,225—the trader buys 1 INTC June 22.50 call at 0.85, for a total of $85.
|
||||
The trader is paying 0.85 for the right to buy 100 shares of Intel at $22.50 per share. If Intel is trading below the strike price of $22.50 at expiration, the call will expire and the total premium of 0.85 will be lost. Why? The trader will not exercise the right to buy the stock at a $22.50 if he can buy it cheaper in the market. Therefore, if Intel is below $22.50 at expiration, this call will expire with no value.
|
||||
However, if the stock is trading above the strike price at expiration, the call can be exercised, in which case the trader may purchase the stock below its trading price. Here, the call has value to the trader. The higher the stock, the more the call is worth. For the trade to be profitable, at expiration the stock must be trading above the trader’s break-even price. The break-even price for a long call is the strike price plus the premium paid—in this example, $23.35 per share. The point here is that if the call is exercised, the effective purchase price of the stock upon exercise is $23.35. The stock is literally bought at the strike price, which is $22.50, but the premium of 0.85 that the trader has paid must be taken into account.
|
||||
Exhibit 1.1
|
||||
illustrates this example.
|
||||
EXHIBIT 1.1
|
||||
Long Intel call.
|
||||
Exhibit 1.1
|
||||
is an at-expiration diagram for the Intel 22.50 call. It shows the profit and loss, or P&(L), of the option if it is held until expiration. The X-axis represents the prices at which INTC could be trading at expiration. The Y-axis represents the associated profit or loss on the position. The at-expiration diagram of any long call position will always have this same hockey-stick shape, regardless of the stock or strike. There is always a limit of loss, represented by the horizontal line, which in this case is drawn at −0.85. And there is always a line extending upward and to the right, which represents effectively a long stock position stemming from the strike.
|
||||
The trade-offs between a long stock position and a long call position are shown in
|
||||
Exhibit 1.2
|
||||
.
|
||||
EXHIBIT 1.2
|
||||
Long Intel call vs. long Intel stock.
|
||||
The thin dotted line represents owning 100 shares of Intel at $22.25. Profits are unlimited, but the risk is substantial—the stock
|
||||
can
|
||||
go to zero. Herein lies the trade-off. The long call has unlimited profit potential with limited risk. Whenever an option is purchased, the most that can be lost is the premium paid for the option. But the benefit of reduced risk comes at a cost. If the stock is above the strike at expiration, the call will always underperform the stock by the amount of the premium.
|
||||
Because of this trade-off, conservative traders will sometimes buy a call rather than the associated stock and sometimes buy the stock rather than the call. Buying a call can be considered more conservative when the volatility of the stock is expected to rise. Traders are willing to risk a comparatively small premium when a large price decline is feared possible. Instead, in an interest-bearing vehicle, they harbor the capital that would otherwise have been used to purchase the stock. The cost of this protection is acceptable to the trader if high-enough price advances are anticipated. In terms of percentage, much higher returns
|
||||
and losses
|
||||
are possible with the long call. If the stock is trading at $27 at expiration, as the trader in this example expected, the trader reaps a 429 percent profit on the $0.85 investment ([$27 − 23.35] / $0.85). If Intel is below the strike price at expiration, the trader loses 100 percent.
|
||||
This makes call buying an excellent speculative alternative. Those willing to accept bigger risk can further increase returns by purchasing more calls. In this example, around 26 Intel calls—representing the rights on 2,600 shares—can be purchased at 85 cents for the cost of 100 shares at $22.25. This is the kind of leverage that allows for either a lower cash outlay than buying the stock—reducing risk—or the same cash outlay as buying the stock but with much greater exposure—creating risk in pursuit of higher returns.
|
||||
Sell Call
|
||||
Selling a call creates the obligation to sell the stock at the strike price. Why is a trader willing to accept this obligation? The answer is option premium. If the position is held until expiration without getting assigned, the entire premium represents a profit for the trader. If assignment occurs, the trader will be obliged to sell stock at the strike price. If the trader does not have a long position in the underlying stock (a naked call), a short stock position will be created. Otherwise, if stock is owned (a covered call), that stock is sold. Whether the trader has a profit or a loss depends on the movement of the stock price and how the short call position was constructed.
|
||||
Consider a naked call example:
|
||||
Sell 1 TGT October 50 call at 1.45
|
||||
In this example, Target Corporation (TGT) is trading at $49.42. A trader, Sam, believes Target will continue to be trading below $50 by October expiration, about two months from now. Sam sells 1 Target two-month 50 call at 1.45, opening a short position in that series.
|
||||
Exhibit 1.3
|
||||
will help explain the expected payout of this naked call position if it is held until expiration.
|
||||
EXHIBIT 1.3
|
||||
Naked Target call.
|
||||
If TGT is trading below the exercise price of 50, the call will expire worthless. Sam keeps the 1.45 premium, and the obligation to sell the stock ceases to exist. If Target is trading above the strike price, the call will be in-the-money. The higher the stock is above the strike price, the more intrinsic value the call will have. As a seller, Sam wants the call to have little or no intrinsic value at expiration. If the stock is below the break-even price at expiration, Sam will still have a profit. Here, the break-even price is $51.45—the strike price plus the call premium. Above the break-even, Sam has a loss. Since stock prices can rise to infinity (although, for the record, I have never seen this happen), the naked call position has unlimited risk of loss.
|
||||
Because a short stock position may be created, a naked call position must be done in a margin account. For retail traders, many brokerage firms require different levels of approval for different types of option strategies. Because the naked call position has unlimited risk, establishing it will generally require the highest level of approval—and a high margin requirement.
|
||||
Another tactical consideration is what Sam’s objective was when he entered the trade. His goal was to profit from the stock’s being below $50 during this two-month period—not to short the stock. Because equity options are American exercise and can be exercised/assigned any time from the moment the call is sold until expiration, a short stock position cannot always be avoided. If assigned, the short stock position will extend Sam’s period of risk—because stock doesn’t expire. Here, he will pay one commission shorting the stock when assignment occurs and one more when he
|
||||
buys back
|
||||
the unwanted position. Many traders choose to close the naked call position before expiration rather than risk assignment.
|
||||
It is important to understand the fundamental difference between buying calls and selling calls. Buying a call option offers limited risk and unlimited reward. Selling a naked call option, however, has limited reward—the call premium—and unlimited risk. This naked call position is not so much bearish as
|
||||
not bullish
|
||||
. If Sam thought the stock was going to zero, he would have chosen a different strategy.
|
||||
Now consider a covered call example:
|
||||
Buy 100 shares TGT at $49.42
|
||||
Sell 1 TGT October 50 call at 1.45
|
||||
Unlimited
|
||||
and
|
||||
risk
|
||||
are two words that don’t sit well together with many traders. For that reason, traders often prefer to sell calls as part of a spread. But since spreads are strategies that involve multiple components, they have different risk characteristics from an outright option. Perhaps the most commonly used call-selling spread strategy is the covered call (sometimes called a
|
||||
covered write
|
||||
or a
|
||||
buy-write
|
||||
). While selling a call naked is a way to take advantage of a “not bullish” forecast, the covered call achieves a different set of objectives.
|
||||
After studying Target Corporation, another trader, Isabel, has a neutral to slightly bullish forecast. With Target at $49.42, she believes the stock will be range-bound between $47 and $51.50 over the next two months, ending with October expiration. Isabel buys 100 shares of Target at $49.42 and sells 1 TGT October 50 call at 1.45. The implications for the covered-call strategy are twofold: Isabel must be content to own the stock at current levels, and—since she sold the right to buy the stock at $50, that is, a 50 call, to another party—she must be willing to sell the stock if the price rises to or through $50 per share.
|
||||
Exhibit 1.4
|
||||
shows how this covered call performs if it is held until the call expires.
|
||||
EXHIBIT 1.4
|
||||
Target covered call.
|
||||
The solid kinked line represents the covered call position, and the thin, straight dotted line represents owning the stock outright. At the expiration of the call option, if Target is trading below $50 per share—the strike price—the call expires and Isabel is left with a long position of 100 shares
|
||||
plus
|
||||
$1.45 per share of expired-option premium. Below the strike, the buy-write always outperforms simply owning the stock by the amount of the premium. The call premium provides limited downside protection; the stock Isabel owns can decline $1.45 in value to $47.97 before the trade is a loser. In the unlikely event the stock collapses and becomes worthless, this limited downside protection is not so comforting. Ultimately, Isabel has $47.97 per share at risk.
|
||||
The trade-off comes if Target is above $50 at expiration. Here, assignment will likely occur, in which case the stock will be sold. The call can be assigned before expiration, too, causing the stock to be
|
||||
called away
|
||||
early. Because the covered call involves this obligation to sell the sock at the strike price, upside potential is limited. In this case, Isabel’s profit potential is $2.03. The stock can rise from $49.42 to $50—a $0.58 profit—plus $1.45 of option premium.
|
||||
Isabel does not want the stock to decline too much. Below $47.97, the trade is a loser. If the stock rises too much, the stock is sold prematurely and upside opportunity is lost. Limited reward and unlimited risk. (Technically, the risk is not unlimited—the stock can only go to zero. But if the stock drops from $49.42 to zero in a short time, the risk will certainly feel unlimited.) The covered call strategy is for a neutral to moderately bullish outlook.
|
||||
Sell Put
|
||||
Selling a put has many similarities to the covered call strategy. We’ll discuss the two positions and highlight the likenesses. Chapter 6 will detail the nuts and bolts of why these similarities exist.
|
||||
Consider an example of selling a put:
|
||||
Sell 1 BA January 65 put at 1.20
|
||||
In this example, trader Sam is neutral to moderately bullish on Boeing (BA) between now and January expiration. He is not bullish enough to buy BA at the current market price of $69.77 per share. But if the shares dropped below $65, he’d gladly scoop some up. Sam sells 1 BA January 65 put at 1.20. The at-expiration diagram in
|
||||
Exhibit 1.5
|
||||
shows the P&(L) of this trade if it is held until expiration.
|
||||
EXHIBIT 1.5
|
||||
Boeing short put.
|
||||
At the expiration of this option, if Boeing is above $65, the put expires and Sam retains the premium of $1.20. The obligation to buy stock expires with the option. Below the strike, put owners will be inclined to exercise their option to sell the stock at $65. Therefore, those short the put, as Sam is in this example, can expect assignment. The break-even price for the position is $63.80. That is the strike price minus the option premium. If assigned, this is the effective purchase price of the stock. The obligation to buy at $65 is fulfilled, but the $1.20 premium collected makes the purchase effectively $63.80. Here, again, there is limited profit opportunity ($1.20 if the stock is above the strike price) and seemingly unlimited risk (the risk of potential stock ownership at $63.80) if Boeing is below the strike price.
|
||||
Why would a trader short a put and willingly assume this substantial risk with comparatively limited reward? There are a number of motivations that may warrant the short put strategy. In this example, Sam had the twin goals of profiting from a neutral to moderately bullish outlook on Boeing and buying it if it traded below $65. The short put helps him achieve both objectives.
|
||||
Much like the covered call, if the stock is above the strike at expiration, this trader reaches his maximum profit potential—in this case 1.20. And if the price of Boeing is below the strike at expiration, Sam has ownership of the stock from assignment. Here, a strike price that is lower than the current stock level is used. The stock needs to decline in order for Sam to get assigned and become long the stock. With this strategy, he was able to establish a target price at which he would buy the stock. Why not use a limit order? If the put is assigned, the effective purchase price is $63.80 even if the stock price is above this price. If the put is not assigned, the premium is kept.
|
||||
A consideration every trader must make before entering the short put position is how the purchase of the stock will be financed in the event the put is assigned. Traders hoping to acquire the stock will often hold enough cash in their trading account to secure the purchase of the stock. This is called a
|
||||
cash-secured put
|
||||
. In this example, Sam would hold $6,380 in his account in addition to the $120 of option premium received. This affords him enough free capital to fund the $6,500 purchase of stock the short put dictates. More speculative traders may be willing to buy the stock on margin, in which case the trader will likely need around 50 percent of the stock’s value.
|
||||
Some traders sell puts without the intent of ever owning the stock. They hope to profit from a low-volatility environment. Just as the short call is a not-bullish stance on the underlying, the short put is a not-bearish play. As long as the underlying is above the strike price at expiration, the option premium is all profit. The trader must actively manage the position for fear of being assigned. Buying the put back to close the position eliminates the risk of assignment.
|
||||
Buy Put
|
||||
Buying a put gives the holder the right to sell stock at the strike price. Of course, puts can be a part of a host of different spreads, but this chapter discusses the two most basic and common put-buying strategies: the long put and the protective put. The long put is a way to speculate on a bearish move in the underlying security, and the protective put is a way to protect a long position in the underlying security.
|
||||
Consider a long put example:
|
||||
Buy 1 SPY May 139 put at 2.30
|
||||
In this example, the Spiders have had a good run up to $140.35. Trader Isabel is looking for a 10 percent correction in SPY between now and the end of May, about three months away. She buys 1 SPY May 139 put at 2.30. This put gives her the right to sell 100 shares of SPY at $139 per share.
|
||||
Exhibit 1.6
|
||||
shows Isabel’s P&(L) if the put is held until expiration.
