================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:26 SCORE: 0.00 ================================================================================ 8 A Complete Guide to the Futures mArket 7. trading hours. Trading hours are listed in terms of the local times for the given exchange. (all U.s. exchanges are currently located in either the eastern or Central time zones.) 8. Daily price limit. exchanges normally specify a maximum amount by which the contract price can change on a given day. For example, if the December corn contract closed at $4.10 on the previous day, and the daily price limit is 25¢/bu, corn cannot trade above $4.35 or below $3.85. some markets employ formulas for increasing the daily limit after a specified number of consecutive limit days. in cases in which free market forces would normally seek an equilibrium price outside the range boundaries implied by the limit, the market will simply move to the limit and virtually cease to trade. For example, if after the market close the U. s. Department of agriculture (UsDa) releases a very bullish corn crop production estimate, which hypothetically would result in an immediate 30¢/bu price rise in an unrestricted market, prices will be locked limit up (25¢/bu) the next day. This means that the market will open and stay at the limit, with virtually no trading tak- ing place. The reason for the absence of trading activity is that the limit rule restriction maintains an artificially low price, leading to a deluge of buy orders at that price but few if any sell orders. in the case of a very severe surprise event (e.g., sudden major crop damage), a market could move several limits in succession, although such moves are less common than in the days before near-24-hour electronic trading. in such situations, traders on the wrong side of the fence might not be able to liquidate their positions until the market trades freely. The new trader should be aware of, but not be overly frightened by, this possibility, since such events of extreme volatility rarely come as a complete surprise. in most cases, markets vulnerable to such volatile price action can be identified. some examples of such markets would include commodities in which the UsDa is scheduled to release a major report, coffee or frozen concentrated orange juice during their respective freeze seasons, and markets that have exhibited recent extreme trading volatility. For some markets, the limit on the nearby contract is removed at some point table 1.2 Contract Month Designations Month ticker Designation January F February g March H april J May K June M July n august Q september U October V november X December Z ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:27 SCORE: 21.00 ================================================================================ 9FOr Beginners Only approaching expiration (frequently first notice day—see item 10). Daily price limits can change frequently, so traders should consult the exchange on which their products trade to ensure they are aware of current thresholds. 9. Settlement type. Markets are designated either as physically deliverable or cash settled. in Table 1.1, the e-mini s&P 500 futures are cash settled, while all the other markets can be physi- cally delivered. 10. First notice day. This is the first day on which a long can receive a delivery notice. First notice day presents no problem for shorts, since they are not obligated to issue a notice until after the last trading day. Furthermore, in some markets, first notice day occurs after last trading day, presenting no problem to the long either, since all remaining longs at that point presumably wish to take delivery. However, in markets in which first notice day precedes last trading day, longs who do not wish to take delivery should be sure to offset their positions in time to avoid receiving a delivery notice. (Brokerage firms routinely supply their clients with a list of these important dates.) although longs can pass on an undesired delivery notice by liquidating their position, this transaction will incur extra transaction costs and should be avoided. Last notice day is the final day a long can receive a delivery notice. 11. last trading day. This is the last day on which positions can be offset before delivery becomes obligatory for shorts and the acceptance of delivery obligatory for longs. as indicated previously, the vast majority of traders will liquidate their positions before this day. 12. Deliverable grade. This is the specific quality and type of the underlying commodity or finan- cial instrument that is acceptable for delivery. ■ Volume and Open Interest V olume is the total number of contracts traded on a given day. V olume figures are available for each traded month in a market, but most traders focus on the total volume of all traded months. Open interest is the total number of outstanding long contracts, or equivalently, the total number of outstanding short contracts—in futures, the two are always the same. When a new contract begins trading (typically about 12 to 18 months before its expiration date), its open interest is equal to zero. if a buy order and sell order are matched, then the open interest increases to 1. Basically, open interest increases when a new buyer purchases from a new seller and decreases when an existing long sells to an existing short. The open interest will remain unchanged if a new buyer purchases from an existing long or a new seller sells to an existing short. V olume and open interest are very useful as indicators of a market’s liquidity. not all listed futures mar- kets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading activity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the trader will often have to accept very poor trade execution prices if he wants to get in or out of a position. generally speaking, markets with open interest levels below 5,000 contracts, or average daily volume levels below 1,000 contracts, should be avoided, or at least approached very cautiously. new markets will usually exhibit volume and open interest figures below these levels during their ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:28 SCORE: 6.00 ================================================================================ 10a COMPleTe gUiDe TO THe FUTUres MarKeT initial months (and sometimes even years) of trading. By monitoring the volume and open interest fi gures, a trader can determine when the market’s level of liquidity is suffi cient to warrant participa- tion. Figure 1.1 shows February 2016 gold (top) and april 2016 gold (bottom) prices, along with their respective daily volume fi gures. February gold’s volume is negligible until november 2015, at which point it increases rapidly into December and maintains a high level through January (the February contract expires in late February). Meanwhile, april gold’s volume is minimal until Janu- ary, at which point it increases steadily and becomes the more actively traded contract in the last two days of January—even though the February gold contract is still a month from expiration at that point. The breakdown of volume and open interest fi gures by contract month can be very useful in determining whether a specifi c month is suffi ciently liquid. For example, a trader who prefers to initiate a long position in a nine-month forward futures contract rather than in more nearby con- tracts because of an assessment that it is relatively underpriced may be concerned whether its level of trading activity is suffi cient to avoid liquidity problems. in this case, the breakdown of volume and open interest fi gures by contract month can help the trader decide whether it is reasonable to enter the position in the more forward contract or whether it is better to restrict trading to the nearby contracts. Traders with short-term time horizons (e.g., intraday to a few days) should limit trading to the most liquid contract, which is usually the nearby contract month. FIGURE  1.1 V olume shift in gold Futures Chart created using Tradestation. ©Tradestation T echnologies, inc. all rights reserved. ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:497 SCORE: 0.00 ================================================================================ 479 AN INTrOduCTION TO OPTIONS ON FuTureS between the futures price and the strike price were less than the premium paid for the option, the net result of the trade would still be a loss. In order for the call buyer to realize a net profit, the dif- ference between the futures price and the strike price would have to exceed the premium at the time the call was purchased (after adjusting for commission cost). The higher the futures price, the greater the resulting profit. Of course, if the futures reach the desired objective, or the call buyer changes his market opinion, he could sell his call prior to expiration. 4 The buyer of a put seeks to profit from an anticipated price decline by locking in a sales price. Similar to the call buyer, his maximum possible loss is limited to the dollar amount of the premium paid for the option. In the case of a put held until expiration, the trade would show a net profit if the strike price exceeded the futures price by an amount greater than the premium of the put at purchase (after adjusting for commission cost). While the buyer of a call or put has limited risk and unlimited potential gain, 5 the reverse is true for the seller. The option seller (“writer”) receives the dollar value of the premium in return for undertaking the obligation to assume an opposite position at the strike price if an option is exercised. For example, if a call is exercised, the seller must assume a short position in futures at the strike price (since by exercising the call, the buyer assumes a long position at that price). upon exercise, the exchange’s clearinghouse will establish these opposite futures positions at the strike price. After exercise, the call buyer and seller can either maintain or liquidate their respective futures positions. The seller of a call seeks to profit from an anticipated sideways to modestly declining market. In such a situation, the premium earned by selling a call will provide the most attractive trading oppor- tunity. However, if the trader expected a large price decline, he would usually be better off going short futures or buying a put—trades with open-ended profit potential. In a similar fashion, the seller of a put seeks to profit from an anticipated sideways to modestly rising market. Some novices have trouble understanding why a trader would not always prefer the buy side of an option (call or put, depending on his market opinion), since such a trade has unlimited potential and limited risk. Such confusion reflects the failure to take probability into account. Although the option seller’s theoretical risk is unlimited, the price levels that have the greatest probability of occurring (i.e., prices in the vicinity of the market price at the time the option trade occurs) would result in a net gain to the option seller. roughly speaking, the option buyer accepts a large probability of a small loss in return for a small probability of a large gain, whereas the option seller accepts a small probability of a large loss in exchange for a large probability of a small gain. In an efficient market, neither the consistent option buyer nor the consistent option seller should have any advantage over the long run. 6 4 even if the call is held until the expiration date, it will usually still be easier to offset the position in the options market rather than exercising the call. 5 T echnically speaking, the gains on a put would be limited, since prices cannot fall below zero; but for practical purposes, it is entirely reasonable to speak of the maximum possible gain on a long put position as being unlimited. 6 T o be precise, this statement is not intended to imply that the consistent option buyer and consistent option seller would both have the same expected outcome (zero excluding transactions costs). Theoretically, on average, it is rea- sonable to expect the market to price options so there is some advantage to the seller to compensate option sellers for providing price insurance—that is, assuming the highly undesirable exposure to a large, open-ended loss. So, in effect, option sellers would have a more attractive return profile and a less attractive risk profile than option buyers, and it is in this sense that the market will, on average, price options so that there is no net advantage to the buyer or seller. ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:498 SCORE: 56.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:499 SCORE: 24.00 ================================================================================ 481 AN INTrOduCTION TO OPTIONS ON FuTureS risk is limited is not worth very much, because the strike price is so far away from the prevailing futures price. As Figure 34.1 shows, the time value will be at a maximum at the strike price. 2. time remaining until expiration. The more time remaining until expiration, the greater the time value of the option. This is true because a longer life span increases the probability of the intrinsic value increasing by any specifi ed amount prior to expiration. In other words, the more time until expiration, the greater the probable price range of futures. Figure 34.2 illustrates the standard theoretical assumption regarding the relationship between time value and time remaining until expiration for an at-the-money option. Specifi cally, the time value is FIGURE  34.1 Theoretical Option Premium Curve Source: Chicago Board of Trade, Marketing department. Call Option Strike price Intrinsic value T -bond futures price130 132 134 136 138 140 Time value premium 8 6 4 2 Option premium Strike price Intrinsic value T-bond futures price 124 126 128 130 8 6 4 2 Option premium Put Option Time value premium FIGURE  34.2 Time Value decay Source: Options on Comex Gold Futures, published by Commodity exchange, Inc. (COMeX), 1982. Time value decay 94 10 Time remaining until expiration (months) Time value premium ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:500 SCORE: 15.00 ================================================================================ 482 A Complete Guide to the Futures mArket table 34.2 Option prices as a Function of V olatility in e-Mini S&p 500 Futures pricesa annualized V olatility put or Call premium 10 22.88 ($1,144) 20 45.75 ($2,288) 30 68.62 ($3,431) 40 91.46 ($4,573) 50 114.29 ($5,715) a At-the-money options at a strike price of 2000 with 30 days to expiration. 8 James Bowe, Option Strategies T rading Handbook (New Y ork, NY: Coffee, Sugar, and Cocoa exchange, 1983). assumed to be a function of the square root of time. (This relationship is a consequence of the typical assumption regarding the shape of the probability curve for prices of the underlying futures contract.) Thus, an option with nine months until expiration would have 1.5 times the time value of a four-month option with the same strike price (; ;. )93 42 32 15== ÷= and three times the time value of a one-month option (; ;)93 11 31 3== ÷= . 3. V olatility. Time value will vary directly with the estimated volatility of the underlying futures contract for the remaining lifespan of the option. This relationship is the result of the fact that greater volatility raises the probability the intrinsic value will increase by any specified amount prior to expiration. In other words, the greater the volatility, the larger the probable range of futures prices. As Table 34.2 shows, volatility has a strong impact on theoretical option pre- mium values. Although volatility is an extremely important factor in determining option premium values, it should be stressed that the future volatility of the underlying futures contract is never pre- cisely known until after the fact. (In contrast, the time remaining until expiration and the rela - tionship between the current price of futures and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of historical volatility data. As will be explained, this factor is crucial in explaining the deviation between theoretical and actual premium values. 4. Interest rates. The effect of interest rates on option premiums is considerably smaller than any of the above three factors. The specific nature of the relationship between interest rates and premiums was succinctly summarized by James Bowe 8: The effect of interest rates is complicated because changes in rates affect not only the underlying value of the option, but the futures price as well. Taking it in steps, a buyer of any given option must pay the premium up front, and of course the seller receives the money. If interest rates go up and everything else stays constant, the opportunity cost to the option buyer of giving up the use of his money increases, and so he is will- ing to bid less. Conversely, the seller of options can make more on the premiums by ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:501 SCORE: 3.00 ================================================================================ 483 AN INTrOduCTION TO OPTIONS ON FuTureS investing the cash received and so is willing to accept less; the value of the options fall. However, in futures markets, part of the value of distant contracts in a carry market reflects the interest costs associated with owning the commodity. An increase in the interest rate might cause the futures price to increase, leading to the value of existing calls going up. The net effect on calls is ambiguous, but puts should decline in value with increasing interest rates, as the effects are reinforcing. ■ Theoretical versus Actual Option Premiums There is a variety of mathematical models available that will indicate the theoretical “fair value” for an option, given specific information regarding the four factors detailed in the previous section. Theoret- ical values will approximate, but by no means coincide with, actual premiums. does the existence of such a discrepancy necessarily imply that the option is mispriced? definitely not. The model-implied premium will differ from the actual premium for two reasons: 1. The model’s assumption regarding the mathematical relationship between option prices (premi- ums) and the factors that affect option prices may not accurately describe market behavior. This is always true because, to some extent, even the best option-pricing models are only theoretical approximations of true market behavior. 2. The volatility figure used by an option-pricing model will normally differ somewhat from the market’s expectation of future volatility. This is a critical point that requires further elaboration. recall that although volatility is a crucial input in any option pricing formula, its value can only be estimated. The theoretical “fair value” of an option will depend on the specific choice of a volatility figure. Some of the factors that will influence the value of the volatility estimate are the length of the prior period used to estimate volatility, the time interval in which volatility is mea- sured, the weighting scheme (if any) used on the historical volatility data, and adjustments (if any) to reflect relevant influences (e.g., the recent trend in volatility). It should be clear that any specific volatility estimate will implicitly reflect a number of unavoidably arbitrary decisions. different assumptions regarding the best procedure for estimating future volatility from past volatility will yield different theoretical premium values. Thus, there is no such thing as a single, well-defined fair value for an option. All that any option pricing model can tell you is what the value of the option should be given the specific assumptions regarding expected volatility and the form of the mathematical relationship between option prices and the key factors affecting them. If a given mathematical model provides a close approximation of market behavior, a discrepancy between the theoretical value and the actual premium means the market expectation for volatility, called the implied volatility, differs from the historically based volatility estimate used in the model. The question of whether the volatility assump- tions of a specific pricing model provide more accurate estimates of actual volatility than the implied volatility figures (i.e., the future volatility suggested by actual premiums) can only be answered empirically. A bias toward buying “underpriced” options (relative to the theoretical model fair value) ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:543 SCORE: 0.00 ================================================================================ 525 OPTION TrAdINg STrATegIeS In most cases, it will make more sense for the trader simply to buy an in-the-money put since the transaction costs will be lower. However, if a speculator is already short futures, the purchase of an out-of-the-money call might present a viable alternative to liquidating this position and buying an in-the-money put. tabLe 35.12b profit/Loss Calculations: Option-protected Short Futures—Short Futures + Long Out- of-the-Money Call (Similar to Long In-the-Money put) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,300 Call at Initiation ($/oz) $ amount of premium paid profit/Loss on Short Futures position Call Value at expiration profit/Loss on position [(4) + (5) – (3)] 1,000 9.1 $910 $20,000 $0 $19,090 1,050 9.1 $910 $15,000 $0 $14,090 1,100 9.1 $910 $10,000 $0 $9,090 1,150 9.1 $910 $5,000 $0 $4,090 1,200 9.1 $910 $0 $0 –$910 1,250 9.1 $910 –$5,000 $0 –$5,910 1,300 9.1 $910 –$10,000 $0 –$10,910 1,350 9.1 $910 –$15,000 $5,000 –$10,910 1,400 9.1 $910 –$20,000 $10,000 –$10,910 FIGURE  35.12b Profi t/loss Profi le: Option-Protected Short Futures—Short Futures + long Out-of-the-Money Call (Similar to long In-the-Money Put) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Breakeven price = $1,190.90 Profit/loss at expiration ($) 1,000 10,000 15,000 20,000 5,000 −5,000 −10,000 −15,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Strike price ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:544 SCORE: 40.00 ================================================================================ 526 A Complete Guide to the Futures mArket Strategy 13: Covered Call Write (Long Futures + Short Call) example. Buy August gold futures at $1,200/oz and simultaneously sell an August $1,200 gold futures call at a premium of $38.80/oz ($3,880). (See Table 35.13 and Figure 35.13.) Comment. There has been a lot of nonsense written about covered call writing. In fact, even the term is misleading. The implication is that covered call writing—the sale of calls against long positions—is somehow a more conservative strategy than naked call writing—the sale of calls without any offsetting long futures position. This assumption is absolutely false. Although naked call writing implies unlimited risk, the same statement applies to covered call writing. As can be seen in Figure 35.13, the covered call writer merely exchanges unlimited risk in the event of a market advance (as is the case for the naked call writer) for unlimited risk in the event of a market decline. In fact, the reader can verify that this strategy is virtually equivalent to a “naked” short put position (see Strategy 35.6a). One frequently mentioned motivation for covered call writing is that it allows the holder of a long position to realize a better sales price. For example, if the market is trading at $1,200 and the holder of a long futures contract sells an at-the-money call at a premium of $38.80/oz instead of liquidating his position, he can realize an effective sales price of $1,238.80 if prices move higher (the $1,200 strike price plus the premium received for the sale of the call). And, if prices move down by no more than $38.80/oz by option expiration, he will realize an effective sales price of at least $1,200. Pre- sented in this light, this strategy appears to be a “heads you win, tails you win” proposition. However, there is no free lunch. The catch is that if prices decline by more than $38.80, the trader will realize a lower sales price than if he had simply liquidated the futures position. And, if prices rise substantially higher, the trader will fail to participate fully in the move as he would have if he had maintained his long position. The essential point is that although many motivations are suggested for covered call writing, the trader should keep in mind that this strategy is entirely equivalent to selling puts. tabLe 35.13 profit/Loss Calculations: Covered Call Write—Long Futures + Short Call (Similar to Short put) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) $ amount of premium received profit/Loss on Long Futures position Call Value at expiration profit/Loss on position [(3) + (4) – (5)] 1,000 38.8 $3,880 –$20,000 $0 –$16,120 1,050 38.8 $3,880 –$15,000 $0 –$11,120 1,100 38.8 $3,880 –$10,000 $0 –$6,120 1,150 38.8 $3,880 –$5,000 $0 –$1,120 1,200 38.8 $3,880 $0 $0 $3,880 1,250 38.8 $3,880 $5,000 $5,000 $3,880 1,300 38.8 $3,880 $10,000 $10,000 $3,880 1,350 38.8 $3,880 $15,000 $15,000 $3,880 1,400 38.8 $3,880 $20,000 $20,000 $3,880 ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:545 SCORE: 10.00 ================================================================================ 527 OPTION TrAdINg STrATegIeS Strategy 14: Covered put Write (Short Futures + Short put) example . Sell August futures at $1,200 and simultaneously sell an August $1,200 gold futures put at a premium of $38.70/oz ($3,870). (See Table 35.14 and Figure 35.14 .) FIGURE  35.13 Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to Short Put) Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 5,000 2,500 0 −2,500 −7 ,500 −10,000 −12,500 −15,000 −5,000 1,050 1,100 1,150 1,200 1,250 Futures price at time of position initiation and strike price Breakeven price = $1,161 .20 1,300 1,350 1,400 −17 ,500 tabLe 35.14 profit/Loss Calculations: Covered put Write—Short Futures + Short put (Similar to Short Call) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 put at Initiation ($/oz) $ amount of premium received profit/Loss on Short Futures position put Value at expiration profit/Loss on position [(3) + (4) – (5)] 1,000 38.7 $3,870 $20,000 $20,000 $3,870 1,050 38.7 $3,870 $15,000 $15,000 $3,870 1,100 38.7 $3,870 $10,000 $10,000 $3,870 1,150 38.7 $3,870 $5,000 $5,000 $3,870 1,200 38.7 $3,870 $0 $0 $3,870 1,250 38.7 $3,870 –$5,000 $0 –$1,130 1,300 38.7 $3,870 –$10,000 $0 –$6,130 1,350 38.7 $3,870 –$15,000 $0 –$11,130 1,400 38.7 $3,870 –$20,000 $0 –$16,130 ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:546 SCORE: 12.00 ================================================================================ 528A COMPleTe gUIde TO THe FUTUreS MArKeT Comment. Comments analogous to those made for Strategy 13 would apply here. The sale of a put against a short futures position is equivalent to the sale of a call. The reader can verify this by compar- ing Figure 35.14 to Figure 35.4 a. The two strategies would be precisely equivalent (ignoring transac- tion cost diff erences) if the put and call premiums were equal. Strategy 15: Synthetic Long Futures (Long Call + Short put) example . Buy an August $1,150 gold futures call at a premium of $70.10/oz ($7,010) and simultane- ously sell an August $1,150 gold futures put at a premium of $19.90/oz ($1,990). (See Table 35.15 and Figure 35.15 .) Comment. A synthetic long futures position can be created by combining a long call and a short put for the same expiration date and the same strike price. For example, as illustrated in Table 35.15 and Figure 35.15 , the combined position of a long August $1,150 call and a short August $1,150 put is virtually identical to a long August futures position. The reason for this equivalence is tied to the fact that the diff erence between the premium paid for the call and the premium received for the put is approxi- mately equal to the intrinsic value of the call. each $1 increase in price will raise the intrinsic value of the call by an equivalent amount and each $1 decrease in price will reduce the intrinsic value of the FIGURE  35.14 Profi t/loss Profi le: Covered Put Write—Short Futures + Short Put (Similar to Short Call) Price of August gold futures at option expiration ($/oz) 1,000 1,050 1,100 1,150 1,200 1,250 Futures price at time of position initiation and strike price Breakeven price = $1,238.70 1,300 1,350 1,400 Profit/loss at expiration ($) 5,000 2,500 0 −2,500 −7 ,500 −10,000 −12,500 −17 ,500 −15,000 −5,000 ================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:547 SCORE: 0.00 ================================================================================ 529 OPTION TrAdINg STrATegIeS tabLe 35.15 profit/Loss Calculations: Synthetic Long Futures (Long Call + Short put) (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,150 Call at Initiation ($/oz) $ amount of premium paid premium of august $1,150 put at Initiation ($/oz) $ amount of premium received Call Value at expiration put Value at expiration profit/Loss on position [(5) − (3) + (6) − (7)] 1,000 70.1 $7,010 19.9 $1,990 $0 $15,000 −$20,020 1,050 70.1 $7,010 19.9 $1,990 $0 $10,000 −$15,020 1,100 70.1 $7,010 19.9 $1,990 $0 $5,000 −$10,020 1,150 70.1 $7,010 19.9 $1,990 $0 $0 −$5,020 1,200 70.1 $7,010 19.9 $1,990 $5,000 $0 −$20 1,250 70.1 $7,010 19.9 $1,990 $10,000 $0 $4,980 1,300 70.1 $7,010 19.9 $1,990 $15,000 $0 $9,980 1,350 70.1 $7,010 19.9 $1,990 $20,000 $0 $14,980 1,400 70.1 $7,010 19.9 $1,990 $25,000 $0 $19,980 FIGURE  35.15 Profi t/loss Profi le: Synthetic long Futures (long Call + Short Put) Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 20,000 15,000 10,000 5,000 −5,000 −10,000 −15,000 −20,000 0 1,050 1,100 1,150 1,200 1,250 Futures price at time of position initiation Breakeven price = $1,200.20 1,300 1,350 1,400 ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:72 SCORE: 0.00 ================================================================================ The Intelligent Investor’s Guide to Option Pricing  •  55 would be more expensive than the following put option, which looks like this: 5/18/2012 5/20/2013 249 499 749 999 - 10 20 30 40 50 60 70 80 90 100 Advanced Building Corp. (ABC) Date/Day Count Stock Price GREEN The former would be more expensive than the latter simply because the range of exposure for the first lies further within the BSM cone of prob- ability than the latter. We can extrapolate these lessons regarding calls and puts to come up with a generalized rule about comparing the prices of two or more op- tions. Options will be more expensive in proportion to the total range of exposure that lies within the BSM cone. Graphically, we can represent this rule as follows: This call option will be much less expensive… GREEN GREEN than this call option. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:73 SCORE: 16.00 ================================================================================ 56  •   The Intelligent Option Investor This is so because the area of the range of exposure for the option on the left that is bounded by the BSM probability cone is much smaller than the range of exposure for the option on the right that is bounded by the same BSM probability cone. Time Value versus Intrinsic Value One thing that I hope you will have noticed is that so far we have talked about options that are either out of the money (OTM) or at the money (ATM). In-the-money (ITM) options—options whose range of exposure already contains the present stock price—may be bought and sold in just the same way as ATM and OTM options, and the pricing principle is ex- actly the same. That is, an ITM option is priced in proportion to how much of its range of exposure is contained within the BSM probability cone. However, if we think about the case of an OTM call option, we realize that the price we are paying to gain access to the stock’s upside potential is based completely on potentiality. Contrast this case with the case of an ITM call option, where an investor is paying not only for potential upside exposure but also for actual upside as well. It makes sense that when we think about pricing for an ITM call option, we divide the total option price into one portion that represents the poten- tial for future upside and another portion that represents the actual upside. These two portions are known by the terms time value and intrinsic value, respectively. It is easier to understand this concept if we look at a specific example, so let’s consider the case of purchasing a call option struck at $40 and having it expire in one year for a stock presently trading at $50 per share. We know that a call option deals with the upside potential of a stock and that buying a call option allows an investor to gain exposure to that up- side potential. As such, if we buy a call option struck at $40, we have access to all the upside potential over that $40 mark. Because the stock is trading at $50 right now, we are buying two bits of upside: the actual bit and the potential bit. The actual upside we are buying is $10 worth (= $50 − $40) and is termed the intrinsic value of the option. A simple way to think of intrinsic value that is valid for both call options and put options is the amount by which an option is ITM. However, the option’s cost will be greater than only the intrinsic value as long as there is still time ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:74 SCORE: 12.00 ================================================================================ The Intelligent Investor’s Guide to Option Pricing  •  57 before the option expires. The reason for this is that although the intrinsic value represents the actual upside of the stock’s price over the option strike price, there is still the possibility that the stock price will move further upward in the future. This possibility for the stock to move further upward is the potential bit mentioned earlier. Formally, this is called the time value of an option. Let us say that our one-year call option struck at $40 on a $50 stock costs $11.20. Here is the breakdown of this example’s option price into in- trinsic and time value: $10.00 Intrinsic value: the amount by which the option is ITM + $1.20 Time value: represents the future upside potential of the stock = $11.20 Overall option price Recall that earlier in this book I mentioned that it is almost always a mis- take to exercise a call option when it is ITM. The reason that it is almost always a mistake is the existence of time value. If we exercised the preceding option, we would generate a gain of exactly the amount of intrinsic value—$10. How- ever, if instead we sold the preceding option, we would generate a gain totaling both the intrinsic value and the time value—$11.20 in this example—and then we could use that gain to purchase the stock in the open market if we wanted. Our way of representing the purchase of an ITM call option from a risk-reward perspective is as follows: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 EBP = $51.25 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price GREEN ORANGE ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:75 SCORE: 4.00 ================================================================================ 58  •   The Intelligent Option Investor Usually, our convention is to shade a gain of exposure in green, but in the case of an ITM option, we will represent the range of exposure with intrinsic value in orange. This will remind us that if the stock falls from its present price of $50, we stand to lose the intrinsic value for which we have already paid. Notice also that our (two-tone) range of exposure completely over - laps with the BSM probability cone. Recalling that each upper and lower line of the cone represents about a 16 percent chance of going higher or lower, respectively, we can tell that according to the option market, this stock has a little better than an 84 percent chance of trading for $40 or above in one year’s time. 2 Again, the pricing used in this example is made up, but if we take a look at option prices in the market today and redo our earlier table to in- clude this ITM option, we will get the following: Strike Price ($) Strike–Stock Price Ratio (%) Call Price ($) Call Price as a Percent of Stock Price 70 140 $0.25 0.5 60 120 $1.15 2.3 50 100 $4.15 8.3 40 80 10.85 21.7 Again, it might seem confounding that anyone would want to use the ITM strategy as part of their investment plan. After all, you end up paying much more and being exposed to losses if the stock price drops. I ask you to suspend your disbelief until we go into more detail regarding option investment strategies in Part III of this book. For now, the important points are (1) to understand the difference between time and intrinsic value, (2) to see how ITM options are priced, and (3) to understand our convention for diagramming ITM options. From these diagrams and examples it is clear that moving the range of exposure further and further into the BSM probability cone will increase the price of the option. However, this is not the only case in which options will change price. Every moment that time passes, changes can occur to ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:167 SCORE: 7.00 ================================================================================ 150  •   The Intelligent Option Investor 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 Strike Price Oracle (ORCL) Implied Volatility Implied Volatility (Percent) 160 180 140 100 120 80 40 60 20 0 Thinking about what volatility means with regard to future stock prices—namely, that it is a prediction of a range of likely values—it does not make sense that options struck at different prices would predict such radi- cally different stock price ranges. What the market is saying, in effect, is that it expects different things about the likely future range of stock prices depending on what option is selected. Clearly, this does not make much sense. This “nonsensical” effect is actually proof that practitioners understand that the Black-Scholes-Merton model’s (BSM’s) assumptions are not correct and specifically that sudden downward jumps in a stock price can and do occur more often than would be predicted if returns fol- lowed a normal distribution. This effect does occur and even has a name— the volatility smile . Although this effect is extremely noticeable when graphed in this way, it is not particularly important for the intelligent op- tion investing strategies about which I will speak. Probably the most im- portant thing to realize is that the pricing on far OTM and far ITM options is a little more informal and approximate than for ATM options, so if you are thinking about transacting in OTM or ITM options, it is worth looking for the best deal available. For example, notice that in the preceding dia- gram, the $21-strike implied volatility is actually notably higher than the ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:168 SCORE: 12.00 ================================================================================ Finding Mispriced Options    • 151 $20-strike volatility. If you were interested in buying an ITM call option, you would pay less time value for the $20-strike than for the $21-strike op- tions—essentially the same investment. I will talk more about the volatility smile in the next section when discussing delta. In a similar way, sometimes the implied volatility for puts is different from the implied volatility for calls struck at the same price. Again, this is one of the market frictions that arises in option markets. This effect also has investing implications that I will discuss in the chapters detailing dif- ferent option investing strategies. The last column in this price display is delta , a measure that is so important that it deserves its own section—to which we turn now. Delta: The Most Useful of the Greeks Someone attempting to find out something about options will almost certainly hear about how the Greeks are so important. In fact, I think that they are so unimportant that I will barely discuss them in this book. If you understand how options are priced—and after reading Part I, you do—the Greeks are mostly common sense. Delta, though, is important enough for intelligent option investors to understand with a bit more detail. Delta is the one number that gives the probability of a stock being above (for calls) or below (for puts) a given strike price at a specific point in time. Deltas for calls always carry a positive sign, whereas deltas for puts are always negative, so, for instance, a call option on a given stock whose delta is exactly 0.50 will have a put delta of −0.50. The call delta of 0.50 means that there is a 50 percent chance that the stock will expire above that strike, and the put delta of −0.50 means that there is a 50 percent chance that the stock will expire below that strike. In fact, this strike demonstrates the technical definition of ATM—it is the most likely future price of the stock according to the BSM. The reason that delta is so important is that it allows you one way of creating the BSM probability cones that you will need to find option investment opportunities. Recall that the straight dotted line in our BSM cone diagrams meant the statistically most likely future price for the stock. The statistically most likely future price for a stock—assuming that stocks ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:169 SCORE: 0.00 ================================================================================ 152  •   The Intelligent Option Investor move randomly, which the BSM does—is the price level at which there is an equal chance of the actual future stock price to be above or below. In other words, the 50-delta mark represents the forward price of a stock in our BSM cones. Recall now also that each line demarcating the cone represents roughly a 16 percent probability of the stock reaching that price at a particular time in the future. This means that if we find the call strike prices that have deltas closest to 0.16 and 0.84 (= 1.00 − 0.16) or the put strike prices that have deltas closest to −0.84 and −0.16 for each expiration, we can sketch out the BSM cone at points in the future (the data I used to derive this graph are listed in tabular format at the end of this section). 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Date Oracle (ORCL) Price per Share 45 40 35 30 25 20 5 10 15 - Obviously, the bottom range looks completely distended compared with the nice, smooth BSM cone shown in earlier chapters. This dis- tension is simply another way of viewing the volatility smile. Like the volatility smile, the distended BSM cone represents an attempt by partici- pants in the options market to make the BSM more usable in real situa- tions, where stocks really can and do fall heavily even though the efficient market hypothesis (EMH) says that they should not. The shape is saying, ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:172 SCORE: 0.00 ================================================================================ 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! ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:173 SCORE: 12.00 ================================================================================ 156  •   The Intelligent Option Investor I’ll break the process into three steps: 1. Create a BSM cone. 2. Overlay your rational valuation range on the BSM cone. 3. Look for discrepancies. Create a BSM Cone The heart of a BSM cone is the forward volatility number. As we have seen, as forward volatility increases, the range of future stock prices projected by the BSM (and expected by the market) also increases. However, after hav- ing looked at the market pricing of options, we also know that a multitude of volatility numbers is available. Which one should we look at? Each strike price has its own implied volatility number. What strike price’s volatility should we use? There are also multiple tenors. What tenor options should we look at? Should we look at implied volatility at the bid price? At the ask price? Perhaps we should take the “kitchen sink” approach and just average all the implied volatilities listed! The answer is, in fact, easy if you use some simplifying assumptions to pick a single volatility number. I am not an academic, so I don’t neces- sarily care if these simplifying assumptions are congruent with theory. Also, I am not an arbitrageur, so I don’t much care about very precise numbers, and this attitude also lends itself well to the use of simplifying assumptions. All we have to make sure of is that the simplifying as- sumptions don’t distort our perception to the degree that we make bad economic choices. Here are the assumptions that we will make: 1. The implied volatility on a contract one or two months from expi- ration that is ATM or at least within the 40- to 60-delta band and that is the most heavily traded will contain the market’s best idea of the true forward volatility of the stock. 2. If a big announcement is scheduled for the near future, implied volatility numbers may be skewed, so their information might not be reliable. In this case, try to find a heavily traded near ATM strike at an expiry after the announcement will be made. If the announcement will be made in about four months or more, just try ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:174 SCORE: 28.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:175 SCORE: 4.00 ================================================================================ 158  •   The Intelligent Option Investor For Mueller Water, it’s a little trickier: 2.5 5 7.5 10 Last C5.30 C2.80 0.55 C0.00 Change BidA sk Delta AUG 16 ´13 2.5 5 7.5 10 NOV 15 ´13 2.5 5 7.5 10 12.5 FEB 21 ´14 DescriptionCall Last Change BidA sk Impl. Bid Vol. Impl. Ask Vol.Impl. Bid Vol. Impl. Ask Vol. Delta Put C0.00 C0.00 C0.25 C2.25 C0.00 C0.00 C0.55 C2.35 C0.00 C0.10 C0.85 C2.55 C4.80 5.20 5.50N /A 340.099% 0.9978 0.9978 0.7330 0.1316 0.9347 0.8524 0.6103 0.1516 0.9933 0.9190 0.6070 0.2566 0.1024 142.171% 46.039% 76.652% N/A N/A 2.95 0.55 0.10 0.20 0.10 N/A N/A N/A 0.10 0.30 2.35 40.733% N/A N/A N/A N/A 36.550% 38.181% 35.520% 35.509% 35.664% 2.10 0.50 0.05 0.10 0.60 2.402.30 0.05 0.15 0.15 0.85 2.60 4.90 2.70 0.500.00 5.20 5.50 3.00 0.90 0.20 2.80 0.80 0.10 5.505.10 3.102.85 1.151.05 0.400.30 0.200.05 39.708% N/A N/A 36.722% N/A 38.754% 38.318% 39.127% 36.347% 36.336% 292.169% 0.0000 -0.0000 -0.2778 -0.8663 -0.0616 -0.1447 -0.3886 -0.8447 -0.0018 -0.0787 -0.3890 -0.7375 -0.8913 128.711% 53.108% 88.008% 117.369% 60.675% 42.433% 44.802% 110.810% 50.757% 42.074% 43.947% 49.401% 163.282% 75.219% 42.610% 45.215% 122.894% 64.543% 42.697% 44.728% 50.218% C5.30 C2.80 C0.85 C0.10 C5.30 C1.10 C0.35 C0.10 3.00 +0.15 0.70 2.45 4.60 In the end, I would probably end up picking the implied volatility associated with the options struck at $7.50 and expiring in August 2013 (26 days until expiration). I was torn between these and the same strike expiring in November, but the August options are at least being actively traded, and the percentage bid-ask spread on the call side is lower for them than for the November options. Note, though, that the August 2013 put options are so far OTM that the bid-ask spread is very wide. In this case, I would probably look closer at the call options’ implied volatilities. In the end, I would have a bid volatility of around 39 percent and an ask volatility of around 46 percent. Because the bid-ask spread is large, I would probably want to see a cone for both the bid and ask. Plugging in the 22.0/22.5 for Oracle, 2 I would come up with this cone: Date Oracle (ORCL) Price per Share 60 40 50 30 10 20 - 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:187 SCORE: 8.00 ================================================================================ 170  •   The Intelligent Option Investor Because investment leverage comes about by changing the amount of your own capital that is at risk vis-à-vis the total size of the investment, you can imagine that moneyness has a large influence on lambda. Let’s take a look at how investment leverage changes for in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) options. The stock underlying the following options was trading at $31.25 when these data were taken, so I’m showing the $29 and $32 strikes as ATM: Strike Price K /S Ratio Call Price Delta Lambda 15.00 0.48 17.30 0.91 1.64 20.00 0.64 11.50 0.92 2.50 ITM 21.00 0.67 11.30 0.86 2.38 22.00 0.70 9.60 0.89 2.90 … … … … … 29.00 0.93 3.40 0.68 6.25 30.00 0.96 2.74 0.61 6.96 ATM 31.00 0.99 2.16 0.54 7.81 … … … … … 39.00 1.25 0.18 0.09 15.63 40.00 1.28 0.13 0.06 14.42 OTM 41.00 1.31 0.09 0.05 17.36 When an option is deep ITM, as in the case of the $20-strike call, we are making a significant expenditure of our own capital compared with the size of the investment. Buying a call option struck at $20, we are— as explained in the preceding section—effectively borrowing an amount equal to the $20 strike price. In addition to this, we are spending $11.50 in premium. Of this amount, $11.25 is intrinsic value, and $0.25 is time value. We can look at the time value portion as the prepaid interest we discussed in the preceding section, and we can even calculate the interest rate im- plied by this price (this option had 189 days left before expiration, implying an annual interest charge of 2.4 percent, for example). This prepaid interest can be offset partially or fully by profit realized on the position, but it can never be recaptured so must be considered a sunk cost. Time value always decays independent of the price changes of the underlying, so although an ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:188 SCORE: 16.00 ================================================================================ Understanding and Managing Leverage    • 171 upward movement in the stock will offset the money spent on time value, the amount spent on time value is never recoverable. The remaining $11.25 of the premium paid for a $20-strike call op- tion is intrinsic value . Buying intrinsic value means that we are exposing our own capital to the risk of an unrealized loss if the stock falls below $31.25. Lambda is directly related to the amount of capital we are exposing to an unrealized loss versus the size of the “loan” from the option, so be- cause we are risking $11.25 of our own capital and borrowing $20 with the option (a high capital-to-loan proportion), our investment leverage meas- ured by lambda is a relatively low 2.50. Now direct your attention to a far OTM call option—the one struck at $39. If we invest in the $39-strike option, we are again effectively taking out a $39 contingent loan to buy the shares. Again, we take the time-value portion of the option’s price—in this case the entire premi- um of $1.28—to be the prepaid interest (an implied annualized rate of 6.3 percent) and note that we are exposing none of our own capital to the risk of an unrealized loss. Because we are subjecting none of our own capital in this investment and taking out a large loan, our invest- ment leverage soars to a very high value of 15.63. This implies that a 1 percentage point move in the underlying stock will boost our invest- ment return by over 15 percent! Obviously, these calculations tell us that our investment returns are going to be much more volatile for small changes in the underlying’s price when buying far OTM options than when buying far ITM options. This is fine information for someone interested in more speculative strategies—if a speculator has the sense that a stock will rise quickly, he or she could, rather than buying the stock, buy OTM options, and if the stock went up fast enough and soon enough offset any drop of implied volatility and time decay, he or she would pocket a nice, highly levered profit. However, there are several factors that limit the usefulness of lambda. First, because delta is not a constant, the leverage factor does not stay put as the stock moves around. For someone who intends to hold a position for a longer time, then, lambda provides little information regarding how the position will perform over their investment horizon. In addition, reading the preceding descriptions of lambda, it is ob- vious that this measure deals exclusively with the percentage change in ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:189 SCORE: 0.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:206 SCORE: 4.