|
||||
EXHIBIT 1.6
|
||||
SPY long put.
|
||||
If SPY is above the strike price of 139 at expiration, the put will expire and the entire premium of 2.30 will be lost. If SPY is below the strike price at expiration, the put will have value. It can be exercised, creating a short position in the Spiders at an effective price of $136.70 per share. This price is found by subtracting the premium paid, 2.30, from the strike price, 139. This is the point at which the position breaks even. If SPY is below $136.70 at expiration, Isabel has a profit. Profits will increase on a tick-for-tick basis, with downward movements in SPY down to zero. The long put has limited risk and substantial reward potential.
|
||||
An alternative for Isabel is to short the ETF at the current price of $140.35. But a short position in the underlying may not be as attractive to her as a long put. The margin requirements for short stock are significantly higher than for a long put. Put buyers must post only the premium of the put—that is the most that can be lost, after all.
|
||||
The margin requirement for short stock reflects unlimited loss potential. Margin requirements aside, risk is a very real consideration for a trader deciding between shorting stock and buying a put. If the trader expects high volatility, he or she may be more inclined to limit upside risk while leveraging downside profit potential by buying a put. In general, traders buy options when they expect volatility to increase and sell them when they expect volatility to decrease. This will be a common theme throughout this book.
|
||||
Consider a protective put example:
|
||||
This is an example of a situation in which volatility is expected to increase.
|
||||
Own 100 shares SPY at 140.35
|
||||
Buy 1 SPY May139 put at 2.30
|
||||
Although Isabel bought a put because she was bearish on the Spiders, a different trader, Kathleen, may buy a put for a different reason—she’s bullish but concerned about increasing volatility. In this example, Kathleen has owned 100 shares of Spiders for some time. SPY is currently at $140.35. She is bullish on the market but has concerns about volatility over the next two or three months. She wants to protect her investment. Kathleen buys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and the put at the same time, as a spread, the position would be called a married put.)
|
||||
Kathleen is buying the right to sell the shares she owns at $139. Effectively, it is an insurance policy on this asset.
|
||||
Exhibit 1.7
|
||||
shows the risk profile of this new position.
|
||||
EXHIBIT 1.7
|
||||
SPY protective put.
|
||||
The solid kinked line is the protective put (put and stock), and the thin dotted line is the outright position in SPY alone, without the put. The most Kathleen stands to lose with the protective put is $3.65 per share. SPY can decline from $140.35 to $139, creating a loss of $1.35, plus the $2.30 premium spent on the put. If the stock does not fall and the insuring put hence does not come into play, the cost of the put must be recouped to justify its expense. The break-even point is $142.65.
|
||||
This position implies that Kathleen is still bullish on the Spiders. When traders believe a stock or ETF is going to decline, they sell the shares. Instead, Kathleen sacrifices 1.6 percent of her investment up front by purchasing the put for $2.30. She defers the sale of SPY until the period of perceived risk ends. Her motivation is not to sell the ETF; it is to hedge volatility.
|
||||
Once the anticipated volatility is no longer a concern, Kathleen has a choice to make. She can let the option run its course, holding it to expiration, at which point it will either expire or be exercised; or she can sell the option before expiration. If the option is out-of-the-money, it may have residual time value prior to expiration that can be recouped. If it is in-the-money, it will have intrinsic value and maybe time value as well. In this situation, Kathleen can look at this spread as two trades—one that has declined in price, the SPY shares, and one that has risen in price, the put. Losses on the ETF shares are to some degree offset by gains on the put.
|
||||
Measuring Incremental Changes in Factors Affecting Option Prices
|
||||
At-expiration diagrams are very helpful in learning how a particular option strategy works. They show what the option’s price will ultimately be at various prices of the underlying. There is, however, a caveat when using at-expiration diagrams. According to the Options Industry Council, most options are closed before they reach expiration. Traders not planning to hold an option until it expires need to have a way to develop reasonable expectations as to what the option’s price will be given changes that can occur in factors affecting the option’s price. The tool option traders use to aid them in this process is option greeks.
|
||||
@@ -0,0 +1,40 @@
|
||||
770 Part VI: Measuring and Trading Volatility
|
||||
FIGURE 37-4.
|
||||
Bull spread profit picture in 30 days.
|
||||
1000
|
||||
500
|
||||
iv=80%
|
||||
(/)
|
||||
(/)
|
||||
0
|
||||
0 -' :;:,
|
||||
70 801 90 e
|
||||
~
|
||||
a.
|
||||
fl'>
|
||||
-500
|
||||
130 140
|
||||
iv= 20%
|
||||
-1000 Stock
|
||||
ty is a rather flat thing, sloping only slightly upward - and exhibiting far less risk and
|
||||
reward potential than its lower implied volatility counterpart. This points out anoth
|
||||
er important fact: For volatile stocks, one cannot expect a 4-rrwnth bull spread to
|
||||
expand or contract much during the first rrwnth of life, even if the stock makes a sub
|
||||
stantial rrwve. Longer-term spreads have even less movement.
|
||||
As a corollary, note that if implied volatility shrinks while the stock rises, the
|
||||
profit outlook will improve. Graphically, using Figure 37-4, if one's profit picture
|
||||
moves from the 80% curve to the 20% curve on the right-hand side of the chart, that
|
||||
is a positive development. Of course, if the stock drops and the implied volatility
|
||||
drops too, then one's losses would be worse - witness the left-hand side of the graph
|
||||
in Figure 37-4.
|
||||
A graph could be drawn that would incorporate other implied volatilities, but
|
||||
that would be overkill. The profit graphs of the other spreads from Tables 37-6 or
|
||||
37-7 would lie between the two curves shown in Figure 37-4.
|
||||
If this discussion had looked at bull spreads as put credit spreads instead of call
|
||||
debit spreads, perhaps these conclusions would not have seemed so unusual.
|
||||
Experienced option traders already understand much of what has been shown here,
|
||||
but less experienced traders may find this information to be different from what they
|
||||
expected.
|
||||
Some general facts can be drawn about the bull spread strategy. Perhaps the
|
||||
most important one is that, if used on a volatile stock, you won't get much expansion
|
||||
in the spread even if the stock makes a nice move upward in your favor. In fact, for
|
||||
@@ -0,0 +1,38 @@
|
||||
712 Part V: Index Options and Futures
|
||||
stitute for futures spreads - that is, using in-the-money options. If one buys in-the
|
||||
rnoney calls instead of buying futures, and buys in-the-money puts instead of selling
|
||||
futures, he can often create a position that has an advantage over the intramarket or
|
||||
intermarket futures spread. In-the-money options avoid most of the problems
|
||||
described in the two previous examples. There is no increase of risk, since the options
|
||||
are being bought, not sold. In addition, the amount of money spent on time value
|
||||
premium is small, since both options are in-the-money. In fact, one could buy them
|
||||
so far in the money as to virtually eliminate any expense for time value premium.
|
||||
However, that is not recommended, for it would negate the possible advantage of
|
||||
using moderately in-the-money options: If the underlyingfutures behave in a volatile
|
||||
manner, it might be possible for the option spread to make money, even if the futures
|
||||
spread does not behave as expected.
|
||||
In order to illustrate these points, the TED spread, an intermarket spread, will
|
||||
be used. Recall that in order to buy the TED spread, one would buy T-bill futures
|
||||
and sell an equal quantity of Eurodollar futures.
|
||||
Options exist on both T-bill futures and Eurodollar futures. If T-bill calls were
|
||||
bought instead of T-bill futures, and if Eurodollar puts were bought instead of sell
|
||||
ing Eurodollar futures, a similar position could be created that might have some
|
||||
advantages over buying the TED spread using futures. The advantage is that if T-bills
|
||||
and/or Eurodollars change in price by a large enough amount, the option strategist
|
||||
can make money, even if the TED spread itself does not cooperate.
|
||||
One might not think that short-term rates could be volatile enough to make this
|
||||
a worthwhile strategy. However, they can move substantially in a short period of time,
|
||||
especially if the Federal Reserve is active in lowering or raising rates. For example,
|
||||
suppose the Fed continues to lower rates and both T-bills and Eurodollars substan
|
||||
tially rise in price. Eventually, the puts that were purchased on the Eurodollars will
|
||||
become worthless, but the T-bill calls that are owned will continue to grow in value.
|
||||
Thus, one could make money, even if the TED spread was unchanged or shrunk, as
|
||||
long as short-term rates dropped far enough.
|
||||
Similarly, if rates were to rise instead, the option spread could make money as
|
||||
the puts gained in value (rising rates mean T-bills and Eurodollars will fall in price)
|
||||
and the calls eventually became worthless.
|
||||
Example: The following prices for June T-bill and Eurodollar futures and options
|
||||
exist in January. All of these products trade in units of 0.01, which is worth $25. So a
|
||||
whole point is worth $2,500.
|
||||
June T-bill futures: 94.75
|
||||
June Euro$ futures: 94.15
|
||||
@@ -0,0 +1,39 @@
|
||||
Chapter 23: Spreads Combining Calls and Puts
|
||||
FIGURE 23-1.
|
||||
Call buy and put credit (bull) spread.
|
||||
+$2,000
|
||||
+$1,000
|
||||
(/J
|
||||
(/J
|
||||
0 ..J
|
||||
0 $0 -e a.
|
||||
-$1,000
|
||||
-$2,000
|
||||
70 80
|
||||
.... ,, -----,, -=-----'
|
||||
THE BEARISH SCENARIO
|
||||
~ Spread at Expiration
|
||||
Call Buy Only, at Expiration
|
||||
341
|
||||
Stock
|
||||
In a similar manner, one can construct a position to take advantage of a bearish opin
|
||||
ion on a stock. Again, this would be most useful when the options were overpriced
|
||||
and one felt that an at-the-money put was too expensive to purchase by itself.
|
||||
Example: XYZ is trading at 80, and one has a definite bearish opinion on the stock.
|
||||
However, the December 80 put, which is selling for 8, is expensive according to an
|
||||
option analysis. Therefore, one might consider selling a call credit spread (out-of-the
|
||||
money) to help reduce the cost of the put. The entire position would thus be:
|
||||
Buy 1 December 80 put:
|
||||
Sell l December 90 call:
|
||||
Buy 1 December 100 call:
|
||||
Total cost:
|
||||
8 debit
|
||||
4 credit
|
||||
2 debit
|
||||
6 debit ($600)
|
||||
The profitability of this position is shown in Figure 23-2. The straight line on that
|
||||
graph shows how the position would behave at expiration. The introduction of the
|
||||
call credit spread has increased the risk to $1,600 if the stock should rally to 100 or
|
||||
higher by expiration. Note that the risk is limited since both the put purchase and the
|
||||
call credit spread are limited-risk strategies. The margin required would be this max
|
||||
imum risk, or $1,600.
|
||||
@@ -0,0 +1,38 @@
|
||||
Chapter 31,: 1be Basics of Volatility Trading 747
|
||||
implied volatility is high. Given that fact, he can then construct positions around a
|
||||
neutral strategy or around his view of the future. The time when the volatility seller
|
||||
must be careful is when the options are expensive and no one seems to know why.
|
||||
That's when insider trading may be present, and that's when the volatility seller
|
||||
should defer from selling options.
|
||||
CHEAP OPTIONS
|
||||
When options are cheap, there are usually far less discernible reasons why they have
|
||||
become cheap. An obvious one may be that the corporate structure of the company
|
||||
has changed; perhaps it is being taken over, or perhaps the company· has acquired
|
||||
another company nearly its size. In either case, it is possible that the combined enti
|
||||
ty's stock will be less volatile than the original company's stock was. As the takeover
|
||||
is in the process of being consummated, the implied volatility of the company's
|
||||
options will drop, giving the false impression that they are cheap.
|
||||
In a similar vein, a company may mature, perhaps issuing more shares of stock,
|
||||
or perhaps building such a.., good earnings stream that the stock is considered less
|
||||
volatile than it formerly was. Some of the Internet companies will be classic cases: In
|
||||
the beginning they were high-flying stocks with plenty of price movement, so the
|
||||
options traded with a relatively high degree of implied volatility. However, as the com
|
||||
pany matures, it buys other Internet companies and then perhaps even merges with a
|
||||
large, established company (America Online and Time-Warner Communications, for
|
||||
example). In these cases, actual (statistical) volatility will diminish as the company
|
||||
matures, and implied volatility will do the same. On the surface, a buyer of volatility
|
||||
may see the reduced volatility as an attractive buying situation, but upon further
|
||||
inspection he may find that it is justified. If the decrease in implied volatility seems
|
||||
justified, a buyer of volatility should ignore it and look for other opportunities.
|
||||
All volatility traders should be suspicious when volatility seems to be extreme -
|
||||
either too expensive or too cheap. The trader should investigate the possibilities as to
|
||||
why volatility is trading at such extreme levels. In some cases, the supply and demand
|
||||
of the public just pushes the options to extreme levels; there is nothing more involved
|
||||
than that. Those are the best volatility trading situations. However, if there is a hint
|
||||
that the volatility has gotten to an extreme reading because of some logical (but per
|
||||
haps nonpublic) reason, then the volatility trader should be suspicious and should
|
||||
probably avoid the trade. Typically this happens with expensive options.
|
||||
Buyers of volatility really have little to fear if they miscalculate and thus buy an
|
||||
option that appears inexpensive but turns out not to be, in reality. The volatility buyer
|
||||
might lose money if he does this, and overpaying for options constantly will lead to
|
||||
ruin, but an occasional mistake will probably not be fatal.
|
||||
@@ -0,0 +1,29 @@
|
||||
822 Part VI: Measuring and Trading Volatility
|
||||
Consider the historical volatilities of one of the wilder stocks of the tech stock
|
||||
boom, Rambus (RMBS). Historical volatilities had ranged between 50% and ll0%,
|
||||
from the listing of RMBS stock, through February 2000. At that time, the stock aver
|
||||
aged a price of about $20 per share.
|
||||
Things changed mightily when RMBS stock began to rise at a tremendous rate
|
||||
in February 2000. At that time, the stock blasted to ll5, pulled back to 35, made a
|
||||
new high near 135, and then collapsed to a price near 20. Hence, the stock itself had
|
||||
completed a wild round-trip over the two-year period. See Figures 39-2 and 39-3 for
|
||||
the stock chart and the historical volatility chart of RMBS over the time period in
|
||||
question.
|
||||
As this happened, historical volatility skyrocketed. After February 2000, and
|
||||
well into 2001, historical volatility was well above 120%. Thus it is clear that the
|
||||
behavior patterns of Rambus changed greatly after February 2000. However, if one
|
||||
had been comparing historical volatilities at any time after that, he would have erro
|
||||
neously concluded that RMBS was about to slow down, that the historic volatilities
|
||||
were too high in comparison with where they'd been in the past. If this had led one
|
||||
to sell volatility on RMBS, it could have been a very expensive mistake.
|
||||
While RMBS may be an extreme example, it is certainly not alone. Many other
|
||||
stocks experienced similar changes in behavior. In this author's opinion, such behav
|
||||
ior debunks the usefulness of comparing historical volatility with past measures of
|
||||
historical volatility as a valid way of selecting volatility trades.
|
||||
FIGURE 39-2.
|
||||
Historical volatilities of RMBS.
|
||||
RMBS 19.000 17.250 18.875 20010410
|
||||
............ ······· 60.0
|
||||
· ·················· 50.0
|
||||
...... ······· 40. 0
|
||||
39 M i·h··-:; s ·~ s a ~--f:i--·5--r;;····~··h s·s- A s a N □ s--r·;; r
|
||||
@@ -0,0 +1,37 @@
|
||||
O.,,ter 19: The Sale of a Put 295
|
||||
writer receives the dividends on the underlying stock, but the naked put writer does
|
||||
not. In certain cases, this may be a substantial amount, but it should also be pointed
|
||||
out that the puts on a high-yielding stock will have more value and the naked put
|
||||
writer will thus be taking in a higher premium initially. From strictly a rate of return
|
||||
viewpoint, naked put writing is superior to covered call writing. Basically, there is a
|
||||
different psychology involved in writing naked puts than that required for covered call
|
||||
writing. The covered call write is a comfortable strategy for most investors, since it
|
||||
involves common stock ownership. Writing naked options, however, is a more foreign
|
||||
concept to the average investor, even if the strategies are equivalent. Therefore, it is
|
||||
relatively unlikely that the same investor would be a participant in both strategies.
|
||||
FOLLOW-UP ACTION
|
||||
The naked put writer would take protective follow-up action if the underlying stock
|
||||
drops in price. His simplest form of follow-up action is to close the position at a small
|
||||
loss if the stock drops. Since in-the-money puts tend to lose time value premium rap
|
||||
idly, he may find that his loss is often quite small if the stock goes against him. In the
|
||||
example above, XYZ was at 50 with the put at 4. If the stock falls to 45, the writer
|
||||
may be able to quite easily repurchase the put for 5½ or 6 points, thereby incurring
|
||||
a fairly small loss.
|
||||
In the covered call writing strategy, it was recommended that the strategist roll
|
||||
down wherever possible. One reason for doing so, rather than closing the covered call
|
||||
position, is that stock commissions are quite large and one cannot generally afford to
|
||||
be moving in and out of stocks all the time. It is more advantageous to try to preserve
|
||||
the stock position and roll the calls down. This commission disadvantage does not
|
||||
exist with naked put writing. When one closes the naked put position, he merely buys
|
||||
in the put. Therefore, rolling down is not as advantageous for the naked put writer.
|
||||
For example, in the paragraph above, the put writer buys in the put for 5½ or 6
|
||||
points. He could roll down by selling a put with striking price 45 at that time.
|
||||
However, there may be better put writing situations in other stocks, and there should
|
||||
be no reason for him to continue to preserve a position in XYZ stock
|
||||
In fact, this same reasoning can be applied to any sort of rolling action for the
|
||||
naked put writer. It is extremely advantageous for the covered call writer to roll for
|
||||
ward; that is, to buy back the call when it has little or no time value premium remain
|
||||
ing in it and sell a longer-term call at the same striking price. By doing so, he takes in
|
||||
additional premium without having to disturb his stock position at all. However, the
|
||||
naked put writer has little advantage in rolling forward. He can also take in addition
|
||||
al premium, but when he closes the initial uncovered put, he should then evaluate
|
||||
@@ -0,0 +1,33 @@
|
||||
Chapter 29: Introduction to Index Option Products and Futures 513
|
||||
At the present time, there are futures options on all of the various index futures
|
||||
contracts.
|
||||
EXPIRATION DATES
|
||||
Futures options have specifics much the same as stock options do: expiration month
|
||||
(agreeing with the expiration months of the underlying futures contract), striking
|
||||
price, etc. If a trader buys a futures option, he must pay for it in full, just as with stock
|
||||
options. Margin requirements vary for naked futures options, but are generally more
|
||||
lenient than stock options. Often, the naked requirement is based on the futures
|
||||
margin, which is much less than the 20% of the underlying stock price as is the case
|
||||
with listed stock options.
|
||||
When the futures option has a cash-based futures contract underlying it, the
|
||||
option and the future generally expire on the same day. Thus, if one were to exercise
|
||||
a '.ZYX option on expiration day, one would receive the future in his account, which
|
||||
would in tum become cash because the future is cash-settled and expiring as well.
|
||||
Example: Suppose that a trader owns a '.ZYX December 165 futures worth $500 per
|
||||
point - call option and holds it through the last day of trading. On that last day, the
|
||||
'.ZYX Index closes at 174.00. He gives instructions to exercise the call, so the follow
|
||||
ing sequence occurs:
|
||||
1. Buy one '.ZYX future at 165.00 via the call exercise.
|
||||
2. Mark the future at 17 4.00, the closing price. This is a variation margin profit of
|
||||
$4,500 (174.00-165.00) X $500.
|
||||
3. The option is removed from the account because it was exercised, and the future
|
||||
is removed as well because it expired.
|
||||
Thus, the exercise of the option generates $4,500 in cash into the account and leaves
|
||||
behind no futures or option contracts. We do not know if this represents a profit or
|
||||
loss for this call holder, since we do not know if his original cost was greater than
|
||||
$4,500 or not.
|
||||
It should be noted that futures option expiration dates, in general, are fairly
|
||||
complex. They are not normally the third Friday of the expiration month, as stock
|
||||
options are. Index futures options generally do expire on the third Friday of the expi
|
||||
ration month, but many physical commodity options do not. These differences will
|
||||
be discussed in the later chapter on futures options.
|
||||
@@ -0,0 +1,33 @@
|
||||
Chapter 28: Mathematical Applications 471
|
||||
Thus, once the low starting point is chosen and the probability of being below that
|
||||
price is determined, one can compute the probability of being at prices that are suc
|
||||
cessively higher merely by iterating with the preceding formula. In reality, one is
|
||||
using this information to integrate the distribution curve. Any method of approxi
|
||||
mating the integral that is used in basic calculus, such as the Trapezoidal Rule or
|
||||
Simpson's Rule, would be applicable here for more accurate results, if they are
|
||||
desired.
|
||||
A partial example of an expected return calculation follows.
|
||||
Example: XYZ is currently at 33 and has an annual volatility of 25%. The previous
|
||||
bull spread is being established- buy the February 30 and sell the February 35 for a
|
||||
2-point debit - and these are 6-month options. Table 28-7 gives the necessary com
|
||||
ponents for computing the expected return. Column (A), the probability of being
|
||||
below price q, is computed according to the previously given formula, where p = 33
|
||||
and vt = .177 (t = .25-V ½). The first stock price that needs to be looked at is 30, since
|
||||
all results for the bull spread are equal below that price - a 100% loss on the spread.
|
||||
The calculations would be performed for each eighth (or tenth) of a point up through
|
||||
a price of 35. The expected return is compute<l by multiplying the two right-hand
|
||||
columns, (B) and (C), and summing the results. Note that column (B) is determined
|
||||
by subtracting successive numbers in column (A). It would not be particularly
|
||||
enlightening to carry this example to completion, since the rest of the computations
|
||||
are similar and there is a large number of them.
|
||||
In theory, if one had the data and the computer power, he could evaluate a wide
|
||||
range of strategies every day and come up with the best positions on an expected
|
||||
return basis. He would probably get a few option buys (puts or calls), some bull
|
||||
TABLE 28-7.
|
||||
Calculation of expected returns.
|
||||
Price at Expiration (A) (B) (()
|
||||
(q) P (below q) P (of being at q) Profit on Spread
|
||||
30 .295 .295 -$200
|
||||
30 1/s .301 .006 - 187.50
|
||||
30 1/4 .308 .007 - 175
|
||||
303/s .316 .008 - 162.50
|
||||
@@ -0,0 +1,34 @@
|
||||
622 Part V: Index Options and Futures
|
||||
For the remainder of this chapter, the call price of the PERCS will be referrea
|
||||
to as the redemption price. Since much of the rest of this chapter will be concemec
|
||||
with discussing the fact that a PERCS is related to a call option, there could be somE
|
||||
confusion when the word call is used. In some cases, call could refer to the price at
|
||||
which the PER CS can be called; in other cases, it could refer to a call option - either
|
||||
a listed one or one that is imbedded within the PERCS. Hence, the word redemp
|
||||
tion will be used to refer to the action and price at which the issuing compa:J)ly may
|
||||
call the PERCS.
|
||||
A PERCS IS A COVERED CALL WRITE
|
||||
It was stated earlier that a PER CS is like a covered write. However, that has not yet
|
||||
been proven. It is known that any two strategies are equivalent if they have the same
|
||||
profit potential. Thus, if one can show that the profitability of owning a PER CS is the
|
||||
same as that of having established a covered call write, then one can conclude that
|
||||
they are equivalent.
|
||||
Example: For the purposes of this example, suppose that there is a three-year listed
|
||||
call option with striking price 39 available to be sold on XYZ common stock. Also,
|
||||
assume that there is a PERCS on XYZ that has a redemption price of 39 in three
|
||||
years. The following prices exist:
|
||||
XYZ common: 35
|
||||
XYZ PERCS: 35
|
||||
3-year call on XYZ common with striking price of 39: 4.50
|
||||
First, examine the XYZ covered call write's profitability from buying 100 XY2 and
|
||||
selling one call. It was initially established at a debit of 30.50 (35 less the 4.50
|
||||
received from the call sale). The common pays $1 per year in dividends, for a total of
|
||||
$3 over the life of the position.
|
||||
XYZ Price Price of a Profit/loss on Total Profit/loss
|
||||
in 3 Years 3-Year Call Securities Incl. Dividend
|
||||
25 0 -$550 -$250
|
||||
30 0 -50 +250
|
||||
35 0 +450 +750
|
||||
39 0 +850 + 1,150
|
||||
45 6 +850 + 1,150
|
||||
50 11 +850 + 1,150
|
||||
@@ -0,0 +1,43 @@
|
||||
344 Part Ill: Put Option Strategies
|
||||
it of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents,
|
||||
quite a bit for just such a short time remaining.
|
||||
However, suppose that one looks at the puts and finds these prices:
|
||||
Put
|
||||
January 80 put
|
||||
January 70 put
|
||||
Bid Price
|
||||
0.20
|
||||
none
|
||||
Asked Price
|
||||
0.40
|
||||
0.10
|
||||
One could "lock in" his call spread profits by buying the January 80 put for 40 cents.
|
||||
Ignoring commissions for a moment, if he bought that put and then held it along with
|
||||
the call spread until expiration, he would unwind the call spread for a 10 credit at
|
||||
expiration. He paid 40 cents for the put, so his net credit to exit the spread would be
|
||||
9.60 - considerably better than the 9.30 he could have gotten above for the call
|
||||
spread alone.
|
||||
This put strategy has one big advantage: If the underlying stock should sudden
|
||||
ly collapse and tumble beneath 70 - admittedly, a remote possibility - large profits
|
||||
could accrue. The purchase of the January 80 put has protected the bull spread's
|
||||
profits at all prices. But below 70, the put starts to make extra money, and the spread
|
||||
er could profit handsomely. Such a drop in price would only occur if some material
|
||||
ly damaging news surfaced regarding X'iZ Company, but it does occasionally happen.