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:207 SCORE: 16.00 ================================================================================ 190  •   The Intelligent Option Investor T enor Selection In general, the rule for gaining exposure is to buy as long a tenor as is available. If a stock moves up faster than you expected, the option will still have time value left on it, and you can sell it to recoup the extra money you spent to buy the longer-tenor option. In addition, long-tenor options are usually proportionally less expensive than shorter-tenor ones. Y ou can see this through the following table. These ask prices are for call options on Google (GOOG) struck at whatever price was closest to the 50-delta mark for every tenor available. Days to Expiration Ask Price Marginal Price/Day Delta 3 6.00 2.00 52 10 10.30 0.61 52 17 12.90 0.37 52 24 15.50 0.37 52 31 17.70 0.31 52 59 22.40 0.17 49 87 34.40 0.43 50 150 42.60 0.13 50 178 47.30 0.17 50 241 56.00 0.14 50 542 86.40 0.10 50 The “Marginal Price/Day” column is simply the extra that you pay to get the extra days on the contract. For example, the contract with three days left is $6.00. For seven more days of exposure, you pay a total of $4.30 extra, which works out to a per-day rate of $0.61. We see blips in the marginal price per day field as we go from 59 to 87 to 150 days, but these are just artifacts of data availability; the closest strikes did not have the same delta for each expiration. The preceding chart, it turns out, is just the inverse of the rule we already learned in Chapter 3: “time value slips away fastest as we get closer to expiration. ” If time value slips away more quickly nearer expiration, it must mean that the time value nearer expiration is proportionally worth more than the time value further away from expiration. The preceding table simply illustrates this fact. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:208 SCORE: 24.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:209 SCORE: 0.00 ================================================================================ 192  •   The Intelligent Option Investor In general, attempting to profit from potential mergers is dif- ficult using options because you have to get both the timing of the suspected transaction and the acquisition price correct. I will discuss a possible solution to this situation in the next section about picking strike prices. The second case in which it is not necessary to buy as long a tenor as possible is when you are trading in expectation of a particular company announcement. In general, this game of anticipating stock price move- ments is a hard one to win and one that value investors usually steer clear of, but if you are sure that some announcement scheduled for a particular day or week is likely to occur but do not want to make a long-term invest- ment on the company, you can buy a shorter-tenor option that obviously must include the anticipated announcement date. It is probably not a bad idea to build in a little cushion between your expiration and the anticipated date of the announcement because sometimes announcements are pushed back and rescheduled. Strike Price Selection From the discussion regarding leverage in the preceding section, it is clear that selecting strike prices has a lot to do with selecting what level of leverage you have on any given bet. Ultimately, then, strike selec- tion—the management of leverage, in other words—is intimately tied to your own risk profile and the degree to which you are risk averse or risk seeking. My approach, which I will talk more about in the following section on portfolio management, may be too conservative for others, but I put it forward as one alternative among many that I have found over time to be sensible. Any investment has risk to the extent that there is never perfect certainty regarding a company’s valuation. Some companies have a fairly tight valuation range—meaning that the confluence of their revenue stream, profit stream, and investment efficacy does not vary a great deal from best to worst case. Other companies’ valuation ranges are wide, with a few clumps of valuation scenarios far apart or with just one or two outlying valuation scenarios that, although not the most likely, are still materially probable. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:211 SCORE: 4.00 ================================================================================ 194  •   The Intelligent Option Investor Advanced Building Corp. (ABC) 100 90 80 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Date/Day Count Stock Price GREEN Here I have again maximized my tenor by buying LEAPS, but this time I increase my leverage to something like an “IRL/10.0” level in case the stars align and the stock price sales to my outlier valuation. Some people would say that the IIM approach is absolutely the op- posite of a rational one. If you are—the counterargument goes—confident in your valuation range, you should try to get as much leverage on that idea as possible; buying an ITM option is stupid because you are not using the leverage of options to their fullest potential. This counterargument has its point, but I find that there is just too much uncertainty in the markets to be too bold with the use of leverage. Options are time-dependent instruments, and if your option expires worthless, you have realized a loss on whatever time value you original- ly spent on it. Economies, now deeply intertwined all over the globe, are phenomenally complex things, so it is the height of hubris to claim that I can perfectly know what the future value of a firm is and how long it will take for the market price to reflect that value. In addition, I as a human decision maker am analyzing the world and investments through a con- genital filter based on behavioral biases. Retaining my humility in light of the enormous complexity of the marketplace and my ingrained human failings and expressing this humility ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:212 SCORE: 12.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:213 SCORE: 0.00 ================================================================================ 196  •   The Intelligent Option Investor the company is taken out. Just keep in mind that the buyout premium is 30 percent over the last price, not 30 percent over the price at which you decided to make your investment. If you buy 20 percent OTM call options and the stock decreases by 10 percent before a 30 percent premium buyout is announced, you will end up with nothing, as shown in the following timeline: $12-Strike Options Bought When the Stock Is Trading for $10 • Stock falls to $9. • Buyout is announced at 30 percent above last price—$11.70. • 12-strike call owner’s profit = $0. However, there is absolutely no assurance that an acguirer will pay some- thing for a prospective acguiree. Depending on how keen the acquirer is to get its hands on the assets of the target, it may actually allow the target company to go bankrupt and then buy its assets at $0.30 on the dollar or whatever. It is precisely this uncertainty that makes it unwise to commit too much capital to an idea involving a bad company—even if you think it may be taken out. Portfolio Management I like to think of intelligent option investing as a meal. In our investment meal, the underlying instrument—the stock—should, in most cases, form the main course. People have different ideas about diversification in a securities portfolio and about the maximum percentage of a portfolio that should be allocated to a specific idea. Clearly, most people are more comfortable allocating a greater percentage of their portfolio to higher-confidence ideas, but this is normal- ly framed in terms of relative levels (i.e., for some people, a high-conviction idea will make up 5 percent of their portfolio and a lower-conviction one 2.5 percent; for others, a high-conviction idea will make up 20 percent of their portfolio and a lower-conviction one 5 percent). Rather than addressing what size of investment meal is best to eat, let’s think about the meal’s composition. Considering the underlying stock as the main course, I consider the leverage as sauces and side dishes. ITM options positions are the main ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:231 SCORE: 0.00 ================================================================================ 214  •   The Intelligent Option Investor from a portfolio of short puts with the yield I might generate from a cor - porate bond portfolio. With this consideration, and keeping in mind that these investments are unlevered, 2 the name of the game is to generate as high a percentage return as possible over the investing time horizon while minimizing the amount of real downside risk you are accepting. T enor Selection To maximize percentage return, in general, it is better to sell options with relatively short-term expirations (usually tenors of from three to nine months before expiration). This is just the other side of the coin of the rule to buy long-tenor options: the longer the time to expiration, the less time value there is on a per-day basis. The rule to sell shorter-tenor options implies that you will make a higher absolute return by chaining together two back-to-back 6-month short puts than you would by selling a single 12-month option at the beginning of the period. During normal market conditions, selling shorter-tenor options is the best tactical choice, but during large market downdrafts, when there is terror in the marketplace and implied volatilities increase enormously for options on all companies, you might be able to make more by sell- ing a longer-tenor option than by chaining together a series of shorter- tenor ones (because, presumably, the implied volatilities of options will drop as the market stabilizes, and this drop means that you will make less money on subsequent put sales). At these times of extreme market stress, there are situations where you can find short-put opportunities on long-tenor options that defy economic logic and should be invested in opportunistically. For example, during the terrible market drops in 2009, I found a company whose slightly ITM put long-term equity anticipation securities (LEAPS) were trading at such a high price that the effective buy price of the stock was less than the amount of cash the firm had on its balance sheet. Obviously, for a firm producing positive cash flows, the stock should not trade at less than the value of cash presently on the balance sheet! I ef- fectively got the chance to buy a firm with $6 of cash on the balance sheet and the near certainty of generating about $2 more over the economic life of the options for $5.50. The opportunity to buy $6–$8 worth of cash for ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:232 SCORE: 12.00 ================================================================================ Accepting Exposure   • 215 $5.50 does not come along very often, so you should take advantage of it when you see it. Of course, the absolute value of premium you will receive by writing (jargon that means selling an option) a short-term put is less than the ab- solute value of the premium you will receive by writing a long-term one. 3 As such, an investor must balance the effective buy price of the stock (the strike price of the option less the amount of premium to be received) in which he or she is investing in the short-put strategy with the percentage return he or she will receive if the put expires OTM. I will talk more about effective buy price in the next section, but keep in mind that we would like to generate the highest percentage return pos- sible and that this usually means choosing shorter-tenor options. Strike Price Selection In general, the best policy is to sell options at as close to the 50-delta [at- the-money (ATM)] mark as one can because that is where time value for any option is at its absolute maximum. Our expectation is that the option’s time value will be worthless at expiration, and if that is indeed the case, we will be selling time value at its maximum and “closing” our time value position at zero—its minimum. In this way, we are obeying (in reverse order) the old investing maxim “Buy low, sell high. ” Selling ATM puts means that our effective buy price will be the strike price at which we sold less the amount of the premium we received. It goes without saying that an intelligent investor would not agree to accept the downside exposure to a stock if he or she were not prepared to buy the stock at the effective buy price. Some people want to sell OTM puts, thereby making the effective buy price much lower than the present market price. This is an understandable impulse, but simply attempting to minimize the effective buy price means that you must ignore the other element of a successful short put strategy: maximizing the return generated. There are times when you might like to sell puts on a company but only at a lower strike price. Rather than accept- ing a lower return for accepting that risk, I find that the best strategy is simply to wait awhile until the markets make a hiccup and knock down the price of the stock to your desired strike price. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:233 SCORE: 0.00 ================================================================================ 216  •   The Intelligent Option Investor Portfolio Management As we have discussed, the best percentage returns on short-put investments come from the sale of short-tenor ATM options. I find that each quarter there are excellent opportunities to find a fairly constant stream of this type of short- term bet that, when strung together in a portfolio, can generate annualized returns in the high-single-digit to low-teens percentage range. This level of returns—twice or more the yield recently found on a high-quality corporate bond portfolio and closer to the bond yield on highly speculative small com- panies with low credit ratings—is possible by investing in strong, high-quality blue chip stocks. In my mind, it is difficult to allocate much money to corpo- rate bonds when this type of alternative is available. Some investors prefer to sell puts on stocks that are not very vola- tile or that have had a significant run-up in price, 4 but if you think about how options are priced, it is clear that finding stocks that the market perceives as more volatile will allow you to generate higher returns. Y ou can confirm this by looking at the diagrams of a short-put investment given two different volatility scenarios. First, a diagram in which implied volatility is low: Advanced Building Corp. (ABC) 80 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Date/Day Count Stock Price RED ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:260 SCORE: 5.00 ================================================================================ Mixing Exposure  •  243 ignore the fact that most people simply want to generate a bit of extra in- come out of the holdings they already have and so are psychologically re- sistant to both selling ATM (because this makes it more likely for their shares to be called away) and selling at a time when the stock price sud- denly drop (because they want to reap the benefit of the shares recovering). Although I understand these sentiments, it is important to realize that options are financial instruments and not magical ones. It would be nice if we could simply find an investment tool that we could bolt onto our present stock holdings that would increase the dividend a nice amount but that wouldn’t put us at risk of having to deliver our beloved stocks to a complete stranger; unfortunately, this is not the case for options. For example, let’s say that you own stock in a company that is paying out a very nice dividend yield of 5 percent at present prices. This is a mature firm that has tons of cash flow but few opportunities for growth, so management has made the welcome choice to return cash to shareholders. The stock is trad- ing at $50 per share, but because the dividend is attractive to you, you are loathe to part with the stock. As such, you would prefer to write the covered call at a $55 or even a $60 strike price. A quick look at the BSM cone tells us why you should not be expecting a big boost in yield from selling the covered calls: 80 Sold call range of exposure 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Cash Flows R Us, Inc. (CASH) Date/Day Count Stock Price GREEN LIGHT GREENGRAY LIGHT REDRED ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:261 SCORE: 15.00 ================================================================================ 244  •   The Intelligent Option Investor Clearly, the range of exposure for the $55-strike call is well above the BSM cone. The BSM cone is pointing downward because the dividend rate is 5 percent—higher than the risk-free rate. This means that BSM drift will be lower. In addition, because this is an old, mature, steady-eddy kind of company, the expected forward volatility is low. Basically, this is a perfect storm for a low option price. My suggestion is to either write calls on stocks you don’t mind de- livering to someone else—stocks for which you are very confident in the valuation range and are now at or above the upper bound—or simply to look for a portfolio of short-put/covered-call investments and treat it like a high-yield bond portfolio, as I described in Chapter 10 when explaining short puts. It goes without saying that if you think that a stock has a lot of unappreciated upside potential, it’s not a good idea to sell that exposure away! One other note about execution: as I have said, short puts and cov- ered calls are the same thing, but a good many investors do not realize this fact or their brokerages prevent them from placing any trade other than a covered call. This leads to a situation in which there is a tremendous sup- ply of calls. Any time there is a lot of supply, the price goes down, and you will indeed find covered calls on some companies paying a lot less than the equivalent short put. Because you will be accepting the same downside exposure, it is better to get paid more for it, so my advice is to write the put rather than the covered call in such situations. To calculate returns for covered calls, I carry out the following steps: 1. Assume that you buy the underlying stock at the market price. 2. Deduct the money you will receive from the call sale as well as any projected dividends—these are the two elements of your cash inflow—from the market price of the stock. The resulting figure is your effective buy price (EBP). 3. Divide your total cash inflow by the EBP . I always include the projected dividend payment as long as I am writ- ing a short-tenor covered call and there are no issues with the company that would prevent it from paying the dividend. Owners of record have a right to receive dividends, even after they have written a covered call on the ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:262 SCORE: 10.00 ================================================================================ Mixing Exposure  •  245 stock, so it makes sense to count the dividend inflow as one element that reduces your EBP . In formula form, this turns out to be −−Coveredc allr eturn= premiumr eceivedf romc all+ projectedd ividends stockp rice premiumf romc allp rojected dividends For a short put, you have no right to receive the dividend, so I find the return using the following formula: −Shortp ut return= premiumr eceivedf roms hort put strikepricep remium from shortp ut Common Pitfalls Taking Profit One mistake I hear people make all the time is saying that they are going to “take profit” using a covered call. Writing a covered call is taking profit in the sense that you no longer enjoy capital gains from the stock’s appre- ciation, but it is certainly not taking profit in the sense of being immune to falls in the market price of the stock. The call premium you receive will cushion a stock price drop, but it will certainly not shield you from it. If you want to take profits on a successful stock trade, hit the “Sell” button. Locking in a Loss A person sent me an e-mail telling me that she had bought a stock at $17, sold covered calls on it when it got to $20 (in order to “take profits”), and now that the stock was trading for $11, she wanted to know how she could “repair” her position using options. Unfortunately, options are not magical tools and cannot make up for a prior decision to buy a stock at $17 and ride it down to $11. If you are in such a position, don’t panic. It will be tempting to write a new call at the lower ATM price ($11 in this example) because the cash inflow from that covered call will be the most. Don’t do it. By writing a covered call at the lower price, you are—if the shares are called away— locking in a realized loss on the position. Y ou can see this clearly if you list each transaction in the example separately. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:263 SCORE: 15.00 ================================================================================ 246  •   The Intelligent Option Investor No. Buy/Sell Instrument Price of Instrument Effective Buy (Sell) Price of Stock Note 1 Buy Stock $17/share $17/share Original purchase 2 Sell Call option $1/share $16/share Selling a covered call to take profits when stock reaches $20/ share leaves the investor with down- side exposure and $1 in premium income. 3 Sell Call option $0.75 ($11.75/ share) Stock falls to $11, and investor sells another covered call to generate income to ameliorate the loss. In transaction 1, the investor buys the shares for $17. In transaction 2, when the stock hits $20 per share, the investor sells a covered call and receives $1 in premium. This reduces the effective buy price to $16 per share and means that the investor will have to deliver the shares if the stock is trad- ing at $20 or above at expiration. When the stock instead falls to $11, the investor—wanting to cushion the pain of the loss—sells another ATM cov- ered call for $0.75. This covered call commits the investor to sell the shares for $11.75. No matter how you look at it, buying at $16 per share and sell- ing at $11.75 per share is not a recipe for investing success. The first step in such a situation as this—when the price of a stock on which you have accepted downside exposure falls—is to look back to your valuation. If the value of the firm has indeed dropped because of some material negative news and the position no longer makes sense from an economic perspective, just sell the shares and take the lumps. If, however, the stock price has dropped but the valuation still makes for a compelling investment, stay in the position; if the investment is ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:264 SCORE: 0.00 ================================================================================ Mixing Exposure  •  247 compelling enough, this is the time to figure out a clever way to get more exposure to it. Y ou can write calls as long as they are at least at the same strike price as your previous purchase price or EBP; this just means that you are buying at $16 and agreeing to sell at at least $16, in other words. Also keep in mind that any dividend payment you receive you can also think of as a reduction of your EBP—that cash inflow is offsetting the cost of the shares. Factoring in dividends and the (very small) cash inflow as- sociated with writing far OTM calls will, as long as you are right about the valuation, eventually reduce your EBP enough so that you can make a profit on the investment. Over-/Underexposure Options are transacted in contract sizes of 100 shares. If you hold a number of shares that is not evenly divisible by 100, you must decide whether you are going to sell the next number down of contracts or the next number up. For example, let’s say that you own 250 shares of ABC. Y ou can either choose to sell two call contracts (in which case you will not be receiving yield on 50 of your shares) or sell three call contracts (in which case you will be effectively shorting 50 shares). My preference is to sell fewer con- tracts controlling fewer shares than I hold, and in fact, your broker may or may not insist that you do so as well. If not, it is an unpleasant feeling to get a call from a broker saying that you have a margin call on a position that you didn’t know you had. Getting Assigned If you write covered calls, you live with the risk that you will have to deliver your beloved shares to a stranger. Y ou can deliver your shares and use the proceeds from that sale (the broker will deposit an amount equal to the strike price times the contract multiplier into your account, and you get to keep the premium you originally received) to buy the shares again, but there is no way around delivering the shares if assigned. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:267 SCORE: 10.00 ================================================================================ 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 $500,000 house, the following table shows what equivalent deductibles, annual premiums, and total liability to a home owner would be for deductibles equivalent to the strike prices I’ve picked for Apple: ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:268 SCORE: 0.00 ================================================================================ Mixing Exposure  •  251 Equivalent AAPL Strike ($) Deductible ($) Annual Premium ($) Total Liability to Home Owner ($) 450 2,795 64,500 67,295 405 52,516 32,500 85,016 360 102,236 13,500 115,736 I know that I would not be insuring my house at these rates and under those conditions! In light of these prices, the first thing you must consider is whether protecting a particular asset from unrealized price declines is worth the huge realized losses you must take to buy put premium. Buying ATM put protection on AAPL is setting up a 12.9 percent hurdle rate that the stock must surpass in one year just for you to start making a profit on the position, and 13 percent per year is quite a hurdle rate! If there is some reason why you believe that you need to pay for insurance, a better option—cheaper from a realized loss perspective—would be to sell the shares and use part of the proceeds to buy call options as an option-based replacement for the stock position. This approach has a few benefits: 1. The risk-reward profile is exactly the same between the two structures. 2. Any ATM or ITM call will be more lightly levered than any OTM put, meaning a lower realized loss on initiation. 3. For dividend-paying stocks, call owners do not have the right to receive dividends, but the amount of the projected dividend is de- ducted from the premium (as part of the drift calculation shown in the section on covered calls). As such, although not being paid dividends over time, you are getting what amounts to a one-time upfront dividend payment. 