|
||||
If one utilizes this strategy, he needs to carefully consider his commission costs
|
||||
and the possibility of early assignment. For a professional trader, these are irrelevant,
|
||||
and so the professional trader should endeavor to exit bull spreads in this manner
|
||||
whenever it makes sense. However, if the public customer allows stock to be assigned
|
||||
at 80 and exercises to buy stock at 70, he will have two stock commissions plus one
|
||||
put option commission. That should be compared to the cost of two in-the-money
|
||||
call option commissions to remove the call spread directly. Furthermore, if the pub
|
||||
lic customer receives an early assignment notice on the short January 80 calls, he may
|
||||
need to provide day-trade margin as he exercises his January 70 calls the next day.
|
||||
Without going into as much detail, a bear spread's profits can be locked in via a
|
||||
similar strategy. Suppose that one owns a January 60 put and has sold a January 50
|
||||
put to create a bear spread. Later, with the stock at 45, the spreader wants to remove
|
||||
the spread, but again finds that the markets for the in-the-money puts are so wide
|
||||
that he cannot realize anywhere near the 10 points that the spread is theoretically
|
||||
worth. He should then see what the January 50 call is selling for. If it is fractionally
|
||||
priced, as it most likely will be if expiration is drawing nigh, then it can be purchased
|
||||
to lock in the profits from the put spread. Again, commission costs should be con
|
||||
sidered by the public customer before finalizing his strategy.
|
||||
@@ -0,0 +1,35 @@
|
||||
O.,,ter 32: Structured Products 623
|
||||
TI1is is the typical picture of the total return from a covered write - potential losses on
|
||||
the downside with profit potential limited above the striking price of the written call.
|
||||
Now look at the profitability of buying the PER CS at 35 and holding it for three
|
||||
(Assume that it is not called prior to maturity.) The PER CS holder will earn a
|
||||
total of $750 in dividends over that time period.
|
||||
XYZ Price Profit/Loss on Total Profit/Loss
|
||||
in 3 Years PERCS Incl. Dividend
|
||||
25 -$1,000 -$250
|
||||
30 -500 +250
|
||||
35 0 +750
|
||||
>=39 +400 + 1, 150
|
||||
This is exactly the same profitability as the covered call write. Therefore, it can be
|
||||
concluded with certainty that a PERCS is equivalent to a covered call write. Note
|
||||
that the PER CS potential early redemption feature does not change the truth of this
|
||||
statement. The early redemption possibility merely allows the PERCS holder to
|
||||
receive the same total dollars at an earlier point in time if the PERCS is demanded
|
||||
prior to maturity. The covered call writer could theoretically be facing a similar situ
|
||||
ation if the written call option were assigned before expiration: He would make the
|
||||
same total profit, but he would realize it in a shorter period of time.
|
||||
The PERCS is like a covered write of a call option with striking price equal to
|
||||
the redemption price of the PERCS, except that the holder does not receive a call
|
||||
option premium, but rather receives additional dividends. In essence, the PERCS
|
||||
has a call option imbedded within it. The value of the imbedded call is really the
|
||||
value of the additional dividends to be paid between the current date and maturity.
|
||||
The buyer of a PERCS is, in effect, selling a call option and buying common
|
||||
stock. He should have some idea of whether or not he is selling the option at a rea
|
||||
sonably fair price. The next section of this chapter addresses the problem of valuing
|
||||
the call option that is imbedded in the PERCS.
|
||||
PRICE BEHAVIOR
|
||||
The way that a PERCS price is often discussed is in relationship to the common
|
||||
stock. One may hear that the PERCS is trading at the same price as the common or
|
||||
at a premium or discount to the common. As an option strategist who understands
|
||||
covered call writing, it should be a simple matter to picture how the PERCS price
|
||||
will relate to the common price.
|
||||
@@ -0,0 +1,40 @@
|
||||
Introduction: Why Trade Options?
|
||||
The house always wins
|
||||
. This cautionary quote is certainly true, but it does not tell the entire story. From table limits to payout odds, every game in a casino is designed to give the house a statistical edge. The casino may take large, infrequent losses at the slot machines or small, frequent losses at the blackjack table, but as long as patrons play long enough, the house will inevitably turn a profit. Casinos have long relied on this principle as the foundation of their business model: People can either bet
|
||||
against
|
||||
the house and hope that luck lands in their favor or
|
||||
be
|
||||
the house and have probability on their side.
|
||||
Unlike casinos, where the odds are fixed against the players, liquid financial markets offer a dynamic, level playing field with more room to strategize. However, similar to casinos, a successful trader does not rely on luck. Rather, traders' long‐term success depends on their ability to obtain a consistent, statistical edge from the tools, strategies, and information available to them. Today's markets are becoming increasingly accessible to the average person, as online and commission‐free trading have basically become industry standards. Investors have access to an
|
||||
almost unlimited selection of strategies, and options play an interesting role in this development. An option is a type of financial contract that gives the holder the right to buy or sell an asset on or before some future date, a concept that will be explained more in the following chapter. Options have tunable risk‐reward profiles, allowing traders to reliably select the probability of profit, max loss, and max profit of a position and potentially profit in any type of market (bullish, bearish, or neutral). These highly versatile instruments can be used to hedge risk and diversify a portfolio,
|
||||
or
|
||||
options can be structured to give more risk‐tolerant traders a probabilistic edge.
|
||||
In addition to being customizable according to specific risk‐reward preferences, options are also tradable with accounts of nearly any size because they are
|
||||
leveraged
|
||||
instruments. In the world of options, leverage refers to the ability to gain or lose more than the initial investment of a trade. An investor may pay $100 for an option and make $200 by the end of the trade, or an investor may make $100 by selling an option and lose $200 by the end of the trade. Leverage may seem unappealing because of its association with risk, but it is not inherently dangerous. When
|
||||
misused
|
||||
, leverage can easily wreak financial havoc. However, when used responsibly, the capital efficiency of leverage is a powerful tool that enables traders to achieve the same risk‐return exposure as a stock position with significantly less capital.
|
||||
There is no free lunch in the market. A leveraged instrument that has a 70% chance of profiting must come with some trade‐off of risk, risk which may even be undefined in some cases. This is why the core principle of sustainable options trading is risk management. Just as casinos control the size of jackpot payouts by limiting the maximum amount a player can bet, options traders must control their exposure to potential losses from leveraged positions by limiting position size. And just as casinos diversify risk across different games with different odds, strategy diversification is essential to the long‐term success of an options portfolio.
|
||||
Beyond the potential downside risk of options, other factors can make them unattractive to investors. Unlike equities, which are passive instruments, options require a more active trading approach due to their volatile nature and time sensitivity. Depending on the choice of strategies, options portfolios should be monitored anywhere from
|
||||
daily to once every two weeks. Options trading also has a fairly steep learning curve and requires a larger base of math knowledge compared to equities. Although the mathematics of options can easily become complicated and burdensome, for the type of options trading covered in this book, trading decisions can often be made with a selection of indicators and intuitive, back‐of‐the‐envelope calculations.
|
||||
The goal of this book is to educate traders to make personalized and informed decisions that best align with their unique profit goals and risk tolerances. Using statistics and historical backtests, this book contextualizes the downside risk of options, explores the strategic capacity of these contracts, and emphasizes the key risk management techniques in building a resilient options portfolio. To introduce these concepts in a straightforward way, this book begins with discussion of the math and finance basics of quantitative options trading (
|
||||
Chapter 1
|
||||
), followed by an intuitive explanation of implied volatility (
|
||||
Chapter 2
|
||||
) and trading short premium (
|
||||
Chapter 3
|
||||
). With these foundational concepts covered, the book then moves onto trading in practice, beginning with buying power reduction and option leverage (
|
||||
Chapter 4
|
||||
), followed by trade construction (
|
||||
Chapter 5
|
||||
) and trade management (
|
||||
Chapter 6
|
||||
).
|
||||
Chapter 7
|
||||
covers essential topics in portfolio management, and
|
||||
Chapter 8
|
||||
covers supplementary topics in advanced portfolio management.
|
||||
Chapter 9
|
||||
provides a brief commentary on atypical trades (Binary Events). The book concludes with a final chapter of key takeaways (
|
||||
Chapter 10
|
||||
) and an appendix of mathematical topics.
|
||||
@@ -0,0 +1,28 @@
|
||||
738 Part VI: Measuring and Trading Volatility
|
||||
FIGURE 36-4.
|
||||
$OEX implied versus historical volatility.
|
||||
10
|
||||
Implied minus Actual 1999 Date
|
||||
ity of $OEX options encompasses all the $OEX options, so it is different from the
|
||||
Volatility Index ($VIX), which uses only the options closest to the money. By
|
||||
using all of the options, a slightly different volatility figure is arrived at, as com
|
||||
pared to $VIX, but a chart of the two would show similar patterns. That is, peaks
|
||||
in implied volatility computed using all of the $OEX options occur at the same
|
||||
points in time as peaks in $VIX.
|
||||
(b) The actual volatility on the graph is a little different from what one normally
|
||||
thinks of as historical volatility. It is the 20-day historical volatility, computed 20
|
||||
days later than the date of the implied volatility calculation. Hence, points on the
|
||||
implied volatility curve are matched with a 20-day historical volatility calculation
|
||||
that was made 20 days later. Thus, the two curves more or less show the predic
|
||||
tion of volatility and what actually happened over the 20-day period. These actu
|
||||
al volatility readings are smoothed as well, with a 20-day moving average.
|
||||
(c) The difference between the two is quite simple, and is shown as the bottom
|
||||
curve on the graph. A "zero" line is drawn through the difference.
|
||||
When this "difference line" passes through the zero line, the projection of
|
||||
volatility and what actually occurred 20 days later were equal. If the difference line
|
||||
is above the zero line, then implied volatility was too high; the options were over
|
||||
priced. Conversely, if the difference line is below the zero line, then actual volatility
|
||||
turned out to be greater than implied volatility had anticipated. The options were
|
||||
underpriced in that case. Those latter areas are shaded in Figure 36-4. Simplistically,
|
||||
you would want to own options during the shaded periods on the chart, and would
|
||||
want to be a seller of options during the non-shaded areas.
|
||||
@@ -0,0 +1,35 @@
|
||||
Chapter 39: Volatility Trading Techniques 813
|
||||
watching the situation for those stocks that they will rarely let volatility get to the
|
||||
extremes that one would consider "too high" or "too low." Yet, with the large num
|
||||
ber of optionable stocks, futures, and indices that exist, there are always some that
|
||||
are out of line, and that's where the independent volatility trader will concentrate
|
||||
his efforts.
|
||||
Once a volatility extreme has been uncovered, there are different methods of
|
||||
trading it. Some traders - market-makers and short-term traders - are just looking
|
||||
for very fleeting trades, and expect volatility to fall back into line quickly after an
|
||||
aberrant move. Others prefer more of a position traders' approach: attempting to
|
||||
determine volatility extremes that are so far out of line with accepted norms that it
|
||||
will probably take some time to move back into line. Obviously, the trader's own sit
|
||||
uation will dictate, to a certain extent, which strategy he pursues. Things such as
|
||||
commission rates, capital requirements, and risk tolerance will determine whether
|
||||
one is more of a short-term trader or a position trader. The techniques to be
|
||||
described in this chapter apply to both methods, although the emphasis will be on
|
||||
position trading.
|
||||
TWO WAYS VOLATILITY PREDICTIONS CAN BE WRONG
|
||||
When traders determine the implied volatility of the options on any particular under
|
||||
lying instrument, they may generally be correct in their predictions; that is, implied
|
||||
volatility will actually be a fairly good estimate of forthcoming volatility. However,
|
||||
when they're wrong, they can actually be wrong in two ways: either in the outright
|
||||
prediction of volatility or in the path of their volatility predictions. Let's discuss both.
|
||||
When they're wrong about the absolute level of volatility, that merely means that
|
||||
implied volatility is either "too low" or "too high." In retrospect, one could only make
|
||||
that assessment, of course, after having seen what actual volatility turned out to be
|
||||
over the life of the option. The second way they could be wrong is by making the
|
||||
implied volatility on some of the options on a particular underlying instrument much
|
||||
cheaper or more expensive than other options on that same underlying instrument.
|
||||
This is called a volatility skew and it is usually an incorrect prediction about the way
|
||||
the underlying will perform during the life of the options.
|
||||
The rest of this chapter will be divided into two main parts, then. The first part
|
||||
will deal with volatility from the viewpoint of the absolute level of implied volatility
|
||||
being "wrong" (which we'll call "trading the volatility prediction"), and the second
|
||||
part will deal with trading the volatility skew.
|
||||
@@ -0,0 +1,35 @@
|
||||
Chapter 35: Futures Option Strategies for Futures Spreads 711
|
||||
or out-of-the-money puts instead of selling futures, he could be exposing his spread
|
||||
profits to the ravages of time decay. Do not substitute at- or out-of-the-rrwney options
|
||||
for the futures in intramarket or intennarket spreads. The next example will show
|
||||
why not.
|
||||
Example: A futures spreader notices that a favorable situation exists in wheat. He
|
||||
wants to buy July and sell May. The following prices exist for the futures and options:
|
||||
May futures: 410
|
||||
July futures: 390
|
||||
May 410 put: 20
|
||||
July 390 call: 25
|
||||
This trader decides to buy the May 410 put instead of selling May futures; he
|
||||
also buys the July 390 call instead of buying July futures.