4. If you do not like the thought of leverage in your portfolio, you can self-margin the position (i.e., keep enough cash in reserve such that you are not “borrowing” any money through the call purchase). I do not hedge individual positions, but I do like the ITM call op- tion as an alternative for people who feel the need to do so. For hedg- ing of a general portfolio, rather than hedging of a particular holding in a portfolio, options on sector or index exchange-traded funds (ETFs) are more reasonably priced. Here are the ask prices for put options on the SPX ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:275 SCORE: 0.00 ================================================================================ 258  •   The Intelligent Option Investor plan like this in place will allow you to size and time your hedges appropri- ately and will help you to make the most out of whatever temporary crisis might come your way. 2 Now that you have a good understanding of protective puts and hedging, let’s turn to the last overlay strategy—the collar. Collar Contingent Exposure Contingent Exposure Contingent Exposure GREEN LIGHT GREEN LIGHT ORANGE LIGHT RED ORANGE RED Downside: Irrelevant Upside: Undervalued Execute: Sell a call option on a stock or index that you own and on which you have a gain, and use the proceeds from the call sale to buy an OTM put Risk: Flexible, depending on selection of strikes Reward: Limited to level of sold call strike Margin: None because the long position in the hedged security serves as collateral for the sold call option, and the OTM put option is purchased, so it does not require margining ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:276 SCORE: 25.00 ================================================================================ Mixing Exposure  •  259 The Gist This structure is really much simpler and has a much more straightfor - ward investment purpose than it may seem when you look at the preceding diagram. When people talk about “taking profits” using a covered call, the collar is actually the strategy they should be using. Imagine that you bought a stock some time ago and have a nice unrealized gain on it. The stock is about where you think its likely fair value is, but you do not want to sell it for whatever reason (e.g., it is paying a nice dividend or you bought it less than a year ago and do not want to be taxed on short-term capital gains or whatever). Although you do not want to sell it, you would like to protect yourself from downside exposure. Y ou can do this cheaply using a collar. The collar is a covered call, which we have already discussed, whose income subsidizes the purchase of a protective put at some level that will allow you to keep some of the unre- alized gains on your securities position. The band labeled “Orange” on the diagram shows an unrealized gain (or, conversely, a potential unrealized loss). If you buy a put that is within this orange band or above, you will be guaranteed of making at least some realized profit on your original stock or index investment. Depending on how much you receive for the covered call and what strike you select for the protective put, this collar may rep- resent completely “free” downside protection or you might even be able to realize a net credit. Execution The execution of this strategy depends a great deal on personal prefer - ence and on the individual investor’s situation. For example, an investor can sell a short-tenor covered call and use those proceeds to buy a longer- tenor protective put. He or she can sell the covered call ATM and buy a protective put that is close to ATM; this means the maximum and mini- mum potential return on the previous security purchase is in a fairly tight band. Conversely, the investor might sell an OTM covered call and buy a protective put that is also OTM. This would lock in a wider range of guaranteed profits over the life of the option. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:277 SCORE: 0.00 ================================================================================ 260  •   The Intelligent Option Investor I show a couple of examples below that give you the flavor of the possibilities of the collar strategy. With these examples, you can experi- ment yourself with a structure that fits your particular needs. Look on my website for a collar scenario calculator that will allow you to visualize the collar and understand the payoff structure given different conditions. For these examples, I am assuming that I bought Qualcomm stock at $55 per share. Qualcomm is now trading for $64.71—an unrealized gain of 17.7 percent. Collar 1: 169 Days to Expiration Strike Price ($) Bid (Ask) Price ($) Sold call 65.00 3.40 Purchased put 60.00 (2.14) Net credit $1.26 This collar yields the following best- and worst-case effective sell prices (ESPs) and corresponding returns (assuming a $55 buy price): ESP ($) Return (%) Best case 66.26 20.5 Worst case 61.26 11.4 Here we sold the $65-strike calls for $3.40 and used those proceeds to buy the $60-strike put options at $2.14. This gave us a net credit of $1.26, which we simply add to both strike prices to calculate our ESP . We add the net credit to the call strike because if the stock moves above the call strike, we will end up delivering the stock at the strike price while still keeping the net credit. We add the net credit to the put strike because if the stock closes below the put strike, we have the right to sell the shares at the strike price and still keep the net credit. The return numbers are calculated on the basis of a $55 purchase price and the ESPs listed. Thus, by setting up this collar in ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:307 SCORE: 0.00 ================================================================================ 290  •   The Intelligent Option Investor preceding equation, we can see that the left side of the equation is levered (because it contains only options, and options are levered instruments), and the right side is unlevered. Obviously, then, the two cannot be exactly the same. We can fix this problem by delevering the left side of the preceding equation. Any time we sell a put option, we have to place cash in a mar - gin account with our broker. Recall that a short put that is fully margined is an unlevered instrument, so margining the short put should delever the entire option position. Let’s add a margin account to the left side and put $K in it: C K − PK + K = S This equation simply says that if you sell a put struck at K and put $K worth of margin behind it while buying a call option, you’ll have the same risk, return, and leverage profile as if you bought a stock—just as in our big-picture diagram. But this is not quite right if one is dealing with small differences. First, let’s say that you talk your broker into funding the margin ac- count using a risk-free bond fund that will pay some fixed amount of interest over the next year. To fund the margin account, you tell your broker you will buy enough of the bond account that one year from now, when the put expires, the margin account’s value will be exactly the same as the strike price. In this way, even by placing an amount less than the strike price in your margin account originally, you will be able to fulfill the commitment to buy the stock at the strike price if the put expires in the money (ITM). The amount that will be placed in margin originally will be the strike price less the amount of interest you will receive from the risk-free bond. In mathematical terms, the preceding equation becomes C K − PK + (K – Int) = S Now all is right with the world. For a non-dividend-paying stock, this fully expresses the technical definition of put-call parity. However, because we are talking about dividend arbitrage, we have to think about how to adjust our equation to include dividends. We know that a call option on a dividend-paying stock is worth less because the dividend ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:308 SCORE: 16.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:309 SCORE: 3.00 ================================================================================ 292  •   The Intelligent Option Investor From this equation, it follows that if PK + Int < Div your call option has a negative implied time value, and you should sell the option in order to collect the dividend. This is what is meant by dividend arbitrage . But it is hard to get the flavor for this without seeing a real-life example of it. The following table shows the closing prices for Oracle’s stock and options on January 9, 2014, when they closed at $37.72. The options had an expiration of 373 days in the future—as close as I could find to one year—the one-year risk-free rate was 0.14 percent, and the company was expected to pay $0.24 worth of dividends before the options expired. Calls Puts Bid Ask Delta Strike Bid Ask Delta 19.55 19.85 0.94 18 0.08 0.13 −0.02 17.60 17.80 0.94 20 0.13 0.15 −0.03 14.65 14.85 0.92 23 0.25 0.28 −0.05 12.75 12.95 0.91 25 0.36 0.39 −0.07 10.00 10.25 0.86 28 0.66 0.69 −0.12 8.30 8.60 0.81 30 0.97 1.00 −0.17 6.70 6.95 0.76 32 1.40 1.43 −0.23 4.70 4.80 0.65 35 2.33 2.37 −0.34 3.55 3.65 0.56 37 3.15 3.25 −0.43 2.22 2.26 0.42 40 4.80 4.90 −0.57 1.55 1.59 0.33 42 6.15 6.25 −0.65 0.87 0.90 0.22 45 8.25 8.65 −0.75 0.31 0.34 0.10 50 12.65 13.05 −0.87 In the theoretical option portfolio, we are short a put, so its value to us is the amount we would have to pay if we tried to flatten the position by buying it back—the ask price. Conversely, we are long a call, so its value to us is the price we could sell it for—the bid price. Let’s use these data to figure out which calls we might want to exercise early if a dividend payment was coming up. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:25 SCORE: 0.00 ================================================================================ Chapter 1: Definitions s Striking Price. Striking prices are generally spaced 5 points apart for stocks, although for more expensive stocks, the striking prices may be 10 points apart. A $35 stock might, for example, have options with striking prices, or "strikes," of 30, 35, and 40, while a $255 stock might have one at 250 and one at 260. Moreover, some stocks have striking prices that are 2½ points apart - generally those selling for less than $35 per share. That is, a $17 stock might have strikes at 15, 17½, and 20. These striking price guidelines are not ironclad, however. Exchange officials may alter the intervals to improve depth and liquidity, perhaps spacing the strikes 5 points apart on a nonvolatile stock even if it is selling for more than $100. For exam­ ple, if a $155 stock were very active, and possibly not volatile, then there might well be a strike at 155, in addition to those at 150 and 160. Expiration Dates. Options have expiration dates in one of three fixed cycles: L the January/April/July/October cycle, 2. the February/May/August/November cycle, or 3. the March/June/September/December cycle. In addition, the two nearest months have listed options as well. However, at any given time, the longest-term expiration dates are normally no farther away than 9 months. Longer-term options, called LEAPS, are available on some stocks (see Chapter 25). Hence, in any cycle, options may expire in 3 of the 4 major months (series) plus the near-term months. For example, on February 1 of any year, XYZ options may expire in February, March, April, July, and October - not in January. The February option ( the closest series) is the short- or near-term option; and the October, the far- or long­ term option. If there were LEAPS options on this stock, they would expire in January of the following year and in January of the year after that. The exact date of expiration is fixed within each month. The last trading day for an option is the third Friday in the expiration month. Although the option actually does not expire until the following day (the Saturday following), a public customer must invoke the right to buy or sell stock by notifying his broker by 5:30 P.M., New York time, on the last day of trading. THE OPTION ITSELF: OTHER DEFINITIONS Classes and Series. A class of options refers to all put and call contracts on the same underlying security. For instance, all IBM options - all the puts and calls at various strikes and expiration months - form one class. A series, a subset of a class, ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:26 SCORE: 15.00 ================================================================================ 6 Part I: Basic Properties of Stock Options consists of all contracts of the same class (IBM, for example) having the same expi­ ration date and striking price. Opening and Closing Transactions. An opening transaction is the ini­ tial transaction, either a buy or a sell. For example, an opening buy transaction creates or increases a long position in the customer's account. A closing trans­ action reduces the customer's position. Opening buys are often followed by clos­ ing sales; correspondingly, opening sells often precede closing buy trades. Open Interest. The option exchanges keep track of the number of opening and closing transactions in each option series. This is called the open interest. Each opening transaction adds to the open interest and each closing transaction decreases the open interest. The open interest is expressed in number of option contracts, so that one order to buy 5 calls opening would increase the open interest by 5. Note that the open interest does not differentiate between buyers and sellers - there is no way to tell if there is a preponderance of either one. While the magnitude of the open interest is not an extremely important piece of data for the investor, it is useful in determining the liquidity of the option in question. If there is a large open interest, then there should be little problem in making fairly large trades. However, if the open interest is small - only a few hundred contracts outstanding - then there might not be a reasonable second­ ary market in that option series. The Holder and Writer. Anyone who buys an option as the initial transac­ tion - that is, buys opening - is called the holder. On the other hand, the investor who sells an option as the initial transaction - an opening sale - is called the writer of the option. Commonly, the writer ( or seller) of an option is referred to as being short the option contract. The term "writer" dates back to the over­ the-counter days, when a direct link existed between buyers and sellers of options; at that time, the seller was the writer of a new contract to buy stock. In the listed option market, however, the issuer of all options is the Options Clearing Corporation, and contracts are standardized. This important difference makes it possible to break the direct link between the buyer and seller, paving the way for the formation of the secondary markets that now exist. Exercise and Assignment. An option owner ( or holder) who invokes the right to buy or sell is said to exercise the option. Call option holders exercise to buy stock; put holders exercise to sell. The holder of most stock options may exercise the option at any time after taking possession of it, up until 8:00 P.M. on ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:27 SCORE: 24.00 ================================================================================ 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). ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:28 SCORE: 32.00 ================================================================================ 8 Part I: Basic Properties ol Stoclc Options If the call is out-of-the-money, then the premium and the time value premium are the same. Example: With XYZ at 48 and an XYZ July 50 call selling at 2, both the premium and the time value premium of the call are 2 points. The call has no intrinsic value by itself with the stock price below the striking price. An option normally has the largest amount of time value premium when the stock price is equal to the striking price. As an option becomes deeply in- or out-of­ the-money, the time value premium shrinks substantially. Table 1-1 illustrates this effect. Note that the time value premium increases as the stock nears the striking price (50) and then decreases as it draws away from 50. Parity. An option is said to be trading at parity with the underlying security if it is trading for its intrinsic value. Thus, if XYZ is 48 and the xyz July 45 call is selling for 3, the call is at parity. A common practice of particular interest to option writers ( as shall be seen later) is to refer to the price of an option by relat­ ing how close it is to parity with the common stock. Thus, the XY2 July 45 call is said to be a half-point over parity in any of the cases shown in Table 1-2. TABLE 1-1. Changes in time value premium. XYZ Stock XYZ Jul 50 Intrinsic Time Value Price Call Price Value Premium 40 1/2 0 ¼ 43 1 0 1 35 2 0 2 47 4 0 3 ➔50 5 0 5 53 7 3 4 55 8 5 3 57 9 7 2 60 101/2 10 ¼ 70 191/2 20 -1/20 asimplistically, a deeply in-the-money call may actually trade at a discount from intrinsic value, because call buyers are more interested in less expensive calls that might return better percentage profits on an upward move in the stock. This phenomenon is discussed in more detail when arbitrage techniques are examined. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:29 SCORE: 0.00 ================================================================================ Cl,apter 1: Definitions 9 TABLE 1-2. Comparison of XYZ stock and call prices. XYZ July 45 XYZ Stock Over Striking Price + Coll Price Price Parity (45 + 45 1/2) 1/2 (45 + 21/2 47 ) 1/2 (45 + 51/2 50 ) ½ (45 + 151/2 60 ) 1/2 FACTORS INFLUENCING THE PRICE OF AN OPTION An option's price is the result of properties of both the underlying stock and the terms of the option. The major quantifiable factors influencing the price of an option are the: 1.. price of the underlying stock, 2. striking price of the option itself, 3. time remaining until expiration of the option, 4. volatility of the underlying stock, 5. current risk-free interest rate (such as for 90-day Treasury bills), and 6. dividend rate of the underlying stock. The first four items are the major determinants of an option's price, while the latter two are generally less important, although the dividend rate can be influential in the case of high-yield stock. THE FOUR MAJOR DETERMINANTS Probably the most important influence on the option's price is the stock price, because if the stock price is far above or far below the striking price, the other fac­ tors have little influence. Its dominance is obvious on the day that an option expires. On that day, only the stock price and the striking price of the option determine the option's value; the other four factors have no bearing at all. At this time, an option is worth only its intrinsic value. Example: On the expiration day in July, with no time remaining, an XYZ July 50 call has the value shown in Table 1-3; each value depends on the stock price at the time. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:30 SCORE: 12.00 ================================================================================ 10 Part I: Basic Properties of Stock Options TABLE 1-3. XYZ option's values on the expiration day. XYZ July 50 Coll (Intrinsic) Value XYZ Stock Price ot Expiration 40 45 48 50 52 55 60 0 0 0 0 2 5 10 The Call Option Price Curve. The call option price curve is a curve that plots the prices of an option against various stock prices. Figure 1-1 shows the axes needed to graph such a curve. The vertical axis is called Option Price. The horizontal axis is for Stock Price. This figure is a graph of the intrinsic value. When the option is either out-of-the-money or equal to the stock price, the intrinsic value is zero. Once the stock price passes the striking price, it reflects the increase of intrinsic value as the stock price goes up. Since a call is usually worth at least its intrinsic value at any time, the graph thus represents the min­ imum price that a call may be worth. FIGURE 1-1. The value of an option at expiration, its intrinsic value. ~ it C: .Q 15.. 0 The intrinsic value line bends at the st~iking ~ pnce. ~ Stock Price ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:31 SCORE: 28.00 ================================================================================ Chapter 1: Definitions 11 When a call has time remaining to its expiration date, its total price consists of its intrinsic value plus its time value premium. The resultant call option price curve takes the form of an inverted arch that stretches along the stock price axis. If one plots the data from Table 1-4 on the grid supplied in Figure 1-2, the curve assumes two characteristics: 1. The time value premium ( the shaded area) is greatest when the stock price and the striking price are the same. 2. When the stock price is far above or far below the striking price (near the ends of the curve), the option sells for nearly its intrinsic value. As a result, the curve nearly touches the intrinsic value line at either end. [Figure 1-2 thus shows both the intrinsic value and the option price curve.] This curve, however, shows only how one might expect the XYZ July 50 call prices to behave with 6 months remaining until expiration. As the time to expiration grows shorter, the arched line drops lower and lower, until, on the final day in the life of the option, it merges completely with the intrinsic value line. In other words, the call is worth only its intrinsic value at expiration. Examine Figure 1-3, which depicts three separate XYZ calls. At any given stock price (a fixed point on the stock price scale), the longest-term call sells for the highest price and the nearest-term call sells for the lowest price. At the striking price, the actual differences in the three option prices are the greatest. Near either end of the scale, the three curves are much clos­ er together, indicating that the actual price differences from one option to another are small. For a given stock price, therefore, option prices decrease as the expiration date approaches. TABLE 1-4. The prices of a hypothetical July 50 call with 6 months of time remaining, plotted in Figure 1-2. XYZ Stock Price (Horizontal Axis) 40 45 48 ➔SO 52 55 60 XYZ July 50 Call Price (Vertical Axis) 2 3 4 5 61/2 11 Intrinsic Value 0 0 0 0 2 5 10 Time Value Premium (Shading) 2 3 4 3 11/2 1 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:32 SCORE: 4.00 ================================================================================ 12 Part I: Basic Properties of Stock Options Example: On January 1st, XYZ is selling at 48. An XYZ July 50 call will sell for more than an April 50 call, which in turn will sell for more than a January 50 call. FIGURE 1-2. Six-month July call option (see Table 1 ·4). .g a. C 0 a 11 10 9 8 7 6 5 Greatest Value for Time Value Premium 0 4 ---------------------- 3 2 0 FIGURE 1-3. 40 45 represents the option's time value premium. --------L---------50\ 55 60 Stock Price Intrinsic value remains at zero until striking price is passed. Price Curves for the 3-, 6·, and 9-month call options. / Intrinsic Value 9-Month Curve Striking Price Stock Price As expiration date draws closer, the lower curve merges with the intrinsic value line. The option price then equals its intrinsic value. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:33 SCORE: 12.00 ================================================================================ Chapter 1: Definitions 13 This statement is true no matter what the stock price is. The only reservation is that with the stock deeply in- or out-of-the-money, the actual difference between the January, April, and July calls will be smaller than with XYZ stock selling at the strik­ ing price of 50. Time Value Premium Decay. In Figure 1-3, notice that the price of the 9- month call is not three times that of the 3-month call. Note next that the curve in Figure 1-4 for the decay of time value premium is not straight; that is, the rate of decay of an option is not linear. An option's time value premium decays much more rapidly in the last few weeks of its life ( that is, in the weeks immediately preceding expiration) than it does in the first few weeks of its existence. The rate of decay is actually related to the square root of the time remaining. Thus, a 3- month option decays (loses time value premium) at twice the rate of a 9-month option, since the square root of 9 is 3. Similarly, a 2-month option decays at twice the rate of a 4-month option (-..f4 = 2). This graphic simplification should not lead one to believe that a 9-month option necessarily sells for twice the price of a 3-month option, because the other factors also influence the actual price relationship between the two calls. Of those other fac­ tors, the volatility of the underlying stock is particularly influential. More volatile underlying stocks have higher option prices. This relationship is logical, because if a FIGURE 1-4. Time value premium decay, assuming the stock price remains con­ stant. 