|
||||
Later, the following prices exist:
|
||||
May futures: 400
|
||||
July futures: 400
|
||||
May 410 put: 25
|
||||
July 390 call: 30
|
||||
The futures spread would have made 20 points, since they are now the same
|
||||
price. At least this time, he has made money in the option spread. He has made 5
|
||||
points on each option for a total of 10 points overall - only half the money that could
|
||||
have been made with the futures themselves. Nate that these sample option prices
|
||||
still show a good deal of time value premium remaining. If more time had passed and
|
||||
these options were trading closer to parity, the result of the option spread would be
|
||||
worse.
|
||||
It might be pointed out that the option strategy in the above example would
|
||||
work better if futures prices were volatile and rallied or declined substantially. This
|
||||
is true to a certain extent. If the market had moved a lot, one option would be very
|
||||
deeply in-the-money and the other deeply out-of-the-money. Neither one would
|
||||
have much time value premium, and the trader would therefore have wasted all the
|
||||
money spent for the initial time premium. So, unless the futures moved so far as to
|
||||
outdistance that loss of time value premium, the futures strategy would still outrank
|
||||
the option strategy.
|
||||
However, this last point of volatile futures movement helping an option position
|
||||
is a valid one. It leads to the reason for the only favorable option strategy that is a sub-
|
||||
@@ -0,0 +1,37 @@
|
||||
250 • The Intelligent Option Investor
|
||||
The graphic conventions are a little different, but both diagrams show
|
||||
the acceptance of a narrow band of downside exposure offset by a bound-
|
||||
less gain of upside exposure. The area below the protective put’s strike price
|
||||
shows that economic exposure has been neutralized, and the area below
|
||||
the ITM call shows no economic exposure. The pictures are slightly differ-
|
||||
ent, but the economic impact is the same.
|
||||
The objective of a protective put is obvious—allow yourself the
|
||||
economic benefits from gaining upside exposure while shielding yourself
|
||||
from the economic harm of accepting downside exposure. The problem is
|
||||
that this protection comes at a price. I will provide more infromation about
|
||||
this in the next section.
|
||||
Execution
|
||||
Everyone understands the concept of protective puts—it’s just like the
|
||||
home insurance you buy every year to insure your property against dam-
|
||||
age. If you buy an OTM protective put (let’s say one struck at 90 percent of
|
||||
the current market price of the stock), the exposed amount from the stock
|
||||
price down to the put strike can be thought of as your “deductible” on your
|
||||
home insurance policy. The premium you pay for your put option can be
|
||||
thought of as the “premium” you pay on your home insurance policy.
|
||||
Okay—let’s go shopping for stock insurance. Apple (AAPL) is trad-
|
||||
ing for $452.53 today, so I’ll price both ATM and OTM put insurance for
|
||||
these shares with an expiration of 261 days in the future. I’ll also annualize
|
||||
that rate.
|
||||
Strike ($) “Deductible” ($) “Premium” ($)
|
||||
Premium as
|
||||
Percent of
|
||||
Stock Price
|
||||
Annualized
|
||||
Premium (%)
|
||||
450 2.53 40.95 9.1 12.9
|
||||
405 47.53 20.70 4.6 6.5
|
||||
360 92.53 8.80 1.9 2.7
|
||||
Now, given these rates and assuming that you are insuring a $500,000
|
||||
house, the following table shows what equivalent deductibles, annual
|
||||
premiums, and total liability to a home owner would be for deductibles
|
||||
equivalent to the strike prices I’ve picked for Apple:
|
||||
@@ -0,0 +1,41 @@
|
||||
408 Part Ill: Put Option Strategies
|
||||
a LEAPS may be used as the long option in the spread. Recall that the object of the
|
||||
spread is for the stock to be volatile, particularly to the upside if calls are used. If that
|
||||
doesn't happen, and the stock declines instead, at least the premium captured from
|
||||
the in-the-money sale will be a gain to offset against the loss suffered on the longer
|
||||
term calls that were purchased. The strategy can be established with puts as well, in
|
||||
which case the spreader would want the underlying stock to fall dramatically while the
|
||||
spread was in place.
|
||||
Without going into as much detail as in the examples above, the diagonal back
|
||||
spreader should realize that he is going to have a significant debit in the spread and
|
||||
could lose a significant portion of it should the underlying stock fall a great deal in
|
||||
price. To the upside, his LEAPS calls will retain some time value premium and will
|
||||
move quite closely with the underlying common stock. Thus, he does not have to buy
|
||||
as many LEAPS as he might think in order to have a neutral spread.
|
||||
Example: XYZ is at 105 and a spreader wants to establish a backspread. Recall that
|
||||
the quantity of options to use in a neutral strategy is determined by dividing the
|
||||
deltas of the two options. Assume the following prices and deltas exist:
|
||||
Option
|
||||
April 100 call
|
||||
July 110 call
|
||||
January (2-year) LEAPS 100 call
|
||||
XYZ: 105 in January
|
||||
Price
|
||||
8
|
||||
5
|
||||
15
|
||||
Delta
|
||||
0.75
|
||||
0.50
|
||||
0.60
|
||||
Two backspreads are available with these options. In the first, one would sell the
|
||||
April 100 calls and buy the July llO calls. He would be selling 3-month calls and buy
|
||||
ing 6-month calls. The neutral ratio is 0.75/0.50 or 3 to 2; that is, 3 calls are to be
|
||||
bought for every 2 sold. Thus, a neutral spread would be:
|
||||
Buy 6 July 110 calls
|
||||
Sell 4 April l 00 calls
|
||||
As a second alternative, he might use the LEAPS as the long side of the spread; he
|
||||
would still sell the April 100 calls as the short side of the spread. In this case, his neu
|
||||
tral ratio would be 0.75/0.60, or 5 to 4. The resulting neutral spread would be:
|
||||
Buy 5 January LEAPS 110 calls
|
||||
Sell 4 April 100 calls
|
||||
@@ -0,0 +1,38 @@
|
||||
Chapter 25: LEAPS 401
|
||||
At this point, if XYZ rises in price by 1 point, the spread can be expected to lose 20
|
||||
cents, since the delta of the short option is 0.20 greater than the delta of the long
|
||||
option.
|
||||
This phenomenon has ramifications for the diagonal spreader of LEAPS. If the
|
||||
two strike prices of the spread are too close together, it may actually be possible to
|
||||
construct a bull spread that loses money on the upside. That would be very difficult
|
||||
for most traders to accept. In the above example, as depicted in Table 25-4, that's
|
||||
what happens. One way around this is to widen the strike prices out so that there is
|
||||
at least some profit potential, even if the stock rises dramatically. That may be diffi
|
||||
cult to do and still be able to sell the short-term option for any meaningful amount
|
||||
of premium.
|
||||
Note that a diagonal spread could even be considered as a substitute for a cov
|
||||
ered write in some special cases. It was shown that a LEAPS call can sometimes be
|
||||
used as a substitute for the common stock, with the investor placing the difference
|
||||
between the cost of the LEAPS call and the cost of the stock in the bank (or in T
|
||||
bills). Suppose that an investor is a covered writer, buying stock and selling relative
|
||||
ly short-term calls against it. If that investor were to make a LEAPS call substitution
|
||||
for his stock, he would then have a diagonal bull spread. Such a diagonal spread
|
||||
would probably have less risk than the one described above, since the investor pre
|
||||
sumably chose the LEAPS substitution because it was "cheap." Still, the potential
|
||||
pitfalls of the diagonal bull spread would apply to this situation as well. Thus, if one
|
||||
is a covered writer, this does not necessarily mean that he can substitute LEAPS calls
|
||||
for the long stock without taking care. The resulting position may not resemble a cov
|
||||
ered write as much as he thought it would.
|
||||
The "bottom line" is that if one pays a debit greater than the difference in the
|
||||
strike prices, he may eventually lose money if the stock rises far enough to virtually
|
||||
eliminate the time value premium of both options. This comes into play also if one
|
||||
rolls his options down if the underlying stock declines. Eventually, by doing so, he
|
||||
may invert the strikes - i.e., the striking price of the written option is lower than the
|
||||
striking price of the option that is owned. In that case, he will have locked in a loss if
|
||||
the overall credit he has received is less than the difference in the strikes - a quite
|
||||
likely event. So, for those who think this strategy is akin to a guaranteed profit, think
|
||||
again. It most certainly is not.
|
||||
Backspreads. LEAPS may be applied to other popular forms of diagonal spreads,
|
||||
such as the one in which in-the-money, near-term options are sold, and a greater quan
|
||||
tity of longer-term (LEAPS) at- or out-of-the money calls are bought. (This was
|
||||
referred to as a diagonal backspread in Chapter 14.) This is an excellent strategy, and
|
||||
@@ -0,0 +1,31 @@
|
||||
94 Part II: Call Option Strategies
|
||||
The selection of which call to write should be made on a comparison of avail
|
||||
able returns and downside protection. One can sometimes write part of his position
|
||||
out-of-the-money and the other part in-the-money to force a balance between return
|
||||
and protection that might not otherwise exist. Finally, one should not write against an
|
||||
underlying stock if he is bearish on the stock. The writer should be slightly bullish, or
|
||||
at least neutral, on the underlying stock.
|
||||
Follow-up action can be as important as the selection of the initial position
|
||||
itself. By rolling down if the underlying stock drops, the investor can add downside
|
||||
protection and current income. If one is unwilling to limit his upside potential too
|
||||
severely, he may consider rolling down only part of his call writing position. As the
|
||||
written call expires, the writer should roll forward into a more distant expiration
|
||||
month if the stock is relatively close to the original striking price. Higher consistent
|
||||
returns are achieved in this manner, because one is not spending additional stock
|
||||
commissions by letting the stock be called away. An aggressive follow-up action can
|
||||
also be taken when the underlying stock rises in price: The writer can roll up to a
|
||||
higher striking price. This action increases the maximum profit potential but also
|
||||
exposes the position to loss if the stock should subsequently decline. One would want
|
||||
to take no follow-up action and let his stock be called if it is above the striking price
|
||||
and if there are better returns available elsewhere in other securities.
|
||||
Covered call writing can also be done against convertible securities - bonds or
|
||||
preferred stocks. These convertibles sometimes offer higher dividend yields and
|
||||
therefore increase the overall return from covered writing. Also, the use of warrants
|
||||
or LEAPS in place of the underlying stock may be advantageous in certain circum
|
||||
stances, because the net investment is lowered while the profit potential remains the
|
||||
same. Therefore, the overall return could be higher.
|
||||
Finally, the larger individual stockholder or institutional investor who wants to
|
||||
achieve a certain price for his stock holdings should operate his covered writing strat
|
||||
egy under the incremental return concept. This will allow him to realize the full prof
|
||||
it potential of his underlying stock, up to the target sale price, and to earn additional
|
||||
positive income from option writing.
|
||||
@@ -0,0 +1,33 @@
|
||||
20 Part I: Basic Properties ol Stoclc Options
|
||||
1. Buy the January 40 call at 9.80.
|
||||
2. Sell short XYZ common stock at 50.
|
||||
3. Exercise the call to buy XYZ at 40.
|
||||
The arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from
|
||||
which he deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents
|
||||
- the amount of the discount. Since he pays only a minimal commission, this trans-
|
||||
action results in a net profit. '
|
||||
Also, if the writer can expect assignment when the option has no time value pre
|
||||
mium left in it, then conversely the option will usually not be called if time premium
|
||||
is left in it.
|
||||
Example: Prior to the expiration date, XYZ is trading at 50½, and the January 50 call
|
||||
is trading at 1. The call is not necessarily in imminent danger of being called, since it
|
||||
still has half a point of time premium left.
|
||||
Time value Call Striking Stock
|
||||
= + premium price price price
|
||||
= 1 + 50 50½
|
||||
= ½
|
||||
Early Exercise Due to Dividends on the Underlying Stock. Some
|
||||
times the market conditions create a discount situation, and sometimes a large
|
||||
dividend gives rise to a discount. Since the stock price is almost invariably
|
||||
reduced by the amount of the dividend, the option price is also most likely
|
||||
reduced after the ex-dividend. Since the holder of a listed option does not receive
|
||||
the dividend, he may decide to sell the option in the secondary market before the
|
||||
ex-date in anticipation of the drop in price. If enough calls are sold because of
|
||||
the impending ex-dividend reduction, the option may come to parity or even to a
|
||||
discount. Once again, the arbitrageurs may move in to take advantage of the sit
|
||||
uation by buying these calls and exercising them.
|
||||
If assigned prior to the ex-date, the writer does not receive the dividend for he
|
||||
no longer owns the stock on the ex-date. Furthermore, if he receives an assignment
|
||||
notice on the ex-date, he must deliver the stock with the dividend. It is therefore very
|
||||
important for the writer to watch for discount situations on the day prior to the ex
|
||||
date.
|
||||
@@ -0,0 +1,37 @@
|
||||
274 Part Ill: Put Option Strategies
|
||||
At the opposite end of the spectrum, the stock owner might buy an in-the
|
||||
money put as protection. This would quite severely limit his profit potential, since the
|
||||
underlying stock would have to rise above the strike and more for him to make a
|
||||
profit. However, the in-the-money put provides vast quantities of downside protec
|
||||
tion, limiting his loss to a very small amount.
|
||||
Example: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock
|
||||
owner who purchases the October 45 put would have a maximum risk of½ point, for
|
||||
he could always exercise the put to sell stock at 45, giving him a 5-point gain on the
|
||||
stock, but he paid 5½ points for the put, thereby giving him an overall maximum loss
|
||||
of ½ point. He would have difficulty making any profit during the life of the put,
|
||||
however. XYZ would have to rise by more than 5½ points (the cost of the put) for
|
||||
him to make any total profit on the position by October expiration.
|
||||
The deep in-the-money put purchase is overly conservative and is usually not a
|
||||
good strategy. On the other hand, it is not wise to purchase a put that is too deeply
|
||||
out-of-the-money as protection. Generally, one should purchase a slightly out-ofthe
|
||||
money put as protection. This helps to achieve a balance between the positive feature
|
||||
of protection for the common stock and the negative feature of limiting profits.
|
||||
The reader may find it interesting to know that he has actually gone through this
|
||||
analysis, back in Chapter 3. Glance again at the profit graph for this strategy of using
|
||||
the put purchase to protect a common stock holding (Figure 17-1). It has exactly the
|
||||
same shape as the profit graph of a simple call purchase. Therefore, the call purchase
|
||||
and the long put/long stock strategies are equivalent. Again, by equivalent it is meant
|
||||
that they have similar profit potentials. Obviously, the ownership of a call differs sub
|
||||
stantially from the ownership of common stock and a put. The stock owner continues
|
||||
to maintain his position for an indefinite period of time, while the call holder does not.
|
||||
Also, the stockholder is forced to pay substantially more for his position than is the call
|
||||
holder, and he also receives dividends whereas the call holder does not. Therefore,
|
||||
"equivalent" does not mean exactly the same when comparing call-oriented and put
|
||||
oriented strategies, but rather denotes that they have similar profit potentials.
|
||||
In Chapter 3, it was determined that the slightly in-the-money call often offers
|
||||
the best ratio between risk and reward. When the call is slightly in-the-money, the
|
||||
stock is above the striking price. Similarly, the slightly out-of-the-money put often
|
||||
offers the best ratio between risk and reward for the common stockholder who is buy
|
||||
ing the put for protection. Again, the stock is slightly above the striking price. Actually,
|
||||
since the two positions are equivalent, the same conclusions should be arrived at; that
|
||||
is why it was stated that the reader has been through this analysis previously.
|
||||
@@ -0,0 +1,161 @@
|
||||
CHAPTER 3
|
||||
Understanding Volatility
|
||||
Most option strategies involve trading volatility in one way or another. It’s easy to think of trading in terms of direction. But trading volatility? Volatility is an abstract concept; it’s a different animal than the linear trading paradigm used by most conventional market players. As an option trader, it is essential to understand and master volatility.
|
||||
Many traders trade without a solid understanding of volatility and its effect on option prices. These traders are often unhappily surprised when volatility moves against them. They mistake the adverse option price movements that result from volatility for getting ripped off by the market makers or some other market voodoo. Or worse, they surrender to the fact that they simply don’t understand why sometimes these unexpected price movements occur in options. They accept that that’s just the way it is.
|
||||
Part of what gets in the way of a ready understanding of volatility is context. The term
|
||||
volatility
|
||||
can have a few different meanings in the options business. There are three different uses of the word
|
||||
volatility
|
||||
that an option trader must be concerned with: historical volatility, implied volatility, and expected volatility.
|
||||
Historical Volatility
|
||||
Imagine there are two stocks: Stock A and Stock B. Both are trading at around $100 a share. Over the past month, a typical end-of-day net change in the price of Stock A has been up or down $5 to $7. During that same period, a typical daily move in Stock B has been something more like up or down $1 or $2. Stock A has tended to move more than Stock B as a percentage of its price, without regard to direction. Therefore, Stock A is more volatile—in the common usage of the word—than Stock B. In the options vernacular, Stock A has a higher historical volatility than Stock B. Historical volatility (HV) is the annualized standard deviation of daily returns. Also called
|
||||
realized volatility, statistical volatility
|
||||
, or
|
||||
stock volatility
|
||||
, HV is a measure of how volatile the price movement of a security has been during a certain period of time. But exactly how much higher is Stock A’s HV than Stock B’s?
|
||||
In order to objectively compare the volatilities of two stocks, historical volatility must be quantified. HV relates this volatility information in an objective numerical form. The volatility of a stock is expressed in terms of standard deviation.
|
||||
Standard Deviation
|
||||
Although knowing the mathematical formula behind standard deviation is not entirely necessary, understanding the concept is essential. Standard deviation, sometimes represented by the Greek letter sigma (σ), is a mathematical calculation that measures the dispersion of data from a mean value. In this case, the mean is the average stock price over a certain period of time. The farther from the mean the dispersion of occurrences (data) was during the period, the greater the standard deviation.
|
||||
Occurrences, in this context, are usually the closing prices of the stock. Some utilizers of volatility data may use other inputs (a weighted average of high, low, and closing prices, for example) in calculating standard deviation. Close-to-close price data are the most commonly used.
|
||||
The number of occurrences, a function of the time period, used in calculating standard deviation may vary. Many online purveyors of this data use the closing prices from the last 30 consecutive trading days to calculate HV. Weekends and holidays are not factored into the equation since there is no trading, and therefore no volatility, when the market isn’t open. After each day, the oldest price is taken out of the calculation and replaced by the most recent closing price. Using a shorter or longer period can yield different results and can be useful in studying a stock’s volatility.
|
||||
Knowing the number of days used in the calculation is crucial to understanding what the output represents. For example, if the last 5 trading days were extremely volatile, but the 25 days prior to that were comparatively calm, the 5-day standard deviation would be higher than the 30-day standard deviation.
|
||||
Standard deviation is stated as a percentage move in the price of the asset. If a $100 stock has a standard deviation of 15 percent, a one-standard-deviation move in the stock would be either $85 or $115—a 15 percent move in either direction. Standard deviation is used for comparison purposes. A stock with a standard deviation of 15 percent has experienced bigger moves—has been more volatile—during the relevant time period than a stock with a standard deviation of 6 percent.
|
||||
When the frequency of occurrences are graphed, the result is known as a distribution curve. There are many different shapes that a distribution curve can take, depending on the nature of the data being observed. In general, option-pricing models assume that stock prices adhere to a lognormal distribution.
|
||||
The shape of the distribution curve for stock prices has long been the topic of discussion among traders and academics alike. Regardless of what the true shape of the curve is, the concept of standard deviation applies just the same. For the purpose of illustrating standard deviation, a normal distribution is used here.
|
||||
When the graph of data adheres to a normal distribution, the result is a symmetrical bell-shaped curve. Standard deviation can be shown on the bell curve to either side of the mean.
|
||||
Exhibit 3.1
|
||||
represents a typical bell curve with standard deviation.
|
||||
EXHIBIT 3.1
|
||||
Standard deviation.
|
||||
Large moves in a security are typically less frequent than small ones. Events that cause big changes in the price of a stock, like a company’s being acquired by another or discovering its chief financial officer cooking the books, are not a daily occurrence. Comparatively smaller price fluctuations that reflect less extreme changes in the value of the corporation are more typically seen day to day. Statistically, the most probable outcome for a price change is found around the midpoint of the curve. What constitutes a large move or a small move, however, is unique to each individual security. For example, a two percent move in an index like the Standard & Poor’s (S&P) 500 may be considered a big one-day move, while a two percent move in a particularly active tech stock may be a daily occurrence. Standard deviation offers a statistical explanation of what constitutes a typical move.
|
||||
In
|
||||
Exhibit 3.1
|
||||
, the lines to either side of the mean represent one standard deviation. About 68 percent of all occurrences will take place between up one standard deviation and down one standard deviation. Two- and three-standard-deviation values could be shown on the curve as well. About 95 percent of data occur between up and down two standard deviations and about 99.7 percent between up and down three standard deviations. One standard deviation is the relevant figure in determining historical volatility.
|
||||
Standard Deviation and Historical Volatility
|
||||
When standard deviation is used in the context of historical volatility, it is annualized to state what the one-year volatility would be. Historical volatility is the annualized standard deviation of daily returns. This means that if a stock is trading at $100 a share and its historical volatility is 10 percent, then about 68 percent of the occurrences (closing prices) are expected to fall between $90 and $110 during a one-year period (based on recent past performance).
|
||||
Simply put, historical volatility shows how volatile a stock has been based on price movements that have occurred in the past. Although option traders may study HV to make informed decisions as to the value of options traded on a stock, it is not a direct function of option prices. For this, we must look to implied volatility.
|
||||
Implied Volatility
|
||||
Volatility is one of the six inputs of an option-pricing model. Some of the other inputs—strike price, stock price, the number of days until expiration, and the current interest rate—are easily observable. Past dividend policy allows an educated guess as to what the dividend input should be. But where can volatility be found?
|
||||
As discussed in Chapter 2, the output of the pricing model—the option’s theoretical value—in practice is not necessarily an output at all. When option traders use the pricing model, they commonly substitute the actual price at which the option is trading for the theoretical value. A value in the middle of the bid-ask spread is often used. The pricing model can be considered to be a complex algebra equation in which any variable can be solved for. If the theoretical value is known—which it is—it along with the five known inputs can be combined to solve for the unknown volatility.
|
||||
Implied volatility (IV) is the volatility input in a pricing model that, in conjunction with the other inputs, returns the theoretical value of an option matching the market price.
|
||||
For a specific stock price, a given implied volatility will yield a unique option value. Take a stock trading at $44.22 that has the 60-day 45-strike call at a theoretical value of $1.10 with an 18 percent implied volatility level. If the stock price remains constant, but IV rises to 19 percent, the value of the call will rise by its vega, which in this case is about 0.07. The new value of the call will be $1.17. Raising IV another point, to 20 percent, raises the theoretical value by another $0.07, to $1.24. The question is: What would cause implied volatility to change?
|
||||
Supply and Demand: Not Just a Good Idea, It’s the Law!
|
||||
Options are an excellent vehicle for speculation. However, the existence of the options market is better justified by the primary economic purpose of options: as a risk management tool. Hedgers use options to protect their assets from adverse price movements, and when the perception of risk increases, so does demand for this protection. In this context, risk means volatility—the potential for larger moves to the upside and downside. The relative prices of options are driven higher by increased demand for protective options when the market anticipates greater volatility. And option prices are driven lower by greater supply—that is, selling of options—when the market expects lower volatility. Like those of all assets, option prices are subject to the law of supply and demand.
|
||||
When volatility is expected to rise, demand for options is not limited to hedgers. Speculative traders would arguably be more inclined to buy a call than to buy the stock if they are bullish but expect future volatility to be high. Calls require a lower cash outlay. If the stock moves adversely, there is less capital at risk, but still similar profit potential.
|
||||
When volatility is expected to be low, hedging investors are less inclined to pay for protection. They are more likely to sell back the options they may have bought previously to recoup some of the expense. Options are a decaying asset. Investors are more likely to write calls against stagnant stocks to generate income in anticipated low-volatility environments. Speculative traders will implement option-selling strategies, such as short strangles or iron condors, in an attempt to capitalize on stocks they believe won’t move much. The rising supply of options puts downward pressure on option prices.
|
||||
Many traders sum up IV in two words:
|
||||
fear
|
||||
and
|
||||
greed
|
||||
. When option prices rise and fall, not because of changes in the stock price, time to expiration, interest rates, or dividends, but because of pure supply and demand, it is implied volatility that is the varying factor. There are many contributing factors to traders’ willingness to demand or supply options. Anticipation of events such as earnings reports, Federal Reserve announcements, or the release of other news particular to an individual stock can cause anxiety, or fear, in traders and consequently increase demand for options that causes IV to rise. IV can fall when there is complacency in the market or when the anticipated news has been announced and anxiety wanes. “Buy the rumor, sell the news” is often reflected in option implied volatility. When there is little fear of market movement, traders use options to squeeze out more profits—greed.
|
||||
Arbitrageurs, such as market makers who trade delta neutral—a strategy that will be discussed further in Chapters 12 and 13—must be relentlessly conscious of implied volatility. When immediate directional risk is eliminated from a position, IV becomes the traded commodity. Arbitrageurs who focus their efforts on trading volatility (colloquially called
|
||||
vol traders
|
||||
) tend to think about bids and offers in terms of IV. In the mind of a vol trader, option prices are translated into volatility levels. A trader may look at a particular option and say it is 30 bid at 31 offer. These values do not represent the prices of the options but rather the corresponding implied volatilities. The meaning behind the trader’s remark is that the market is willing to buy implied volatility at 30 percent and sell it at 31 percent. The actual prices of the options themselves are much less relevant to this type of trader.
|
||||
Should HV and IV Be the Same?
|
||||
Most option positions have exposure to volatility in two ways. First, the profitability of the position is usually somewhat dependent on movement (or lack of movement) of the underlying security. This is exposure to HV. Second, profitability can be affected by changes in supply and demand for the options. This is exposure to IV. In general, a long option position benefits when volatility—both historical and implied—increases. A short option position benefits when volatility—historical and implied—decreases. That said, buying options is buying volatility and selling options is selling volatility.