9 4 Time Remaining Until Expiration (Months) 0 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:34 SCORE: 0.00 ================================================================================ 14 Part I: Basic Properties ol Stodc Options stock has the ability to move a relatively large distance upward, buyers of the calls are willing to pay higher prices for the calls - and sellers demand them as well. For exam­ ple, if AT&T and Xerox sell for the same price (as they have been known to do), the Xerox calls would be more highly priced than the AT&T calls because Xerox is a more volatile stock than AT&T. The interplay of the four major variables - stock price, striking price, time, and volatility can be quite complex. While a rising stock price (for example) is directing the price of a call upward, decreasing time may be simultaneously driving the price in the opposite direction. Thus, the purchaser of an out-of-the-money call may wind up with a loss even after a rise in price by the underlying stock, because time has eroded the call value. THE TWO MINOR DETERMINANTS The Risk-Free Interest Rate. This rate is generally construed as the current rate of 90-day Treasury bills. Higher interest rates imply slightly higher option pre­ miums, while lower rates imply lower premiums. Although members of the financial community disagree as to the extent that interest rates actually affect option price, they remain a factor in most mathematical models used for pricing options. (These models are covered much later in this book.) The Cash Dividend Rate of the Underlying Stock. Though not clas­ sified as a major determinant in option prices, this rate can be especially impor­ tant to the writer (seller) of an option. If the underlying stock pays no dividends at all, then a call option's worth is strictly a function of the other five items. Dividends, however, tend to lower call option premiums: The larger the dividend of the underlying common stock, the lower the price of its call options. One of the most influential factors in keeping option premiums low on high-yielding stock is the yield itself. Example: XYZ is a relatively low-priced stock with low volatility selling for $25 per share. It pays a large annual dividend of $2 per share in four quarterly payments of $.50 each. What is a fair price of an XYZ call with striking price 25? A prospective buyer of XYZ options is determined to figure out a fair price. In six months XYZ will pay $1 per share in dividends, and the stock price will thus be reduced by $1 per share when it goes ex-dividend over that time period. In that case, if XYZ's price remains unchanged except for the ex-dividend reductions, it will then be $24. Moreover, since XYZ is a nonvolatile stock, it may not readily climb back to 25 after the ex-dividend reductions. Therefore, the call buyer makes a low bid - even ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:38 SCORE: 0.00 ================================================================================ 18 Part I: Basic Properties of Stock Options bring greater potential to a portfolio. Or if the customer is already short the XYZ stock, he is going to have to buy 100 shares and pay the commissions sooner or later in any case; so exercising the call at the lower stock price of 45 may be more desir­ able than buying at the current price of 55. ANTICIPATING ASSIGNMENT The writer of a call often prefers to buy the option back in the secondary market, rather than fulfill the obligation via a stock transaction. It should be strJssed again that once the writer receives an assignment notice, it is too late to attempt to buy back (cover) the call. The writer must buy before assignment, or live up to the terms upon assignment. The writer who is aware of the circumstances that generally cause the holders to exercise can anticipate assignment with a fair amount of certainty. In antic­ ipation of the assignment, the writer can then close the contract in the secondary mar­ ket. As long as the writer covers the position at any time during a trading day, he can­ not be assigned on that option. Assignment notices are determined on open positions as of the close of trading each day. The crucial question then becomes, "How can the writer anticipate assignment?" Several circumstances signal assignments: 1. a call that is in-the-money at expiration, 2. an option trading at a discount prior to expiration, or 3. the underlying stock paying a large dividend and about to go ex-dividend. Automatic Exercise. Assignment is all but certain if the option is in-the­ money at expiration. Should the stock close even a half-point above the striking price on the last day of trading, the holder will exercise to take advantage of the half-point rather than let the option expire. Assignment is nearly inevitable even if a call is only a few cents in-the-money at expiration. In fact, even if the call trades in-the-money at any time during the last trading day, assignment may be forthcoming. Even if a holder forgets that he owns an option and fails to exer­ cise, the OCC automatically exercises any call that is ¾-point in-the-money at expiration, unless the individual brokerage firm whose customer is long the call gives specific instructions not to exercise. This automatic exercise mechanism ensures that no investor throws away money through carelessness. Example: XYZ closes at 51 on the third Friday of January (the last day of trading for the January option series). Since options don't expire until Saturday, the next day, the OCC and all brokerage firms have the opportunity to review their records to issue assignments and exercises and to see if any options could have been profitably exer- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:39 SCORE: 15.00 ================================================================================ Gapter 1: Definitions 19 cised but were not. If XYZ closed at 51 and a customer who owned a January 45 call option failed to either sell or exercise it, it is automatically exercised. Since it is worth $600, this customer stands to receive a substantial amount of money back, even after stock commissions. In the case of an XYZ January 50 call option, the automatic exercise procedure is not as clear-cut with the stock at 51. Though the OCC wants to exercise the call automatically, it cannot identify a specific owner. It knows only that one or more XYZ January calls are still open on the long side. When the OCC checks with the broker­ age firm, it may find that the firm does not wish to have the XYZ January 50 call exer­ cised automatically, because the customer would lose money on the exercise after incurring stock commissions. Yet the OCC must attempt to automatically exercise any in-the-money calls, because the holder may have overlooked a long position. When the public customer sells a call in the secondary market on the last day of trading, the buyer on the other side of the trade is very likely a market-maker. Thus, when trading stops, much of the open interest in in-the-money calls held long belongs to market-makers. Since they can profitably exercise even for an eighth of a point, they do so. Hence, the writer may receive an assignment notice even if the stock has been only slightly above the strike price on the last trading day before expi­ ration. Any writer who wishes to avoid an assignment notice should always buy back ( or cover) the option if it appears the stock will be above the strike at expiration. The probabilities of assignment are extremely high if the option expires in-the-money. Early Exercise Due to Discount. When options are exercised prior to expiration, this is called early, or premature, exercise. The writer can usually expect an early exercise when the call is trading at or below parity. A parity or discount situation in advance of expiration may mean that an early exercise is forthcoming, even if the discount is slight. A writer who does not want to deliv­ er stock should buy back the option prior to expiration if the option is apparently going to trade at a discount to parity. The reason is that arbitrageurs (floor traders or member firm traders who pay only minimal commissions) can take advantage of discount situations. (Arbitrage is discussed in more detail later in the text; it is mentioned here to show why early exercise often occurs in a dis­ count situation.) Example: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered at a discount price of 9.80. The call is actually "worth" 10 points. The arbitrageur can take advantage of this situation through the following actions, all on the same day: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:40 SCORE: 4.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:61 SCORE: 10.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:62 SCORE: 4.00 ================================================================================ 40 Part II: Call Option Strategies THE BENEFITS OF AN INCREASE IN STOCK PRICE If XYZ increases in price moderately, the trader may be able to have the best of both worlds. Example: If XYZ is at or just below 50 at July expiration, the call still expires worth­ less, and the investor makes the $300 from the option in addition to having a small profit from his stock purchase. Again, he still owns the stock. Should XYZ increase in price by expiration to levels above 50, the covered writer has a choice of alternatives. As one alternative, he could do nothing, in which case the option would be assigned and his stock would be called away at the striking price of 50. In that case, his profits would be equal to the $300 received from selling the call plus the profit on the increase of his stock from the purchase price of 48 to the sale price of 50. In this case, however, he would no longer own the stock. If as another alternative he desires to retain his stock ownership, he can elect to buy back ( or cover) the written call in the open market. This decision might involve taking a loss on the option part of the covered writing transaction, but he would have a cor­ respondingly larger profit, albeit unrealized, from his stock purchase. Using some specific numbers, one can see how this second alternative works out. Example: XYZ rises to a price of 60 by July expiration. The call option then sells near its intrinsic value of 10. If the investor covers the call at 10, he loses $700 on the option portion of his covered write. (Recall that he originally received $300 from the sale of the option, and now he is buying it back for $1,000.) However, he relieves the obligation to sell his stock at 50 ( the striking price) by buying back the call, so he has an unrealized gain of 12 points in the stock, which was purchased at 48. His total profit, including both realized and unrealized gains, is $500. This profit is exactly the same as he would have made if he had let his stock be called from him. If called, he would keep the $300 from the sale of the call, and he would make 2 points ( $200) from buying the stock at 48 and selling it, via exercise, at 50. This profit, again, is a total of $500. The major difference between the two cases is that the investor no longer owns his stock after letting it be called away, whereas he retains stock ownership if he buys back the written call. Which of the two alter­ natives is the better one in a given situation is not always clear. No matter how high the stock climbs in price, the profit from a covered write is limited because the writer has obligated himself to sell stock at the striking price. The covered writer still profits when the stock climbs, but possibly not by as much as he might have had he not written the call. On the other hand, he is receiving $300 of immediate cash inflow, because the writer may take the premium immediately and ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:68 SCORE: 0.00 ================================================================================ 46 Part II: Call Option Strategies philosophy is more like being a stockholder and trading options against one's stock position than actually operating a covered writing strategy. In fact, some covered writers will attempt to buy back written options for quick profits if such profits mate­ rialize during the life of the covered write. This, too, is a stock ownership philosophy, not a covered writing strategy. The total return concept represents the true strategy in covered writing, whereby one views the entire position as a single entity and is not predominantly concerned with the results of his stock ownership. THE CONSERVATIVE COVERED WRITE Covered writing is generally accepted to be a conservative strategy. This is because the covered writer always has less risk than a stockholder, provided that he holds the covered write until expiration of the written call. If the underlying stock declines, the covered writer will always offset part of his loss by the amount of the option premi­ um received, no matter how small. As was demonstrated in previous sections, however, some covered writes are clearly more conservative than others. Not all option writers agree on what is meant by a conservative covered write. Some believe that it involves writing an option (probably out-of-the-money) on a conservative stock, generally one with high yield and low volatility. It is true that the stock itself in such a position is conservative, but the position is more aptly termed a covered write on a conservative stock. This is dis­ tinctly different from a conservative covered write. A true conservative covered write is one in which the total position is conserva­ tive - offering reduced risk and a good probability of making a profit. An in-the-money wiite, even on a stock that itself is not conservative, can become a conservative total position when the option itself is properly chosen. Clearly, an investor cannot write calls that are too deeply in-the-money. If he did, he would get large amounts of down­ side protection, but his returns would be severely limited. If all that one desired was maximum protection of his money at a nominal rate of profit, he could leave the money in a bank. Instead, the conservative covered writer strives to make a potential­ ly acceptable return while still receiving an above-average amount of protection. Example: Again assume XYZ common stock is selling at 45 and an XYZ July 40 call is selling at 8. A covered write of the XYZ July 40 would require, in a cash account, an investment of $3,700 - $4,500 to purchase 100 shares of XYZ, less the $800 received in option premiums. The write has a maximum profit potential of $300. The potential return from this position is therefore $300/$3, 700, just over 8% for the peri­ od during which the write must be held. Since it is most likely that the option has 9 months of life or less, this return would be well in excess of 10% on a per annum ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:69 SCORE: 10.00 ================================================================================ Chapter 2: Covered Call Writing 47 basis. If the write were done in a margin account, the return would be considerably higher. Note that we have ignored dividends paid by the underlying stock and commis­ sion charges, factors that are discussed in detail in the next section. Also, one should be aware that if he is looking at an annualized return from a covered write, there is no guarantee that such a return could actually be obtained. All that is certain is that the writer could make 8% in 9 months. There is no guarantee that 9 months from now, when the call expires, there will be an equivalent position to establish that will extend the same return for the remainder of the annualization period. Annual returns should be used only for comparative purposes between covered writes. The writer has a position that has an annualized return (for comparative pur­ poses) of over 10% and 8 points of downside protection. Thus, the total position is an investment that will not lose money unless XYZ common stock falls by more than 8 points, or about 18%; and is an investment that could return the equivalent of 10% annually should XYZ common stock rise, remain the same, or fall by 5 points (to 40). This is a conservative position. Even if XYZ itself is not a conservative stock, the action of writing this option has made the total position a conservative one. The only factor that might detract from the conservative nature of the total position would be if XYZ were so volatile that it could easily fall more than 8 points in 9 months. In a strategic sense, the total position described above is better and more con­ servative than one in which a writer buys a conservative stock -yielding perhaps 6 or 7% - and writes an out-of-the-money call for a minimal premium. If this conserva­ tive stock were to fall in price, the writer would be in danger of being in a loss situa­ tion, because here the option is not providing anything more than the most minimal downside protection. As was described earlier, a high-yielding, low-volatility stock will not have much time premium in its in-the-money options, so that one cannot effectively establish an in-the-money write on such a "conservative" stock. COMPUTING RETURN ON INVESTMENT Now that the reader has some general feeling for covered call writing, it is time to discuss the specifics of computing return on investment. One should always know exactly what his potential returns are, including all costs, when he establishes a cov­ ered writing position. Once the procedure for computing returns is clear, one can more logically decide which covered writes are the most attractive. There are three basic elements of a covered write that should be computed before entering into the position. The first is the return if exercised. This is the return on investment that one would achieve if the stock were called away. For an out-of-the- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:70 SCORE: 0.00 ================================================================================ 48 Part II: Call Option Strategies money covered write, it is necessary for the stock to rise in price in order for the return if exercised to be achieved. However, for an in-the-money covered write, the return if exercised would be attained even if the stock were unchanged in price at option expi­ ration. Thus, it is often advantageous to compute the return if unchanged - that is, the return that would be realized if the underlying stock were unchanged when the option expired. One can more fairly compare out-of-the-money and in-the-money covered writes by using the return if unchanged, since no assumption is made concerning stock price movement. The third important statistic that the covered writer should consid­ er is the exact downside break-even point after all costs are included. Once this down­ side break-even point is known, one can readily compute the percentage of downside protection that he would receive from selling the call. Example 1: An investor is considering the following covered write of a 6-month call: Buy 500 XYZ common at 43, sell 5 XYZ July 45 calls at 3. One must first compute the net investment required (Table 2-3). In a cash account, this investment consists of paying for the stock in full, less the net proceeds from the sale of the options. Note that this net investment figure includes all commissions necessary to establish the position. (The commissions used here are approximations, as they vary from firm to firm.) Of course, if the investor withdraws the option premium, as he is free to do, his net investment will consist of the stock cost plus commissions. Once the neces­ sary investment is known, the writer can compute the return if exercised. Table 2-4 illustrates the computation. One first computes the profit if exercised and then divides that quantity by the net investment to obtain the return if exercised. Note that dividends are included in this computation; it is assumed that XYZ stock will pay $500 in dividends on the 500 shares during the life of the call. Moreover, all com­ missions are included as well - the net investment includes the original stock pur­ chase and option sale commissions, and the stock sale commission is explicitly listed. For the return computed here to be realized, XYZ stock would have to rise in price from its current price of 43 to any price above 45 by expiration. As noted ear­ lier, it may be more useful to know what return could be made by the writer if the stock did not move anywhere at all. Table 2-5 illustrates the method of computing the TABLE 2-3. Net investment required-cash account. Stock cost (500 shares at 43) Plus stock purchase commissions Less option premiums received Plus option sale commissions Net cash investment + $21,500 320 1,500 + 60 $20,380 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:74 SCORE: 0.00 ================================================================================ 52 TABLE 2-10. Return if unchanged-margin account. Method 1 Unchanged stock value (500 shares at 43) Plus dividends Less margin interest charges (10% on $10,910 debit for 6 months) Less debit balance Less net investment (margin) Net profit if unchanged­ margin $21,500 + 500 545 10,910 - 9 470 $ 1,075 Part II: Call Option Strategies Method 2 Profit if unchanged-cash Less margin interest charges - Net profit if unchanged­ margin $1,620 545 $1,075 Return if unchanged = $ l ,075 = 11 .4% $9,470 TABLE 2-11. Break-even point-margin write. Net margin investment Plus debit balance Less dividends Plus margin interest charges Total stock cost to expiration Divide by shares held Break-even point-margin TABLE 2-12. Percent downside protection-margin write. Initial stock price Less break-even price-margin Points of protection Divide by original stock price Equals percent downside protection-margin $ 9,470 + 10,910 500 + 545 $20,425 + 500 40.9 43 -40.9 2.1 +43 4.9% The return if exercised is 18.4% for the covered write using margin. In Example 1 the return if exercised for a cash write was computed as 11.2%. Thus, the return if exercised from a margin write is considerably higher. In fact, unless a fairly deep in­ the-money write is being considered, the return on margin will always be higher than ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:75 SCORE: 10.00 ================================================================================ Cl,apter 2: Covered Call Writing 53 the return from cash. The farther out-of-the-money that the written call is, the big­ ger the discrepancy between cash and margin returns will be when the return if exer­ cised is computed. As with the computation for return if exercised for a write on margin, the return if unchanged calculation is similar for cash and margin also. The only difference is the subtraction of the margin interest charges from the profit. The return if unchanged is also higher for a margin write, provided that there is enough option premium to com­ pensate for the margin interest charges. The return if unchanged in the cash example was 7.9% versus 11.4% for the margin write. In general, the farther from the strike in either direction - out-of-the-money or in-the-money - the less the return if unchanged on margin will exceed the cash return if unchanged. In fact, for deeply out­ of-the-money or deeply in-the-money calls, the return if unchanged will be higher on cash than on margin. Table 2-11 shows that the break-even point on margin, 40.9, is higher than the break-even point from a cash write, 39.8, because of the margin inter­ est charges. Again, the percent downside protection can be computed as shown in Table 2-12. Obviously, since the break-even point on margin is higher than that on cash, there is less percent downside protection in a margin covered write. One other point should be made regarding a covered write on margin: The bro­ kerage firm will loan you only half of the strike price amount as a maximum. Thus, it is not possible, for example, to buy a stock at 20, sell a deeply in-the-money call struck at 10 points, and trade for free. In that case, the brokerage firm would loan you only 5 - half the amount of the strike. Even so, it is still possible to create a covered call write on margin that has little or even zero margin .requirement. For example, suppose a stock is selling at 38 and that a long-term LEAPS option struck at 40 is selling for 19. Then the margin requirement is zero! This does not mean you're getting something for free, however. True, your invest­ ment is zero, but your risk is still 19 points. Also, your broker would ask for some sort of minimum margin to begin with and would of course ask for maintenance margin if the underlying stock should fall in price. Moreover, you would be paying margin interest all during the life of this long-term LEAPS option position. Leverage can be a good thing or a bad thing, and this strategy has a great deal of leverage. So be careful if you utilize it. COMPOUND INTEREST The astute reader will have noticed that our computations of margin interest have been overly simplistic; the compounding effect of interest rates has been ignored. That is, since interest charges are normally applied to an account monthly, the investor will be paying interest in the later stages of a covered writing position not only on the original debit, but on all previous monthly interest charges. This effect is described in detail in a later chapter on arbitrage techniques. Briefly stated, rather ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:76 SCORE: 0.00 ================================================================================ 54 Part II: Call Option Strategies than computing the interest charge as the debit times the interest rate multiplied by the time to expiration, one should technically use: Margin interest charges = Debit [(l + r/ -1] where r is the interest rate per month and t the number of months to expiration. (It would be incorrect to use days to expiration, since brokerage firms compute interest monthly, not daily.) In Example 2 of the preceding section, the debit was $10,910, the time was 6 months, and the annual interest rate was 10%. Using this more complex formula, the margin interest charges would be $557, as opposed to the $545 charge computed with the simpler formula. Thus, the difference is usually small, in terms of percent­ age, and it is therefore comrrwn practice to use the simpler method. SIZE OF THE POSITION So far it has been assumed that the writer was purchasing 500 shares of XYZ and sell­ ing 5 calls. This requires a relatively considerable investment for one position for the individual investor. However, one should be aware that buying too few shares for cov­ ered writing purposes can lower returns considerably. Example: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call for 3, his return if exercised would drop from the 11.2% return (cash) that was com­ puted earlier to a return of9.9% in a cash account. Table 2-13 verifies this statement. Since commissions are less, on a per-share basis, when one buys more stock and sells more calls, the returns will naturally be higher with a 500- or 1,000-share posi­ tion than with a 100- or 200-share position. This difference can be rather dramatic, as Tables 2-14 and 2-15 point out. Several interesting and worthwhile conclusions can be drawn from these tables. The first and most obvious conclusion is that the rrwre shares TABLE 2-13. Cash investment vs. return. Net Investment-Cash ( l 00 shares) Stock cost $4,300 Plus commissions + 85 Less option premium 300 Plus option commissions + 25 Net investment $4,110 Return If Exercised-Cash ( l 00 shares) Stock sale price Stock commissions Plus dividend Less net investment Net profit if exercised $4,500 85 + 100 - 4 110 $ 405 Return if exercised = $4 05 = 9. 