|
||||
The Relationship of HV and IV
|
||||
It’s intuitive that there should exist a direct relationship between the HV and IV. Empirically, this is often the case. Supply and demand for options, based on the market’s expectations for a security’s volatility, determines IV.
|
||||
It is easy to see why IV and HV often act in tandem. But, although HV and IV are related, they are not identical. There are times when IV and HV move in opposite directions. This is not so illogical, if one considers the key difference between the two: HV is calculated from past stock price movements; it is what has happened. IV is ultimately derived from the market’s expectation for future volatility.
|
||||
If a stock typically has an HV of 30 percent and nothing is expected to change, it can be reasonable to expect that in the future the stock will continue to trade at a 30 percent HV. By that logic, assuming that nothing is expected to change, IV should be fairly close to HV. Market conditions do change, however. These changes are often regular and predictable. Earnings reports are released once a quarter in many stocks, Federal Open Market Committee meetings happen regularly, and dates of other special announcements are often disclosed to the public in advance. Although the outcome of these events cannot be predicted, when they will occur often can be. It is around these widely anticipated events that HV-IV divergences often occur.
|
||||
HV-IV Divergence
|
||||
An HV-IV divergence occurs when HV declines and IV rises or vice versa. The classic example is often observed before a company’s quarterly earnings announcement, especially when there is lack of consensus among analysts’ estimates. This scenario often causes HV to remain constant or decline while IV rises. The reason? When there is a great deal of uncertainty as to what the quarterly earnings will be, investors are reluctant to buy
|
||||
or
|
||||
sell the stock until the number is released. When this happens, the stock price movement (volatility) consolidates, causing the calculated HV to decline. IV, however, can rise as traders scramble to buy up options—bidding up their prices. When the news is out, the feared (or hoped for) move in the stock takes place (or doesn’t), and HV and IV tend to converge again.
|
||||
Expected Volatility
|
||||
Whether trading options or stocks, simple or complex strategies, traders must consider volatility. For basic buy-and-hold investors, taking a potential investment’s volatility into account is innate behavior. Do I buy conservative (nonvolatile) stocks or more aggressive (volatile) stocks? Taking into account volatility, based not just on a gut feeling but on hard numbers, can lead to better, more objective trading decisions.
|
||||
Expected Stock Volatility
|
||||
Option traders must have an even greater focus on volatility, as it plays a much bigger role in their profitability—or lack thereof. Because options can create highly leveraged positions, small moves can yield big profits or losses. Option traders must monitor the likelihood of movement in the underlying closely. Estimating what historical volatility (standard deviation) will be in the future can help traders quantify the probability of movement beyond a certain price point. This leads to better decisions about whether to enter a trade, when to adjust a position, and when to exit.
|
||||
There is no way of knowing for certain what the future holds. But option data provide traders with tools to develop expectations for future stock volatility. IV is sometimes interpreted as the market’s estimate of the future volatility of the underlying security. That makes it a ready-made estimation tool, but there are two caveats to bear in mind when using IV to estimate future stock volatility.
|
||||
The first is that the market can be wrong. The market can wrongly price stocks. This mispricing can lead to a correction (up or down) in the prices of those stocks, which can lead to additional volatility, which may not be priced in to the options. Although there are traders and academics believe that the option market is fairly efficient in pricing volatility, there is a room for error. There is the possibility that the option market can be wrong.
|
||||
Another caveat is that volatility is an annualized figure—the annualized standard deviation. Unless the IV of a LEAPS option that has exactly one year until expiration is substituted for the expected volatility of the underlying stock over exactly one year, IV is an incongruent estimation for the future stock volatility. In practice, the IV of an option must be adjusted to represent the period of time desired.
|
||||
There is a common technique for deannualizing IV used by professional traders and retail traders alike.
|
||||
1
|
||||
The first step in this process to deannualize IV is to turn it into a one-day figure as opposed to one-year figure. This is accomplished by dividing IV by the square root of the number of trading days in a year. The number many traders use to approximate the number of trading days per year is 256, because its square root is a round number: 16. The formula is
|
||||
For example, a $100 stock that has an at-the-money (ATM) call trading at a 32 percent volatility implies that there is about a 68 percent chance that the underlying stock will be between $68 and $132 in one year’s time—that’s $100 ± ($100 × 0.32). The estimation for the market’s expectation for the volatility of the stock for one day in terms of standard deviation as a percentage of the price of the underlying is computed as follows:
|
||||
In one day’s time, based on an IV of 32 percent, there is a 68 percent chance of the stock’s being within 2 percent of the stock price—that’s between $98 and $102.
|
||||
There may be times when it is helpful for traders to have a volatility estimation for a period of time longer than one day—a week or a month, for example. This can be accomplished by multiplying the one-day volatility by the square root of the number of trading days in the relevant period. The equation is as follows:
|
||||
If the period in question is one month and there are 22 business days remaining in that month, the same $100 stock with the ATM call trading at a 32 percent implied volatility would have a one-month volatility of 9.38 percent.
|
||||
Based on this calculation for one month, it can be estimated that there is a 68 percent chance of the stock’s closing between $90.62 and $109.38 based on an IV of 32 percent.
|
||||
Expected Implied Volatility
|
||||
Although there is a great deal of science that can be applied to calculating expected actual volatility, developing expectations for implied volatility is more of an art. This element of an option’s price provides more risk and more opportunity. There are many traders who make their living distilling direction out of their positions and trading implied volatility. To be successful, a trader must forecast IV.
|
||||
Conceptually, trading IV is much like trading anything else. A trader who thinks a stock is going to rise will buy the stock. A trader who thinks IV is going to rise will buy options. Directional stock traders, however, have many more analysis tools available to them than do vol traders. Stock traders have both technical analysis (TA) and fundamental analysis at their disposal.
|
||||
Technical Analysis
|
||||
There are scores, perhaps hundreds, of technical tools for analyzing stocks, but there are not many that are available for analyzing IV. Technical analysis is the study of market data, such as past prices or volume, which is manipulated in such a way that it better illustrates market activity. TA studies are usually represented graphically on a chart.
|
||||
Developing TA tools for IV is more of a challenge than it is for stocks. One reason is that there is simply a lot more data to manage—for each stock, there may be hundreds of options listed on it. The only practical way of analyzing options from a TA standpoint is to use implied volatility. IV is more useful than raw historical option prices themselves. Information for both IV and HV is available in the form of volatility charts, or vol charts. (Vol charts are discussed in detail in Chapter 14.) Volatility charts are essential for analyzing options because they give more complete information.
|
||||
To get a clear picture of what is going on with the price of an option (the goal of technical analysis for any asset), just observing the option price does not supply enough information for a trader to work with. It’s incomplete. For example, if a call rises in value, why did it rise? What greek contributed to its value increase? Was it delta because the underlying stock rose? Or was it vega because volatility rose? How did time decay factor in? Using a volatility chart in conjunction with a conventional stock chart (and being aware of time decay) tells the whole, complete, story.
|
||||
Another reason historical option prices are not used in TA is the option bid-ask spread. For most stocks, the difference between the bid and the ask is equal to a very small percentage of the stock’s price. Because options are highly leveraged instruments, their bid-ask width can equal a much higher percentage of the price.
|
||||
If a trader uses the last trade to graph an option’s price, it could look as if a very large percentage move has occurred when in fact it has not. For example, if the option trades a small contract size on the bid (0.80), then on the offer (0.90) it would appear that the option rose 12.5 percent in value. This large percentage move is nothing more than market noise. Using volatility data based off the midpoint-of-the-market theoretical value eliminates such noise.
|
||||
Fundamental Analysis
|
||||
Fundamental analysis can have an important role in developing expectations for IV. Fundamental analysis is the study of economic factors that affect the value of an asset in order to determine what it is worth. With stocks, fundamental analysis may include studying income statements, balance sheets, and earnings reports. When the asset being studied is IV, there are fewer hard facts available. This is where the art of analyzing volatility comes into play.
|
||||
Essentially, the goal is to understand the psychology of the market in relation to supply and demand for options. Where is the fear? Where is the complacency? When are news events anticipated? How important are they? Ultimately, the question becomes: what is the potential for movement in the underlying? The greater the chance of stock movement, the more likely it is that IV will rise. When unexpected news is announced, IV can rise quickly. The determination of the fundamental relevance of surprise announcements must be made quickly.
|
||||
Unfortunately, these questions are subjective in nature. They require the trader to apply intuition and experience on a case-by-case basis. But there are a few observations to be made that can help a trader make better-educated decisions about IV.
|
||||
Reversion to the Mean
|
||||
The IVs of the options on many stocks and indexes tend to trade in a range unique to those option classes. This is referred to as the mean—or average—volatility level. Some securities will have smaller mean IV ranges than others. The range being observed should be established for a period long enough to confirm that it is a typical IV for the security, not just a temporary anomaly. Traders should study IV over the most recent 6-month period. When IV has changed significantly during that period, a 12-month study may be necessary. Deviations from this range, either above or below the established mean range, will occur from time to time. When following a breakout from the established range, it is common for IV to revert back to its normal range. This is commonly called
|
||||
reversion to the mean
|
||||
among volatility watchers.
|
||||
The challenge is recognizing when things change and when they stay the same. If the fundamentals of the stock change in such a way as to give the options market reason to believe the stock will now be more or less volatile on an ongoing basis than it typically has been in the recent past, the IV may not revert to the mean. Instead, a new mean volatility level may be established.
|
||||
When considering the likelihood of whether IV will revert to recent levels after it has deviated or find a new range, the time horizon and changes in the marketplace must be taken into account. For example, between 1998 and 2003 the mean volatility level of the SPX was around 20 percent to 30 percent. By the latter half of 2006, the mean IV was in the range of 10 percent to 13 percent. The difference was that between 1998 and 2003 was the buildup of “the tech bubble,” as it was called by the financial media. Market volatility ultimately leveled off in 2003.
|
||||
In a later era, between the fall of 2010 and late summer of 2011 SPX implied volatility settled in to trade mostly between 12 and 20 percent. But in August 2011, as the European debt crisis heated up, a new, more volatile range between 24 and 40 percent reigned for some time.
|
||||
No trader can accurately predict future IV any more than one can predict the future price of a stock. However, with IV there are often recurring patterns that traders can observe, like the ebb and flow of IV often associated with earnings or other regularly scheduled events. But be aware that the IV’s rising before the last 15 earnings reports doesn’t mean it will this time.
|
||||
CBOE Volatility Index
|
||||
®
|
||||
Often traders look to the implied volatility of the market as a whole for guidance on the IV of individual stocks. Traders use the Chicago Board Options Exchange (CBOE) Volatility Index
|
||||
®
|
||||
, or VIX
|
||||
®
|
||||
, as an indicator of overall market volatility.
|
||||
When people talk about the market, they are talking about a broad-based index covering many stocks on many diverse industries. Usually, they are referring to the S&P 500. Just as the IV of a stock may offer insight about investors’ feelings about that stock’s future volatility, the volatility of options on the S&P 500—SPX options—may tell something about the expected volatility of the market as a whole.
|
||||
VIX is an index published by the Chicago Board Options Exchange that measures the IV of a hypothetical 30-day option on the SPX. A 30-day option on the SPX only truly exists once a month—30 days before expiration. CBOE computes a hypothetical 30-day option by means of a weighted average of the two nearest-term months.
|
||||
When the S&P 500 rises or falls, it is common to see individual stocks rise and fall in sympathy with the index. Most stocks have some degree of market risk. When there is a perception of higher risk in the market as a whole, there can consequently be a perception of higher risk in individual stocks. The rise or fall of the IV of SPX can translate into the IV of individual stocks rising or falling.
|
||||
Implied Volatility and Direction
|
||||
Who’s afraid of falling stock prices? Logically, declining stocks cause concern for investors in general. There is confirmation of that statement in the options market. Just look at IV. With most stocks and indexes, there is an inverse relationship between IV and the underlying price.
|
||||
Exhibit 3.2
|
||||
shows the SPX plotted against its 30-day IV, or the VIX.
|
||||
EXHIBIT 3.2
|
||||
SPX vs. 30-day IV (VIX).
|
||||
The heavier line is the SPX, and the lighter line is the VIX. Note that as the price of SPX rises, the VIX tends to decline and vice versa. When the market declines, the demand for options tends to increase. Investors hedge by buying puts. Traders speculate on momentum by buying puts and speculate on a turnaround by buying calls. When the market moves higher, investors tend to sell their protection back and write covered calls or cash-secured puts. Option speculators initiate option-selling strategies. There is less fear when the market is rallying.
|
||||
This inverse relationship of IV to the price of the underlying is not unique to the SPX; it applies to most individual stocks as well. When a stock moves lower, the market usually bids up IV, and when the stock rises, the market tends to offer IV creating downward pressure.
|
||||
Calculating Volatility Data
|
||||
Accurate data are essential for calculating volatility. Many of the volatility data that are readily available are useful, but unfortunately, some are not. HV is a value that is easily calculated from publicly accessible past closing prices of a stock. It’s rather straightforward. Traders can access HV from many sources. Retail traders often have access to HV from their brokerage firm. Trading firms or clearinghouses often provide professional traders with HV data. There are some excellent online resources for HV as well.