9% $4,110 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:104 SCORE: 4.00 ================================================================================ 82 Part II: Call Option Strategies has amassed a fairly large series of debits from previous rolls; or (2) he begins to sell some out-of-the-money naked puts to bring in credits to reduce the cost of continu­ ally rolling the calls up for debits. This latter action is even worse, because the entire position is now leveraged tremendously, and a sharp drop in the stock price may cause horrendous losses - perhaps enough to wipe out the entire account. As fate would have it, these mistakes are usually made when the stock is near a top in price. Any price decline after such a dramatic rise is usually a sharp and painful one. The best way to avoid this type of potentially serious mistake is to allow the stock to be called away at some point. Then, using the funds that are released, either establish a new position in another stock or perhaps even utilize another strategy for a while. If that is not feasible, at least avoid making a radical change in strategy after the stock has had a particularly strong rise. Leveraging the position through naked put sales on top of rolling the calls up for debits should expressly be avoided. The discussion to this point has been directed at rolling up before expiration. At or near expiration, when the time value premium has disappeared from the written call, one may have no choice but to write the next-higher striking price if he wants to retain his stock. This is discussed when we analyze action to take at or near expiration. If the underlying stock rises, one's choices are not necessarily limited to rolling up or doing nothing. As the stock increases in price, the written call will lose its time premium and may begin to trade near parity. The writer may decide to close the posi­ tion himself - perhaps well in advance of expiration - by buying back the written call and selling the stock out, hopefully near parity. Example: A customer originally bought XYZ at 25 and sold the 6-month July 25 for 3 points - a net of 22. Now, three months later, XYZ has risen to 33 and the call is trading at 8 (parity) because it is so deeply in-the-money. At this point, the writer may want to sell the stock at 33 and buy back the call at 8, thereby realizing an effective net of 25 for the covered write, which is his maximum profit potential. This is cer­ tainly preferable to remaining in the position for three more months with no more profit potential available. The advantage of closing a parity covered write early is that one is realizing the maximum return in a shorter period than anticipated. He is there­ by increasing his annualized return on the position. Although it is generally to the cash writer's advantage (margin writers read on) to take such action, there are a few additional costs involved that he would not experience if he held the position until the call expired. First, the commission for the option purchase (buy-back) is an addi­ tional expense. Second, he will be selling his stock at a higher price than the striking price, so he may pay a slightly higher commission on that trade as well. If there is a dividend left until expiration, he will not be receiving that dividend if he closes the ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:105 SCORE: 13.00 ================================================================================ Chapter 2: Covered Call Writing 83 write early. Of course, if the trade was done in a margin account, the writer will be reducing the margin interest that he had planned to pay in the position, because the debit will be erased earlier. In most cases, the increased commissions are very small and the lost dividend is not significant compared to the increase in annualized return that one can achieve by closing the position early. However, this is not always true, and one should be aware of exactly what his costs are for closing the position early. Obviously, getting out of a covered writing position can be as difficult as estab­ lishing it. Therefore, one should place the order to close the position with his bro­ kerage firm's option desk, to be executed as a "net" order. The same traders who facil­ itate establishing covered writing positions at net prices will also facilitate getting out of the positions. One would normally place the order by saying that he wanted to sell his stock and buy the option "at parity" or, in the example, at "25 net." Just as it is often necessary to be in contact with both the option and stock exchanges to estab­ lish a position, so is it necessary to maintain the same contacts to renwve a position at parity. ACTION TO TAKE AT OR NEAR EXPIRATION As expiration nears and the time value premium disappears from a written call, the covered writer may often want to roll forward, that is, buy back the currently written call and sell a longer-term call with the same striking price. For an in-the-money call, the optimum time to roll forward is generally when the time value premium has com­ pletely disappeared from the call. For an out-of-the-money call, the correct time to move into the more distant option series is when the return offered by the near-term option is less than the return offered by the longer-term call. The in-the-money case is quite simple to analyze. As long as there is time pre­ mium left in the call, there is little risk of assignment, and therefore the writer is earning time premium by remaining with the original call. However, when the option begins to trade at parity or a discount, there arises a significant probability of exer­ cise by arbitrageurs. It is at this time that the writer should roll the in-the-money call forward. For example, if XYZ were offered at 51 and the July 50 call were bid at 1, the writer should be rolling forward into the October 50 or January 50 call. The out-of-the-money case is a little more difficult to handle, but a relatively straightforward analysis can be applied to facilitate the writer's decision. One can compute the return per day remaining in the written call and compare it to the net return per day from the longer-term call. If the longer-term call has a higher return, one should roll forward. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:106 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:108 SCORE: 4.00 ================================================================================ 86 Part II: Call Option Strategies AVOIDING THE UNCOVERED POSITION There is a margin rule that the covered writer must be aware of if he is considering taking any sort of follow-up action on the day that the written call ceases trading. If another call is sold on that day, even though the written call is obviously going to expire worthless, the writer will be considered uncovered for margin purposes over the weekend and will be obligated to put forth the collateral for an uncovered option. This is usually not what the writer intends to do; being aware of this rule will elimi­ nate unwanted margin calls. Furthermore, uncovered options may be considered unsuitable for many covered writers. Example: A customer owns XYZ and has January 20 calls outstanding on the last day of trading of the January series (the third Friday of January; the calls actually do not expire until the following day, Saturday). IfXYZ is at 15 on the last day of trading, the January 20 call will almost certainly expire worthless. However, should the writer decide to sell a longer-term call on that day without buying back the January 20, he will be considered uncovered over the weekend. Thus, if one plans to wait for an option to expire totally worthless before writing another call, he must wait until the Monday after expiration before writing again, assuming that he wants to remain cov­ ered. The writer should also realize that it is possible for some sort of news item to be announced between the end of trading in an option series and the actual expira­ tion of the series. Thus, call holders might exercise because they believe the stock will jump sufficiently in price to make the exercise profitable. This has happened in the past, two of the most notable cases being IBM in January 1975 and Carrier Corp. in September 1978. WHEN TO LET STOCK BE CALLED AWAY Another alternative that is open to the writer as the written call approaches expira­ tion is to let the stock be called away if it is above the striking price. In many cases, it is to the advantage of the writer to keep rolling options forward for credits, there­ by retaining his stock ownership. However, in certain cases, it may be advisable to allow the stock to be called away. It should be emphasized that the writer often has a definite choice in this matter, since he can generally tell when the call is about to be exercised - when the time value premium disappears. The reason that it is normally desirable to roll forward is that, over time, the covered writer will realize a higher return by rolling instead of being called. The option commissions for rolling forward every three or six months are smaller than the commissions for buying and selling the underlying stock every three or six months, and therefore the eventual return will be higher. However, if an inferior return has ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:109 SCORE: 10.00 ================================================================================ Cl,opter 2: Covered Call Writing 87 to be accepted or the break-even point will be raised significantly by rolling forward, one must consider the alternative of letting the stock be called away. Example: A covered write is established by buying XYZ at 49 and selling an April 50 call for 3 points. The original break-even point was thus 46. Near expiration, suppose XYZ has risen to 56 and the April 50 is trading at 6. If the investor wants to roll for­ ward, now is the time to do so, because the call is at parity. However, he notes that the choices are somewhat limited. Suppose the following prices exist with XYZ at 56: XYZ October 50 call, 7; and XYZ October 60 call, 2. It seems apparent that the pre­ mium levels have declined since the original writing position was established, but that is an occurrence beyond the control of the writer, who must work in the current market environment. If the writer attempts to roll forward to the October 50, he could make at most 1 additional point of profit until October (the time premium in the call). This repre­ sents an extremely low rate of return, and the writer should reject this alternative since there are surely better returns available in covered writes on other securities. On the other hand, if the writer tries to roll up and forward, it will cost 4 points to do so - 6 points to buy back the April 50 less 2 points received for the October 60. This debit transaction means that his break-even point would move up from the orig­ inal level of 46 to a new level of 50. If the common declines below 54, he would be eating into profits already at hand, since the October 60 provides only 2 points of pro­ tection from the current stock price of 56. If the writer is not confidently bullish on the outlook for XYZ, he should not roll up and forward. At this point, the writer has exhausted his alternatives for rolling. His remaining choice is to let the stock be called away and to use the proceeds to establish a cov­ ered write in a new stock, one that offers a more attractive rate of return with rea­ sonable downside protection. This choice of allowing the stock to be called away is generally the wisest strategy if both of the following criteria are met: 1. Rolling forward offers only a minimal return. 2. Rolling up and forward significantly raises the break-even point and leaves the position relatively unprotected should the stock drop in price. SPECIAL WRITING SITUATIONS Our discussions have pertained directly to writing against common stock. However, one may also write covered call options against convertible securities, warrants, or LEAPS. In addition, a different type of covered writing strategy - the incremental ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:110 SCORE: 5.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:112 SCORE: 5.00 ================================================================================ 90 Part II: Call Option Strategies The writer should also be aware of whether or not the convertible is catlable and, if so, what the exact terms are. Once the convertible has been called by the com­ pany, it will no longer trade in relation to the underlying stock, but will instead trade at the call price. Thus, if the stock should climb sharply, the writer could be incur­ ring losses on his written option without any corresponding benefit from his con­ vertible security. Consequently, if the convertible is called, the entire position should normally be closed immediately by selling the convertible and buying the option back. Other aspects of covered writing, such as rolling down or forward, do not change even if the option is written against a convertible security. One would take action based on the relationship of the option price and the common stock price, as usual. WRITING AGAINST WARRANTS It is also possible to write covered call options against warrants. Again, one must own enough warrants to convert into 100 shares of the underlying stock; generally, this would be 100 warrants. The transaction must be a cash transaction, the warrants must be paid for in full, and they have no loan value. Technically, listed warrants may be marginable, but many brokerage houses still require payment in full. There may be an additional investment requirement. Warrants also have an exercise price. If the exercise price of the warrant is higher than the striking price of the call, the covered writer must also deposit the difference between the two as part of his investment. The advantage of using warrants is that, if they are deeply in-the-money, they may provide the cash covered writer with a higher return, since less of an investment is involved. Example: XYZ is at 50 and there are XYZ warrants to buy the common at 25. Since the warrant is so deeply in-the-money, it will be selling for approximately $25 per warrant. XYZ pays no dividend. Thus, if the writer were considering a covered write of the XYZ July 50, he might choose to use the warrant instead of the common, since his investment, per 100 shares of common, would only be $2,500 instead of the $5,000 required to buy 100 XYZ. The potential profit would be the same in either case because no dividend is involved. Even if the stock does pay a dividend (warrants themselves have no dividend), the writer may still be able to earn a higher return by writing against the warrant than against the common because of the smaller investment involved. This would depend, of course, on the exact size of the dividend and on how deeply the warrant is in-the­ money. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:113 SCORE: 20.00 ================================================================================ Cbapter 2: Covered Call Writing 91 Covered writing against warrants is not a frequent practice because of the small number of warrants on optionable stocks and the problems inherent in checking available returns. However, in certain circumstances, the writer may actually gain a decided advantage by writing against a deep in-the-money warrant. It is often not advisable to write against a warrant that is at- or out-of-the-money, since it can decline by a large percentage if the underlying stock drops in price, producing a high­ risk position. Also, the writer's investment may increase in this case if he rolls down to an option with a striking price lower than the warrant's exercise price. WRITING AGAINST LEAPS A form of covered call writing can be constructed by buying LEAPS call options and selling shorter-term out-of-the-money calls against them. This strategy is much like writing calls against warrants. This strategy is discussed in more detail in Chapter 25 on LEAPS, under the subject of diagonal spreads. PERCS The PERCS (Preferred Equity Redemption Cumulative Stock) is a form of covered writing. It is discussed in Chapter 32. THE INCREMENTAL RETURN CONCEPT OF COVERED WRITING The incremental return concept of covered call writing is a way in which the covered writer can earn the full value of stock appreciation between todays stock price and a target sale price, which may be substantially higher. At the same time, the writer can earn an incremental, positive return from writing options. Many institutional investors are somewhat apprehensive about covered call writing because of the upside limit that is placed on profit potential. If a call is writ­ ten against a stock that subsequently declines in price, most institutional managers would not view this as an unfavorable situation, since they would be outperforming all managers who owned the stock and who did not write a call. However, if the stock rises substantially after the call is written, many institutional managers do not like having their profits limited by the written call. This strategy is not only for institu­ tional money managers, although one should have a relatively substantial holding in an underlying stock to attempt the strategy - at least 500 shares and preferably 1,000 shares or more. The incremental return concept can be used by anyone who is plan­ ning to hold his stock, even if it should temporarily decline in price, until it reaches a predetermined, higher price at which he is willing to sell the stock. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:114 SCORE: 4.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:115 SCORE: 15.00 ================================================================================ C1,,,pter 2: Covered Call Writing TABLE 2-26. Two months of incremental return strategy. Day 1 : XYZ = 60 Sell 3 XYZ October 60's at 7 One month later: XYZ = 70 Buy back the 3 XYZ Oct 60's at 11 and sell 5 XYZ Oct 70's at 7 Two months later: XYZ = 80 Buy back the 5 Oct 70's at 11 and sell 10 XYZ Oct 80's at 6 COVERED CALL WRITING SUMMARY 93 +$2, 100 credit -$3,300 debit +$3,500 credit -$5 ,500 debit +$6.000 credit +$2,800 credit This concludes the chapter on covered call writing. The strategy will be referred to later, when compared with other strategies. Here is a brief summary of the more important points that were discussed. Covered call writing is a viable strategy because it reduces the risk of stock own­ ership and will make one's portfolio less volatile to short-term market movements. It should be understood, however, that covered call writing may underperform stock ownership in general because of the fact that stocks can rise great distances, while a covered write has limited upside profit potential. The choice of which call to write can make for a more aggressive or more conservative write. Writing in-the-money calls is strategically more conservative than writing out-of-the-money calls, because of the larger amount of downside protection received. The total return concept of covered call writing attempts to achieve the maximum balance between income from all sources - option premiums, stock ownership, and dividend income - and down­ side protection. This balance is usually realized by writing calls when the stock is near the striking price, either slightly in- or slightly out-of-the-money. The writer should compute various returns before entering into the position: the return if exercised, the return if the stock is unchanged at expiration, and the break-even point. To truly compare various writes, returns should be annualized, and all commissions and dividends should be included in the calculations. Returns will be increased by taking larger positions in the underlying stock - 500 or 1,000 shares. Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the stock and selling the call at a specified net price differential, one will receive better executions and realize higher returns in the long run. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:116 SCORE: 4.00 ================================================================================ 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 ofXYZ, 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. IfXYZ 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 f01ward to a more distant expiration series, keeping the quantity of written calls constant. This transaction would generate additional credits as well. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:117 SCORE: 15.00 ================================================================================ O.,,er 2: Covered Call Writing TABLE 2-26. Two months of incremental return strategy. Doy 1 : XYZ = 60 Sell 3 XYZ October 60's at 7 One month later: XYZ = 70 Buy back the 3 XYZ Oct 60's at 11 and sell 5 XYZ Oct 70's at 7 Twa months later: XYZ = 80 Buy back the 5 Oct 70's at 11 and sell 10 XYZ Oct 80's at 6 COVERED CALL WRITING SUMMARY 93 +$2, 100 credit -$3 ,300 debit +$3,500 credit -$5 ,500 debit +$6,000 credit +$2,800 credit This concludes the chapter on covered call writing. The strategy will be referred to later, when compared with other strategies. Here is a brief summary of the more important points that were discussed. Covered call writing is a viable strategy because it reduces the risk of stock own­ ership and will make one's portfolio less volatile to short-term market movements. It should be understood, however, that covered call writing may underperform stock ownership in general because of the fact that stocks can rise great distances, while a covered write has limited upside profit potential. The choice of which call to write can make for a more aggressive or more conservative write. Writing in-the-money calls is strategically more conservative than writing out-of-the-money calls, because of the larger amount of downside protection received. The total return concept of covered call writing attempts to achieve the maximum balance between income from all sources - option premiums, stock ownership, and dividend income - and down­ side protection. This balance is usually realized by writing calls when the stock is near the striking price, either slightly in- or slightly out-of-the-money. The writer should compute various returns before entering into the position: the return if exercised, the return if the stock is unchanged at expiration, and the break-even point. To truly compare various writes, returns should be annualized, and all commissions and dividends should be included in the calculations. Returns will be increased by taking larger positions in the underlying stock - 500 or 1,000 shares. Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the stock and selling the call at a specified net price differential, one will receive better executions and realize higher returns in the long run. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:118 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:184 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:185 SCORE: 16.00 ================================================================================ Chapter 6: Ratio Call Writing 159 Example: The initial position again consists of buying 100 XYZ at 49 and selling two October 50 calls at 6. If XYZ then rose to 60, the following prices might exist: XYZ, 60; XYZ October 50, 11; and XYZ October 60, 6. The ratio writer could thus roll this position up to reestablish a neutral profit range. If he bought back the two October 50 calls, he would take a 5-point loss on each one for a net loss on the calls of 10 points. This would effectively raise his stock cost by 10 points, to a price of 59. The rolled-up position would then be long 100 XYZ at 59 and short 2 October 60 calls at 6. This new, neutral position has a profit range of 47 to 73 at October expiration. In both of the examples above, the writer could have closed out the ratio write at a very small profit of about 1 point before commissions. This would not be advis­ able, because of the relatively large stock commissions, unless he expects the stock to continue to move dramatically. Either rolling up or rolling down gives the writer a fairly wide new profit range to work with, and he could easily expect to make more than 1 point of profit if the underlying stock stabilizes at all. Having to take rolling defensive action immediately after the position is estab­ lished is the most detrimental case. If the stock moves very quickly after having set up the position, there will not be much time for time value premium erosion in the written calls, and this will make for smaller profit ranges after the roll is done. It may be useful to use technical support and resistance levels as keys for when to take rolling action if these levels are near the break-even points and/or striking prices. It should be noted that this method of defensive action - rolling at or near strik­ ing prices - automatically means that one is buying back little or no time premium and is selling the greatest amount of time premium currently available. That is, if the stock rises, the call's premium will consist mostly of intrinsic value and very little of time premium value, since it is substantially in-the-money. Thus, the writer who rolls up by buying back this in-the-money call is buying back mostly intrinsic value and is selling a call at the next strike. This newly sold call consists mostly of time value. By continually buying back "real" or intrinsic value and by selling "thin air" or time value, the writer is taking the optimum neutral action at any given time. If a stock undergoes a dramatic move in one direction or the other, the ratio writer will not be able to keep pace with the dramatic movement by remaining in the same ratio. Example: If XYZ was originally at 49, but then undergoes a fairly straight-line move to 80 or 90, the ratio writer who maintains a 2:1 ratio will find himself in a deplorable situation. He will have accumulated rather substantial losses on the calls and will not be able to compensate for these losses by the gain in the underlying stock. A similar ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:186 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:201 SCORE: 0.00 ================================================================================ Chapter 7: Bull Spreads 175 DEGREES OF AGGRESSIVENESS AGGRESSIVE BULL SPREAD Depending on how the bull spread is constructed, it may be an extremely aggressive or more conservative position. The most commonly used bull spread is of the aggres­ sive type; the stock is generally well below the higher striking price when the spread is established. This aggressive bull spread generally has the ability to generate sub­ stantial percentage returns if the underlying stock should rise in price far enough by expiration. Aggressive bull spreads are most attractive when the underlying common stock is relatively close to the lower striking price at the time the spread is established. A bull spread established under these conditions will generally be a low-cost spread with substantial profit potential, even after commissions are included. EXTREMELY AGGRESSIVE BULL SPREAD An extremely aggressive type of bull spread is the "out-of-the-money" spread. In such a spread, both calls are out-of-the-money when the spread is established. These spreads are extremely inexpensive to establish and have large potential profits if the stock should climb to the higher striking price by expiration. However, they are usu­ ally quite deceptive in nature. The underlying stock has only a relatively remote chance of advancing such a great deal by expiration, and the spreader could realize a 100% loss of his investment even if the underlying stock advances moderately, since both calls are out-of-the-money. This spread is akin to buying a deeply out-of-the­ money call as an outright speculation. It is not recommended that such a strategy be pursued with more than a very small percentage of one's speculative funds. LEAST AGGRESSIVE BULL SPREAD Another type of bull spread can be found occasionally - the "in-the-money" spread. In this situation, both calls are in-the-money. This is a much less aggressive position, since it offers a large probability of realizing the maximum profit potential, although that profit potential will be substantially smaller than the profit potentials offered by the more aggressive bull spreads. Example: XYZ is at 37 some time before expiration, and the October 30 call is at 7 while the October 35 call is at 4. Both calls are in-the-money and the spread would cost 3 points (debit) to establish. The maximum profit potential is 2 points, but it would be realized as long as XYZ were above 35 at expiration. That is, XYZ could fall by 2 points and the spreader would still make his maximum profit. This is certainly a more conservative position than the aggressive spread described above. The com- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:202 SCORE: 12.00 ================================================================================ 176 Part II: Call Option Strategies mission costs in this spread would be substantially larger than those in the spreads above, which involve less expensive options initially, and they should therefore be fig­ ured into one's profit calculations before entering into the spread transaction. Since this stock would have to decline 7 points to fall below 30 and cause a loss of the entire investment, it would have to be considered a rather low-probability event. This fact adds to the less aggressive nature of this type of spread. RANKING BULL SPREADS To accurately compare the risk and reward potentials of the many bull spreads that are available in a given day, one has to use a computer to perform the mass calcula­ tions. It is possible to use a strictly arithmetic method of ranking bull spreads, but such a list will not be as accurate as the correct method of analysis. In reality, it is necessary to incorporate the volatility of the underlying stock, and possibly the expected return from the spread as well, into one's calculations. The concept of expected return is described in detail in Chapter 28, where a bull spread is used as an example. The exact method for using volatility and predicting an option's price after an upward movement are presented later. Many data services offer such information. However, if the reader wants to attempt a simpler method of analysis, the following one may suffice. In any ranking of bull spreads, it is important not to rank the spreads by their maximum potential profits at expiration. Such a ranking will always give the most weight to deeply out-of-the-money spreads, which can rarely achieve their max­ imum profit potential. It would be better to screen out any spreads whose maximum profit prices are too far away from the current stock price. A simple method of allow­ ing for a stock's movement might be to assume that the stock could, at expiration, advance by an amount equal to twice the time value premium in an at-the-money call. Since more volatile stocks have options with greater time value premium, this is a simple attempt to incorporate volatility into the analysis. Also, since longer-term options have more time value premium than do short-term options, this will allow for larger movements during a longer time period. Percentage returns should include commission costs. This simple analysis is not completely correct, but it may prove useful to those traders looking for a simple arithmetic method of analysis that can be computed quickly. FURTHER CONSIDERATIONS The bull spreads described in previous examples utilize the same expiration date for both the short call and the long call. It is sometimes useful to buy a call with a longer ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:203 SCORE: 4.00 ================================================================================ Chapter 7: Bull Spreads 177 time to maturity than the short call has. Such a position is known as a diagonal bull spread and is discussed in a later chapter. Experienced traders often tum to bull spreads when options are expensive. The sale of the option at the higher strike partially mitigates the cost of buying an expen­ sive option at the lower strike. However, one should not always use the bull spread approach just because the options have a lot of time value premium, for he would be giving up a lot of upside profit potential in order to have a hedged position. With most types of spreads, it is necessary for some time to pass for the spread to become significantly profitable, even if the underlying stock moves in favor of the spreader. For this reason, bull spreads are not for traders unless the options involved are very short-term in nature. If a speculator is bullishly oriented for a short-term upward move in an underlying stock, it is generally better for him to buy a call out­ right than to establish a bull spread. Since the spread differential changes mainly as a function of time, small movements in price by the underlying stock will not cause much of a short-term change in the price of the spread. However, the bull spread has a distinct advantage over the purchase of a call if the underlying stock advances mod­ erately by expiration. In the previous example, a bull spread was established by buying the XYZ October 30 call for 3 points and simultaneously selling the October 35 call for 1 point. This spread can be compared to the outright purchase of the XYZ October 30 alone. There is a short-term advantage in using the outright purchase. Example: The underlying stock jumps from 32 to 35 in one day's time. The October 30 would be selling for approximately 5½ points if that happened, and the outright purchaser would be ahead by 2½ points, less one option commission. The long side of the bull spread would do as well, of course, since it utilizes the same option, but the short side, the October 35, would probably be selling for about 2½ points. Thus, the bull spread would be worth 3 points in total (5½ points on the long side, less 2½ points loss on the short side). This represents a 1-point profit to the spreader, less two option commissions, since the spread was initially established at a debit of 2 points. Clearly, then, for the shortest time period one day - the outright purchase outper­ forms the bull spread on a quick rise. For a slightly longer time period, such as 30 days, the outright purchase still has the advantage if the underlying stock moves up quickly. Even if the stock should advance above 35 in 30 days, the bull spread will still have time premium in it and thus will not yet have reached its maximum spread potential of 5 points. Recall that the maximum potential of a bull spread is always equal to the difference between the striking prices. Clearly, the outright purchaser will do very well if the underlying stock should advance that far in 30 days' time. When risk is considered, however, it ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:204 SCORE: 0.00 ================================================================================ 178 Part II: Call Option Strategies must be pointed out that the bull spread has fewer dollars at risk and, if the under­ lying stock should drop rather than rise, the bull spread will often have a smaller loss than the outright call purchase would. The longer it takes for the underlying stock to advance, the more the advantage swings to the spread. Suppose XYZ does not get to 35 until expiration. In this case, the October 30 call would be worth 5 points and the October 35 call would be worth­ less. The outright purchase of the October 30 call would make a 2-point profit less one commission, but the spread would now have a 3-point profit, less two commis­ sions. Even with the increased commissions, the spreader will make more of a prof­ it, both dollarwise and percentagewise. Many traders are disappointed with the low profits available from a bull spread when the stock rises almost immediately after the position is established. One way to partially off set the problem with the spread not widening out right away is to use a greater distance between the two strikes. When the distance is great, the spread has room to widen out, even though it won't reach its maximum profit potential right away. Still, since the strikes are "far apart," there is more room for the spread to widen even if the underlying stock rises immediately. The conclusion that can be drawn from these examples is that, in general, the outright purchase is a better strategy if one is looking for a quick rise by the under­ lying stock. Overall, the bull spread is a less aggressive strategy than the outright pur­ chase of a call. The spread will not produce as much of a profit on a short-term move, or on a sustained, large upward move. It will, however, outperform the outright pur­ chase of a call if the stock advances slowly and moderately by expiration. Also, the spread always involves fewer actual dollars of risk, because it requires a smaller debit to establish initially. Table 7-2 summarizes which strategy has the upper hand for var­ ious stock movements over differing time periods. TABLE 7-2. Bull spread and outright purchase compared. If the underlying stock ... Remains Relatively Advonces Advances Declines Unchanged Moderately Substantially in ... 1 week Bull spread Bull spread Outright purchase Outright purchase 1 month Bull spread Bull spread Outright purchase Outright purchase At expiration Bull spread Bull spread Bull spread Outright purchase ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:205 SCORE: 12.00 ================================================================================ Chapter 7: Bull Spreads FOLLOW-UP ACTION 179 Since the strategy has both limited profit and limited risk, it is not mandatory for the spreader to take any follow-up action prior to expiration. If the underlying stock advances substantially, the spreader should watch the time value premium in the short call closely in order to close the spread if it appears that there is a possibility of assignment. This possibility would increase substantially if the time value premium disappeared from the short call. If the stock falls, the trader may want to close the spread in order to limit his losses even further. When the spread is closed, the order should also be entered as a spread trans­ action. If the underlying stock has moved up in price, the order to liquidate would be a credit spread involving two closing transactions. The maximum credit that can be recovered from a bull spread is an amount equal to the difference between the striking prices. In the previous example, if XYZ were above 35 at expiration, one might enter an order to liquidate the spread as follows: Buy the October 35 (it is common practice to specify the buy side of a spread first when placing an order); sell the October 30 at a 5-point credit. In reality, because of the difference between bids and offers, it is quite difficult to obtain the entire 5-point credit even if expira­ tion is quite near. Generally, one might ask for a 4¼ or 47/s credit. It is possible to close the spread via exercise, although this method is normally advisable only for traders who pay little or no commissions. If the short side of a spread is assigned, the spreader may satisfy the assignment notice by exercising the long side of his spread. There is no margin required to do so, but there are stock commissions involved. Since these stock commissions to a public customer would be substantial­ ly larger than the option commissions involved in closing the spread by liquidating the options, it is recommended that the public customer attempt to liquidate rather than exercise. A minor point should be made here. Since the amount of commissions paid to liquidate the spread would be larger if higher call prices are involved, the actual net maximum profit point for a bull spread is for the stock to be exactly at the higher striking price at expiration. If the stock exceeds the higher striking price by a great deal, the gross profit will be the same (it was demonstrated earlier that this gross profit is the same anywhere above the higher strike at expiration), but the net profit will be slightly smaller, since the investor will pay more in commissions to liquidate the spread. Some spreaders prefer to buy back the short call if the underlying stock drops in price, in order to lock in the profit on the short side. They will then hold the long call in hopes of a rise in price by the underlying stock, in order to make the long side of the spread profitable as well. This amounts to "legging" out of the spread, although ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:206 SCORE: 0.00 ================================================================================ 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: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:217 SCORE: 4.00 ================================================================================ Calendar Spreads A calendar spread, also frequently called a time spread, involves the sale of one option and the simultaneous purchase of a more distant option, both with the same striking price. In the broad definition, the calendar spread is a horizontal spread. The neutral philosophy for using calendar spreads is that time will erode the value of the near-term option at a faster rate than it will the far-term option. If this happens, the spread will widen and a profit may result at near-term expiration. With call options, one may construct a more aggressive, bullish calendar spread. Both types of spreads are discussed. Example: The following prices exist sometime in late January: XYZ:50 April 50 Call (3-month call) 5 July 50 Call (6-month call) 8 October 50 Call (9-month call) 10 If one sells the April 50 call and buys the July 50 at the same time, he will pay a debit of 3 points - the difference in the call prices plus commissions. That is, his invest­ ment is the net debit of the spread plus commissions. Furthermore, suppose that in 3 months, at April expiration, XYZ is unchanged at 50. Then the 3-month call should be worth 5 points, and the 6-month call should be worth 8 points, as they were pre­ viously, all other factors being equal. XYZ:50 April 50 Call (Expiring) 0 July 50 Call (3-month call) 5 October 50 Call (6-month call) 8 191 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:218 SCORE: 12.00 ================================================================================ 192 Part II: Call Option Strategies The spread between the April 50 and the July 50 has now widened to 5 points. Since the spread cost 3 points originally, this widening effect has produced a 2-point prof­ it. The spread could be closed at this time in order to realize the profit, or the spread­ er may decide to continue to hold the July 50 call that he is long. By continuing to hold the July 50 call, he is risking the profits that have accrued to date, but he could profit handsomely if the underlying stock rises in price over the next 3 months, before July expiration. It is not necessary for the underlying stock to be exactly at the striking price of the options at near-term expiration for a profit to result. In fact, some profit can be made in a range that extends both below and above the striking price. The risk in this type of position is that the stock will drop a great deal or rise a great deal, in which case the spread between the two options will shrink and the spreader will lose money. Since the spread between two calls at the same strike cannot shrink to less than zero, however, the risk is limited to the amount of the original debit spent to establish the spread, plus commissions. THE NEUTRAL CALENDAR SPREAD As mentioned earlier, the calendar spreader can either have a neutral outlook on the stock or he can construct the spread for an aggressively bullish outlook. The neutral outlook is described first. The calendar spread that is established when the underly­ ing stock is at or near the striking price of the options used is a neutral spread. The strategist is interested in selling time and not in predicting the direction of the under­ lying stock. If the stock is relatively unchanged when the near-term option expires, the neutral spread will make a profit. In a neutral spread, one should initially have the intent of closing the spread by the time the near-tenn option expires. Let us again tum to our example calendar spread described earlier in order to more accurately demonstrate the potential risks and rewards from that spread when the near-term, April, call expires. To do this, it is necessary to estimate the price of the July 50 call at that time. Notice that, with XYZ at 50 at expiration, the results agree with the less detailed example presented earlier. The graph shown in Figure 9-1 is the "total profit" from Table 9-1. The graph is a curved rather than straight line, since the July 50 call still has time premium. There is a slightly bullish bias to this graph: The profit range extends slightly farther above the striking price than it does below the striking price. This is due to the fact that the spread is a call spread. If puts had been used, the profit range would have a bearish bias. The total width of the profit range is a function of the volatility of the underlying stock, since that will determine the price ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:219 SCORE: 0.00 ================================================================================ Chapter 9: Calendar Spreads FIGURE 9-1. Calendar spread at near-term expiration. C: i +$200 $ 1i:i ~ 0 ~ o. -$300 Stock Price at Expiration TABLE 9-1. Estimated profit or losses at April expiration. XYZ Stock April 50 April 50 July 50 Price Price Profit Price 40 0 +$500 1/2 45 0 + 500 21/2 48 0 + 500 4 50 0 + 500 5 52 2 + 300 6 55 5 0 8 60 10 - 500 l 01/2 193 July 50 Total Profit Profit -$750 -$250 - 550 - 50 - 400 + 100 - 300 + 200 - 200 + 100 0 0 + 250 - 250 of the remaining long call at expiration, as well as a function of the time remaining to near-term expiration. Table 9-1 and Figure 9-1 clearly depict several of the more significant aspects of the calendar spread. There is a range within which the spread is profitable at near­ term expiration. That range would appear to be about 46 to 55 in the example. Outside that range, losses can occur, but they are limited to the amount of the initial debit. Notice in the example that the stock would have to be well below 40 or well ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:220 SCORE: 16.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:221 SCORE: 0.00 ================================================================================ Chapter 9: Calendar Spreads 195 on the position. Another choice is to leave the spread alone until the near-term call expires and then to hope for a partial recovery from the stock in order to be able to recover some value from the long side of the spread. Such a holding action is often better than the immediate close-out, because the expense of buying back the short call can be quite large percentagewise. A riskier downside defensive action is to sell out the long call if the stock begins to break down heavily. In this way, the spreader recovers something from the long side of his spread immediately, and then looks for the stock to remain depressed so that the short side of the spread will expire worth­ less. This action requires that one have enough collateral available to margin the resulting naked call, often an amount substantially in excess of the original debit paid for the spread. Moreover, if the underlying stock should reverse direction and rally back to or above the striking price, the short side of the spread is naked and could produce substantial losses. The risk assumed by such a follow-up violates the initial neutral premise of the spread, and should therefore be avoided. Of these three types of downside defensive action, the easiest and rrwst conservative one is to do nothing at all, letting the short call expire worthless and then hoping for a recovery by the underlying stock. If this tack is taken, the risk remains fixed at the original debit paid for the spread, and occasionally a rally may produce large profits on the long call. Although this rally is a nonfrequent event, it generally costs the spreader very little to allow himself the opportunity to take advantage of such a rally if it should occur. In fact, the strategist can employ a slight modification of this sort of action, even if the spread is not at a large loss. If the underlying stock is moderately below the striking price at near-term expiration, the short option will expire worthless and the spreader will be left holding the long option. He could sell the long side immediate­ ly and perhaps take a small gain or loss. However, it is often a reasonable strategy to sell out a portion of the long side - recovering all or a substantial portion of the ini­ tial investment - and hold the remainder. If the stock rises, the remaining long posi­ tion may appreciate substantially. Although this sort of action deviates from the true nature of the time spread, it is not overly risky. An early breakout to the upside by the underlying stock is generally handled in much the same way as a downside breakout. Doing nothing is often the best course of action. If the underlying stock rallies shortly after the spread is established, the spread will shrink by a small amount, but not substantially, because both options will hold premium in a rally. If the spreader were to rush in to close the position, he would be paying commissions on two rather expensive options. He will usually do better to wait and give himself as much of a chance for a reversal as possible. In fact, even at near-term expiration, there will normally be some time premium left in the long option so that the maximum loss would not have to be realized. A highly risk­ oriented upside defensive action is to cover the short call on a technical breakout and ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:222 SCORE: 16.00 ================================================================================ 196 Part II: Call Option Strategies continue to hold the long call. This can become disastrous if the breakout fails and the stock drops, possibly resulting in losses far in excess of the original debit. Therefore, this action cannot be considered anything but extremely aggressive and illogical for the neutral strategist. If a breakout does not occur, the spreader will normally be making unrealized profits as time passes. Should this be the case, he may want to set some mental stop­ out points for himself. For example, if the underlying stock is quite close to the strik­ ing price with only two weeks to go, there will be some more profit potential left in the spread, but the spreader should be ready to close the position quickly if the stock begins to get too far away from the striking price. In this manner, he can leave room for more profits to accrue, but he is also attempting to protect the profits that have already built up. This is somewhat similar to the action that the ratio writer takes when he narrows the range of his action points as more and more time passes. THE BULLISH CALENDAR SPREAD A less neutral and more bullish type of calendar spread is preferred by the more aggressive investor. In a bullish calendar spread, one sells the near-term call and buys a longer-term call, but he does this when the underlying stock is some distance below the striking price of the calls. This type of position has the attractive features of low dollar investment and large potential profits. Of course, there is risk involved as well. Example: One might set up a bullish calendar spread in the following manner: XYZ common, 45; sell the XYZ April 50 for l; and buy the XYZ July 50 for 1 ½. This investor ideally wants two things to happen. First, he would like the near­ term call to expire worthless. That is why the bullish calendar spread is established with out-of-the-money calls: to increase the chances of the short call expiring worth­ less. If this happens, the investor will then own the longer-term call at a net cost of his original debit. In this example, his original debit was only ½ of a point to create the spread. If the April 50 call expires worthless, the investor will own the July 50 call at a net cost of ½ point, plus commissions. The investor now needs a second criterion to be fulfilled: The stock must rise in price by the time the July 50 call expires. In this example, even if XYZ were to rally to only 52 between April and July, the July 50 call could be sold for at least 2 points. This represents a substantial percentage gain, because the cost of the call has been ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:223 SCORE: 0.00 ================================================================================ Chapter 9: Calendar Spreads 197 reduced to ¼ point. Thus, there is the potential for large profits in bullish calendar spreads if the underlying stock rallies above the striking price before the longer-term call expires, provided that the short-term call has already expired worthless. What chance does the investor have that both ideal conditions will occur? There is a reasonably good chance that the written call will expire worthless, since it is a short-term call and the stock is below the striking price to start with. If the stock falls, or even rises a little - up to, but not above, the striking price the first condition will have been met. It is the second condition, a rally above the striking price by the underlying stock before the longer-term expiration date, that normally presents the biggest problem. The chances of this happening are usually small, but the rewards can be large when it does happen. Thus, this strategy offers a small probability of making a large profit. In fact, one large profit can easily offset several losses, because the losses are small, dollarwise. Even if the stock remains depressed and the July 50 call in the example expires worthless, the loss is limited to the initial debit of¼ point. Of course, this loss represents 100% of the initial investment, so one cannot put all his money into bullish calendar spreads. This strategy is a reasonable way to speculate, provided that the spreader adheres to the following criteria when establishing the spread: 1. Select underlying stocks that are volatile enough to move above the striking price within the allotted time. Bullish calendar spreads may appear to be very "cheap" on nonvolatile stocks that are well below the striking price. But if a large stock move, say 20%, is required in only a few months, the spread is not worthwhile for a nonvolatile stock. 