|
||||
HV is a calculation with little subjectivity—the numbers add up how they add up. IV, however, can be a bit more ambiguous. It can be calculated different ways to achieve different desired outcomes; it is user-centric. Most of the time, traders consider the theoretical value to be between the bid and the ask prices. On occasion, however, a trader will calculate IV for the bid, the ask, the last trade price, or, sometimes, another value altogether. There may be a valid reason for any of these different methods for calculating IV. For example, if a trader is long volatility and aspires to reduce his position, calculating the IV for the bid shows him what IV level can be sold to liquidate his position.
|
||||
Firms, online data providers, and most options-friendly brokers offer IV data. Past IV data is usually displayed graphically in what is known as a volatility chart or vol chart. Current IV is often displayed along with other data right in the option chain. One note of caution: when the current IV is displayed, however, it should always be scrutinized carefully. Was the bid used in calculating this figure? What about the ask? How long ago was this calculation made? There are many questions that determine the accuracy of a current IV, and rarely are there any answers to support the number. Traders should trust only IV data they knowingly generated themselves using a pricing model.
|
||||
Volatility Skew
|
||||
There are many platforms (software or Web-based) that enable traders to solve for volatility values of multiple options within the same option class. Values of options of the same class are interrelated. Many of the model parameters are shared among the different series within the same class. But IV can be different for different options within the same class. This is referred to as the
|
||||
volatility skew
|
||||
. There are two types of volatility skew: term structure of volatility and vertical skew.
|
||||
Term Structure of Volatility
|
||||
Term structure of volatility—also called
|
||||
monthly skew
|
||||
or
|
||||
horizontal skew
|
||||
—is the relationship among the IVs of options in the same class with the same strike but with different expiration months. IV, again, is often interpreted as the market’s estimate of future volatility. It is reasonable to assume that the market will expect some months to be more volatile than others. Because of this, different expiration cycles can trade at different IVs. For example, if a company involved in a major product-liability lawsuit is expecting a verdict on the case to be announced in two months, the one-month IV may be low, as the stock is not expected to move much until the suit is resolved. The two-month volatility may be much higher, however, reflecting the expectations of a big move in the stock up or down, depending on the outcome.
|
||||
The term
|
||||
structure of volatility
|
||||
also varies with the normal ebb and flow of volatility within the business cycle. In periods of declining volatility, it is common for the month with the least amount of time until expiration, also known as the front month, to trade at a lower volatility than the back months, or months with more time until expiration. Conversely, when volatility is rising, the front month tends to have a higher IV than the back months.
|
||||
Exhibit 3.3
|
||||
shows historical option prices and their corresponding IVs for 32.5-strike calls on General Motors (GM) during a period of low volatility.
|
||||
EXHIBIT 3.3
|
||||
GM term structure of volatility.
|
||||
In this example, no major news is expected to be released on GM, and overall market volatility is relatively low. The February 32.5 call has the lowest IV, at 32 percent. Each consecutive month has a higher IV than the previous month. A graduated increasing or decreasing IV for each consecutive expiration cycle is typical of the term structure of volatility.
|
||||
Under normal circumstances, the front month is the most sensitive to changes in IV. There are two reasons for this. First, front-month options are typically the most actively traded. There is more buying and selling pressure. Their IV is subject to more activity. Second, vegas are smaller for options with fewer days until expiration. This means that for the same monetary change in an option’s value, the IV needs to move more for short-term options.
|
||||
Exhibit 3.4
|
||||
shows the same GM options and their corresponding vegas.
|
||||
EXHIBIT 3.4
|
||||
GM vegas.
|
||||
If the value of the September 32.5 calls increases by $0.10, IV must rise by 1 percentage point. If the February 32.5 calls increase by $0.10, IV must rise 3 percentage points. As expiration approaches, the vega gets even smaller. With seven days until expiration, the vega would be about 0.014. This means IV would have to change about 7 points to change the call value $0.10.
|
||||
Vertical Skew
|
||||
The second type of skew found in option IV is vertical skew, or strike skew. Vertical skew is the disparity in IV among the strike prices within the same month for an option class. The options on most stocks and indexes experience vertical skew. As a general rule, the IV of downside options—calls and puts with strike prices lower than the at-the-money (ATM) strike—trade at higher IVs than the ATM IV. The IV of upside options—calls and puts with strike prices higher than the ATM strike—typically trade at lower IVs than the ATM IV.
|
||||
The downside is often simply referred to as puts and the upside as calls. The rationale for this lingo is that OTM options (puts on the downside and calls on the upside) are usually more actively traded than the ITM options. By put-call parity, a put can be synthetically created from a call, and a call can be synthetically created from a put simply by adding the appropriate long or short stock position.
|
||||
Exhibit 3.5
|
||||
shows the vertical skew for 86-day options on Citigroup Inc. (C) on a typical day, with IVs rounded to the nearest tenth.
|
||||
EXHIBIT 3.5
|
||||
Citigroup vertical skew.
|
||||
Notice the IV of the puts (downside options) is higher than that of the calls (upside options), with the 31 strike’s volatility more than 10 points higher than that of the 38 strike. Also, the difference in IV per unit change in the strike price is higher for the downside options than it is for the upside ones. The difference between the IV of the 31 strike is 2 full points higher than the 32 strike, which is 1.8 points higher than the 33 strike. But the 36 strike’s IV is only 1.1 points higher than the 37 strike, which is also just 1.1 points higher than the 38 strike.
|
||||
This incremental difference in the IV per strike is often referred to as the slope. The puts of most underlyings tend to have a greater slope to their skew than the calls. Many models allow values to be entered for the upside slope and the downside slope that mathematically increase or decrease IVs of each strike incrementally. Some traders believe the slope should be a straight line, while others believe it should be an exponentially sloped line.
|
||||
If the IVs were graphed, the shape of the skew would vary among asset classes. This is sometimes referred to as the volatility smile or sneer, depending on the shape of the IV skew. Although
|
||||
Exhibit 3.5
|
||||
is a typical paradigm for the slope for stock options, bond options and other commodity options would have differently shaped skews. For example, grain options commonly have calls with higher IVs than the put IVs.
|
||||
Volatility skew is dependent on supply and demand. Greater demand for downside protection may cause the overall IV to rise, but it can cause the IV of puts to rise more relative to the calls or vice versa. There are many traders who make their living trading volatility skew.
|
||||
Note
|
||||
1
|
||||
. This technique provides only an estimation of future volatility.
|
||||
@@ -0,0 +1,37 @@
|
||||
308 Part Ill: Put Option Strategies
|
||||
form of an expected return analysis, will be presented in Chapter 28 on mathemati
|
||||
cal applications.
|
||||
More screens can be added to produce a more conservative list of straddl<'
|
||||
writes. For example, one might want to ignore any straddles that are not worth at
|
||||
least a fixed percentage, say 10%, of the underlying stock price. Also, straddles that
|
||||
are too short-term, such as ones with less than 30 days of life remaining, might b<'
|
||||
thrown out as well. The remaining list of straddle writing candidates should be ones
|
||||
that will provide reasonable returns under favorable conditions, and also should be
|
||||
readily adaptable to some of the follow-up strategies discussed later. Finally, one
|
||||
would generally like to have some amount of technical support at or above the lower
|
||||
break-even price and some technical resistance at or below the upper break-even
|
||||
point. Thus, once the computer has generated a list of straddles ranked by an index
|
||||
such as the one listed above, the straddle writer can further pare down the list by
|
||||
looking at the technical pictures of the underlying stocks.
|
||||
FOLLOW-UP ACTION
|
||||
The risks involved in straddle writing can be quite large. When market conditions are
|
||||
favorable, one can make considerable profits, even with restrictive selection require
|
||||
ments, and even by allowing considerable extra collateral for adverse stock move
|
||||
ments. However, in an extremely volatile market, especially a bullish one, losses can
|
||||
occur rapidly and follow-up action must be taken. Since the time premium of a put
|
||||
tends to shrink when it goes into-the-money, there is actually slightly less risk to the
|
||||
downside than there is to the upside. In an extremely bullish market, the time value
|
||||
premiums of call options will not shrink much at all and might even expand. This may
|
||||
force the straddle writer to pay excessive amounts of time value premium to buy back
|
||||
the written straddle, especially if the movement occurs well in advance of expiration.
|
||||
The simplest form of follow-up action is to buy the straddle back when and if the
|
||||
underlying stock reaches a break-even point. The idea behind doing so is to limit the
|
||||
losses to a small amount, because the straddle should be selling for only slightly more
|
||||
than its original value when the stock has reached a break-even point. In practice,
|
||||
there are several flaws in this theory. If the underlying stock arrives at a break-even
|
||||
point well in advance of expiration, the amount of time value premium remaining in
|
||||
the straddle may be extremely large and the writer will be losing a fairly large amount
|
||||
by repurchasing the straddle. Thus, a break-even point at expiration is probably a loss
|
||||
point prior to expiration.
|
||||
Example: After the straddle is established with the stock at 45, there is a sudden rally
|
||||
in the stock and it climbs quickly to 52. The call might be selling for 9 points, even
|
||||
@@ -0,0 +1,46 @@
|
||||
Chapter 35: Futures Option Strategies for Futures Spreads
|
||||
TABLE 35-2.
|
||||
Terms of oil production contract.
|
||||
Contract
|
||||
Crude Oil
|
||||
Unleaded Gasoline
|
||||
Heating Oil
|
||||
Initial
|
||||
Price
|
||||
18.00
|
||||
.6000
|
||||
.5500
|
||||
Subsequent
|
||||
Price
|
||||
19.00
|
||||
.6100
|
||||
.5600
|
||||
The following formula is generally used for the oil crack spread:
|
||||
Crack= (Unleaded gasoline + Heating oil) x 42 - 2 x Crude
|
||||
2
|
||||
(.6000 + .5500) X 42 - 2 X 18.00 =
|
||||
2
|
||||
= (48.3 - 36)/2
|
||||
= 6.15
|
||||
703
|
||||
Gain in
|
||||
Dollars
|
||||
$1,000
|
||||
$ 420
|
||||
$ 420
|
||||
Some traders don't use the divisor of 2 and, therefore, would arrive at a value
|
||||
of 12.30 with the above data.
|
||||
In either case, the spreader can track the history of this spread and will attempt
|
||||
to buy oil and sell the other two, or vice versa, in order to attempt to make an over
|
||||
all profit as the three products move. Suppose a spreader felt that the products were
|
||||
too expensive with respect to crude oil prices. He would then implement the spread
|
||||
in the following manner:
|
||||
Buy 2 March crude oil futures @ 18.00
|
||||
Sell 1 March heating oil future @ 0.5500
|
||||
Sell l March unleaded gasoline future @ 0.6000
|
||||
Thus, the crack spread was at 6.15 when he entered the position. Suppose that
|
||||
he was right, and the futures prices subsequently changed to the following:
|
||||
March crude oil futures: 18.50
|
||||
March unleaded gas futures: .6075
|
||||
March heating oil futures: .5575
|
||||
The profit is shown in Table 35-3.
|
||||
@@ -0,0 +1,28 @@
|
||||
270 Part Ill: Put Option Strategies
|
||||
2½; plus he has spent two commissions to date and would have to spend two more
|
||||
to liquidate the position.
|
||||
At this point, the strategist may decide to do nothing and take his chances that
|
||||
the stock will subsequently rally so that the July 45 put will expire worthless.
|
||||
However, if the stock continues to decline below 45, the spread will most certainly
|
||||
become more of a loss as both puts come closer to parity.
|
||||
This type of spread strategy is not as attractive as the "rolling-up" strategy. In
|
||||
the "rolling-up" strategy, one is not subjected to a loss if the stock declines after the
|
||||
spread is established, although he does limit his profits. The fact that the calendar
|
||||
spread strategy can lead to a loss even if the stock declines makes it a less desirable
|
||||
alternative.
|
||||
EQUIVALENT POSITIONS
|
||||
Before considering other put-oriented strategies, the reader should understand the
|
||||
definition of an equivalent position. Two strategies, or positions, are equivalent when
|
||||
they have the same profit potential. They may have different collateral or investment
|
||||
requirements, but they have similar profit potentials. Many of the call-oriented
|
||||
strategies that were discussed in Part II of the book have an equivalent put strategy.
|
||||
One such case has already been described: The "protected short sale," or shorting the
|
||||
common stock and buying a call, is equivalent to the purchase of a put. That is, both
|
||||
have a limited risk above the striking price of the option and relatively large profit
|
||||
potential to the downside. An easy way to tell if two strategies are equivalent is to see
|
||||
if their profit graphs have the same shape. The put purchase and the "protected short
|
||||
sale" have profit graphs with exactly the same shape (Figures 16-1 and 4-1, respec
|
||||
tively). As more put strategies are discussed, it will always be mentioned if the put
|
||||
strategy is equivalent to a previously described call strategy. This may help to clarify
|
||||
the put strategies, which understandably may seem complex to the reader who is not
|
||||
familiar with put options.
|
||||
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