2. Do not use options more than one striking price above the current market. For example, if XYZ were 26, use the 30 strike, not the 35 strike, since the chances of a rally to 30 are many times greater than the chances of a rally to 35. 3. Do not invest a large percentage of available trading capital in bullish calendar spreads. Since these are such low-cost spreads, one should be able to follow this rule easily and still diversify into several positions. FOLLOW-UP ACTION If the underlying stock should rally before the near-term call expires, the bullish cal­ endar spreader must never consider "legging" out of the spread, or consider cover­ ing the short call at a loss and attempting to ride the long call. Either action could turn the initial small, limited loss into a disastrous loss. Since the strategy hinges on ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:224 SCORE: 12.00 ================================================================================ 198 Part II: Call Option Strategies the fact that all the losses will be small and the infrequent large profits will be able to overcome these small losses, one should do nothing to jeopardize the strategy and possibly generate a large loss. The only reasonable sort of follow-up action that the bullish calendar spreader can take in advance of expiration is to close the spread if the underlying stock has moved up in price and the spread has widened to become profitable. This might occur if the stock moves up to the striking price after some time has passed. In the example above, if XYZ moved up to 50 with a month or so of life left in the April 50 call, the call might be selling for I½ while the July 50 call might be selling for 3 points. Thus, the spread could be closed at I½ points, representing a I-point gain over the initial debit of 1/2 point. Two commissions would have to be paid to close the spread, of course, but there would still be a net profit in the spread. USING ALL THREE EXPIRATION SERIES In either the neutral calendar spread or the bullish calendar spread, the investor has three choices of which months to use. He could sell the nearest-term call and buy the intermediate-term call. This is usually the most common way to set up these spreads. However, there is no rule that prevents him from selling the intermediate-term and buying the longest-term, or possibly selling the near-term and buying the long-term. Any of these situations would still be calendar spreads. Some proponents of calendar spreads prefer initially to sell the near-term and buy the long-term call. Then, if the near-term call expires worthless, they have an opportunity to sell the intermediate-term call if they so desire. Example: An investor establishes a calendar spread by selling the April 50 call and buying the October 50 call. The April call would have less than 3 months remaining and the October call would be the long-term call. At April expiration, if XYZ is below 50, the April call will expire worthless. At that time, the July 50 call could be sold against the October 50 that is held long, thereby creating another calendar spread with no additional commission cost on the long side. The advantage of this type of strategy is that it is possible for the two sales (April 50 and July 50 in this example) to actually bring in more credits than were spent for the one purchase (October 50). Thus, the spreader might be able to create a position in which he has a guaranteed profit. That is, if the sum of his transactions is actually a credit, he cannot lose money in the spread (provided that he does not attempt to "leg" out of the spread). The disadvantage of using the long-term call in the calendar spread is that the initial debit is larger, and therefore more dollars are initially at risk. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:225 SCORE: 4.00 ================================================================================ Chapter 9: Calendar Spreads 199 If the underlying stock moves substantially up or down in the first 3 months, the spreader could realize a larger dollar loss with the October/ April spread because his loss will approach the initial debit. The remaining combination of the expiration series is to initially buy the longest-term call and sell the intermediate-term call against it. This combination will generally require the smallest initial debit, but there is not much profit potential in the spread until the intermediate-term expiration date draws near. Thus, there is a lot of time for the underlying stock to move some distance away from the initial strik­ ing price. For this reason, this is generally an inferior approach to calendar spread­ ing. SUMMARY Calendar spreading is a low-dollar-cost strategy that is a nonaggressive approach, pro­ vided that the spreader does not invest a large percentage of his trading capital in the strategy, and provided that he does not attempt to "leg" into or out of the spreads. The neutral calendar spread is one in which the strategist is mainly selling time; he is attempting to capitalize on the known fact that the near-term call will lose time pre­ mium more rapidly than will a longer-term call. A more aggressive approach is the bullish calendar spread, in which the speculator is essentially trying to reduce the net cost of a longer-term call by the amount of credits taken in from the sale of a nearer­ term call. This bullish strategy requires that the near-term call expire worthless and then that the underlying stock rise in price. In either strategy, the most common approach is to sell the nearest-term call and buy the intermediate-term call. However, it may sometimes prove advantageous to sell the near-term and buy the longest-term initially, with the intention of letting the near-term expire and then pos­ sibly writing against the longer-term call a second time. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:237 SCORE: 4.00 ================================================================================ Chapter 11: Ratio Call Spreads 211 The maximum profit at expiration for a ratio spread occurs if the stock is exact­ ly at the striking price of the written options. This is true for nearly all types of strate­ gies involving written options. In the example, if XYZ were at 45 at April expiration, the April 45 calls would expire worthless for a gain of $600 on the two of them, and the April 40 call would be worth 5 points, resulting in no gain or loss on that call. Thus, the total profit would be $600 less commissions. The greatest risk in a ratio call spread lies to the upside, where the loss may the­ oretically be unlimited. The upside break-even point in this example is 51, as shown in Table 11-1. The table and Figure 11-1 illustrate the statements made in the pre­ ceding paragraphs. In a 2:1 ratio spread, two calls are sold for each one purchased. The maximum profit amount and the upside break-even point can easily be computed by using the following formulae: Points of maximum profit = Initial credit + Difference between strikes or = Difference between strikes - Initial debit Upside break-even point= Higher strike price+ Points of maximum profit In the preceding example, the initial credit was 1 point, so the points of maxi­ mum profit = 1 + 5 = 6, or $600. The upside break-even point is then 45 + 6, or 51. This agrees with the results determined earlier. Note that if the spread is established at a debit rather than a credit, the debit is subtracted from the striking price differ­ ential to determine the points of maximum profit. Many neutral investors prefer ratio spreads over ratio writes for two reasons: TABLE 11-1. Ratio call spread. XYZ Price of April 40 Coll April 45 Coll Total Expiration Profits Profits Profits 35 -$ 500 +$ 600 +$100 40 - 500 + 600 + 100 42 - 300 + 600 + 300 45 0 + 600 + 600 48 + 300 0 + 300 51 + 600 - 600 0 55 +1,000 -1,400 - 400 60 + 1,500 -2,400 - 900 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:238 SCORE: 16.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:239 SCORE: 25.00 ================================================================================ Chapter 11: Ratio Call Spreads 213 the 6 points that the call would be worth less the 1-point initial net credit - a total of $1,520 for this spread ($1,020 + $600 - $100). DIFFERING PHILOSOPHIES For many strategies, there is more than one philosophy of how to implement the strategy. Ratio spreads are no exception, with three philosophies being predominant. One philosophy holds that ratio spreading is quite similar to ratio writing - that one should be looking for opportunities to purchase an in-the-money call with little or no time premium in it so that the ratio spread simulates the profit opportunities from the ratio write as closely as possible with a smaller investment. The ratio spreads established under this philosophy may have rather large debits if the purchased call is substantially in-the-money. Another philosophy of ratio spreading is that spreads should be established for credits so that there is no chance of losing money on the downside. Both philosophies have merit and both are described. A third philosophy, called the "delta spread," is more concerned with neutrality, regardless of the initial debit or credit. It is also described. RATIO SPREAD AS RATIO WRITE There are several spread strategies similar to strategies that involve common stock. In this case, the ratio spread is similar to the ratio write. Whenever such a similarity exists, it may be possible for the strategist to buy an in-the-money call with little or no time premium as a substitute for buying the common stock. This was seen earlier in the covered call writing strategy, where it was shown that the purchase of in-the­ money calls or warrants might be a viable substitute for the purchase of stock. If one is able to buy an in-the-rrwney call as a substitute for the stock, he will not affect his profit potential substantially. When comparing a ratio spread to a ratio write, the max­ imum profit potential and the profit range are reduced by the time value premium paid for the long call. If this call is at parity (the time value premium is thus zero), the ratio spread and the ratio write have exactly the same profit potential. Moreover, the net investment is reduced and there is less downside risk should the stock fall in price below the striking price of the purchased call. The spread also involves smaller com­ mission costs than does the ratio write, which involves a stock purchase. The ratio writer does receive stock dividends, if any are paid, whereas the spreader does not. Example: XYZ is at 50, and an XYZ July 40 call is selling for 11 while an XYZ July 50 call is selling for 5. Table 11-2 compares the important points between the ratio write and the ratio spread. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:240 SCORE: 28.00 ================================================================================ 214 TABLE 11-2. Ratio write and ratio spread compared. Profit range Maximum profit Downside risk Upside risk Initial investment Ratio Write: Buy XYZ of 50 and Sell 2 July SO's at 5 40 to 60 10 points 40 points 40 points $3,000 Part II: Call Option Strategies Ratio Spread: Buy 1 July 40 of 11 and Sell 2 July SO's at 5 41 to 59 9 points 1 point Unlimited $1,600 In Chapter 6, it was pointed out that ratio writing was one of the better strate­ gies from a probability of profit viewpoint. That is, the profit potential conforms well to the expected movement of the underlying stock. The same statement holds true for ratio spreads as substitutes for ratio writes. In fact, the ratio spread may often be a better position than the ratio write itself, when the long call can be purchased with little or no time value premium in it. RATIO SPREAD FOR CREDITS The second philosophy of ratio spreads is to establish them only for credits. Strategists who follow this philosophy generally want a second criterion fulfilled also: that the underlying stock be below the striking price of the written calls when the spread is established. In fact, the farther the stock is below the strike, the more attractive the spread would be. This type of ratio spread has no downside risk because, even if the stock collapses, the spreader will still make a profit equal to the initial credit received. This application of the ratio spread strategy is actually a sub­ case of the application discussed above. That is, it may be possible both to buy a long call for little or no time premium, thereby simulating a ratio write, and also to be able to set up the position for a credit. Since the underlying stock is generally below the maximum profit point when one establishes a ratio spread for a credit, this is actually a mildly bullish position. The investor would want the stock to move up slightly in order for his maximum prof­ it potential to be realized. Of course, the position does have unlimited upside risk, so it is not an overly bullish strategy. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:241 SCORE: 0.00 ================================================================================ Chapter 11: Ratio Call Spreads 215 These two philosophies are not mutually exclusive. The strategist who uses ratio spreads without regard for whether they are debit or credit spreads will generally have a broader array of spreads to choose from and will also be able to assume a more neutral posture on the stock. The spreader who insists on generating credits only will be forced to establish spreads on which his return will be slightly smaller if the under­ lying stock remains relatively unchanged. However, he will not have to worry about downside defensive action, since he has no risk to the downside. The third philoso­ phy, the "delta spread," is described after the next section, in which the uses of ratios other than 2: 1 are described. ALTERING THE RATIO Under either of the two philosophies discussed above, the strategist may find that a 3:1 ratio or a 3:2 ratio better suits his purposes than the 2:1 ratio. It is not common to write in a ratio of greater than 4: 1 because of the large increase in upside risk at such high ratios. The higher the ratio that is used, the higher will be the credits of the spread. This means that the profits to the downside will be greater if the stock collapses. The lower the ratio that is used, the higher the upside break-even point will be, thereby reducing upside risk. Example: If the same prices are used as in the initial example in this chapter, it will be possible to demonstrate these facts using three different ratios (Table 11-3): XYZ common, 44; XYZ April 40 call, 5; and XYZ April 45 call, 3. TABLE 11-3. Comparison of three ratios. Price of spread (downside risk) Upside break-even Downside break-even Maximum profit 3:2 Ratio: Buy 2 April 40's Sell 3 April 45's 1 debit 54 401/2 9 2:1 Ratio: 3:1 Ratio: By 1 April 40 Buy 1 April 40 Sell 2 April 45's Sell 3 April 45's 1 credit 4 credit 51 49½ None None 6 9 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:246 SCORE: 4.00 ================================================================================ 220 Part II: Call Option Strategies Example: Early in this chapter, when selection criteria were described, a neutral ratio was determined to be 16:10, with XYZ at 44. Suppose, after establishing the spread, that the common rallied to 4 7. One could use the current deltas to adjust. This information is summarized in Table 11-4. The current neutral ratio is approxi­ mately 14:10. Thus, two of the short April 45's could be bought closing. In practice, one usually decreases his ratio by adding to the long side. Consequently, one would buy two April 40's, decreasing his overall ratio to 16:12, which is 1.33 and is close to the actual neutral ratio of 1.38. The position would therefore be delta-neutral once more. An alternative way of looking at this is to use the equivalent stock position (ESP), which, for any option, is the multiple of the quantity times the delta times the shares per option. The last three lines of Table 11-4 show the ESP for each call and for the position as a whole. Initially, the position has an ESP of 0, indicating that it is perfectly delta-neutral. In the current situation, however, the position is delta short 140 shares. Thus, one could adjust the position to be delta-neutral by buying 140 shares of XYZ. If he wanted to use the options rather than the stock, he could buy two April 45's, which would add a delta long of 130 ESP (2 x .65 x 100), leaving the position delta short 10 shares, which is very near neutral. As pointed out in the above paragraph, the spreader probably should buy the call with the most intrinsic value - the April 40. Each one of these has an ESP of 90 (1 x .9 x 100). Thus, if one were bought, the position would be delta short 50 shares; if two were bought, the total position would be delta long 40 shares. It would be a matter of individual preference whether the spreader wanted to be long or short the "odd lot" of 40 or 50 shares, respectively. TABLE 11-4. Original and current prices and deltas. XYZ common April 40 call April 45 call April 40 delta April 45 delta Neutral ratio April 40 ESP April 45 ESP Total ESP Original Situation 44 5 3 .80 .50 16:10 (.80/.50) 800 long (l Ox .8 x 100) 800 shrt ( 16 x .5 x l 00) 0 (neutral) Current Situation 47 8 5 .90 .65 14:10 (.90/.65 = 1.38) 900 long (10 x .9 x 100) l ,040 shrt ( 16 x .65 x l 00) 140 shrt ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:247 SCORE: 16.00 ================================================================================ Chapter 11: Ratio Call Spreads 221 The ESP method is merely a confirmation of the other method. Either one works well. The spreader should become familiar with the ESP method because, in a position with many different options, it reduces the exposure of the entire position to a single number. TAKING PROFITS In addition to defensive action, the spreader may find that he can close the spread early to take a profit or to limit losses. If enough time has passed and the underlying stock is close to the maximum profit point - the higher striking price - the spreader may want to consider closing the spread and taking his profit. Similarly, if the under­ lying stock is somewhere between the two strikes as expiration draws near, the writer will normally find himself with a profit as the long call retains some intrinsic value and the short calls are nearly worthless. If at this time one feels that there is little to gain (a price decline might wipe out the long call value), he should close the spread and take his profit. SUMMARY Ratio spreads can be an attractive strategy, similar in some ways to ratio writing. Both strategies offer a large probability of making a limited profit. The ratio spread has limited downside risk, or possibly no downside risk at all. In addition, if the long call(s) in the spread can be bought with little or no time value premium in them, the ratio spread becomes a superior strategy to the ratio write. One can adjust the ratio used to reflect his opinion of the underlying stock or to make a neutral profit range if desired. The ratio adjustment can be accomplished by using the deltas of the options. In a broad sense, this is one of the more attractive forms of spreading, since the strategist is buying mostly intrinsic value and is selling a relatively large amount of time value. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:248 SCORE: 16.00 ================================================================================ Cotnbining Calendar and Ratio Spreads The previous chapters on spreading introduced the basic types of spreads. The sim­ plest forms of bull spreads, bear spreads, or calendar spreads can often be combined to produce a position with a more attractive potential. The butterfly spread, which is a combination of a bull spread and a bear spread, is an example of such a combina­ tion. The next three chapters are devoted to describing other combinations of spreads, wherein the strategist not only mixes basic strategies ..:... bull, bear, and calen­ dar - but uses varying expiration dates as well. Although they may seem overly com­ plicated at first glance, these combinations are often employed by professionals in the field. RATIO CALENDAR SPREAD The ratio cdendar spread is a combination of the techniques used in the calendar and ratio spreads. Recall that one philosophy of the calendar spread strategy was to sell the near-term call and buy a longer-term call, with both being out-of-the-money. This is a bullish calendar spread. If the underlying stock never advances, the spread­ er loses the entire amount of the relatively small debit that he paid for the spread. However, if the stock advances after the near-term call expires worthless, large prof­ its are possible. It was stated that this bullish calendar spread philosophy had a small probability of attaining large profits, and that the few profits could easily exceed the preponderance of small losses. The ratio calendar spread is an attempt to raise the probabilities while allowing for large potential profits. In the ratio calendar spread, one sells a number of near- 222 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:249 SCORE: 16.00 ================================================================================ Chapter 12: Combining Calendar and Ratio Spreads 223 term calls while buyingfewer of the intermediate-term or long-term calls. Since more calls are being sold than are being bought, naked options are involved. It is often pos­ sible to set up a ratio calendar spread for a credit, meaning that if the underlying stock never rallies above the strike, the strategist will still make money. However, since naked calls are involved, the collateral requirements for participating in this strategy may be large. Example: As in the bullish calendar spreads described in Chapter 9, the prices are: XYZ common, 45; XYZ April 50 call, l; and XYZ July 50 call, l½. In the bullish calendar spread strategy, one July 50 is bought for each April 50 sold. This means that the spread is established for a debit of½ point and that the invest­ ment is $50 per spread, plus commissions. The strategist using the ratio calendar / spread has essentially the same philosophy as the bullish calendar spreader: The stock will remain below 50 until April expiration and may then rally. The ratio calen­ dar spread might be set up as follows: Buy 1 XYZ July 50 call at l½ Sell 2 XYZ April 50 calls at 1 each Net l½ debit 2 credit ½ credit Although there is no cash involved in setting up the ratio spread since it is done for a credit, there is a collateral requirement for the naked April 50 call. If the stock remains below 50 until April expiration, the long call - the July 50 - will be owned free. After that, no matter what happens to the underlying stock, the spread cannot lose money. In fact, if the underlying stock advances dramatically after near-term expiration, large profits will accrue as the July 50 call increases in value. Of course, this is entirely dependent on the near-term call expiring worthless. If the underlying stock should rally above 50 before the April calls expire, the ratio calen­ dar spread is in danger of losing a large amount of money because of the naked calls, and defensive action must be taken. Follow-up actions are described later. The collateral required for the ratio calendar spread is equal to the amount of collateral required for the naked calls less the credit taken in for the spread. Since naked calls will be marked to market as the stock moves up, it is always best to allow enough collateral to get to a defensive action point. In the example above, suppose that one felt he would definitely be taking defensive action if the stock rallied to 53 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:250 SCORE: 0.00 ================================================================================ 224 Part II: Call Option Strategies before April expiration. He should then figure his collateral requirement as if the stock were at 53, regardless of what the collateral requirement is at the current time. This is a prudent tactic whenever naked options are involved, since the strategist will never be forced into an unwanted close-out before his defensive action point is reached. The collateral required for this example would then be as follows, assuming the call is trading at 3½: 20% of 53 Call premium Less initial credit Total collateral to set aside $1,060 + 350 -___fill $1,360 The strategist is not really "investing" anything in this strategy, because his require­ ment is in the form of collateral, not cash. That is, his current portfolio assets need not be disturbed to set up this spread, although losses would, of course, create deb­ its in the account. Many naked option strategies are similar in this respect, and the strategist may earn additional money from the collateral value of his portfolio with­ out disturbing the portfolio itself. However, he should take care to operate such strategies in a conservative manner, since any income earned is "free," but losses may force him to disturb his portfolio. In light of this fact, it is always difficult to compute returns on investment in a strategy that requires only collateral to operate. One can, of course, compute the return on the maximum collateral required during the life of the position. The large investor participating in such a strategy should be satisfied with any sort of positive return. Returning to the example above, the strategist would make his $50 credit, less commissions, if the underlying stock remained below 50 until July expiration. It is not possible to determine the results to the upside so definitively. If the April 50 calls expire worthless and then the stock rallies, the potential profits are limited only by time. The case in which the stock rallies before April expiration is of the most con­ cern. If the stock rallies immediately, the spread will undoubtedly show a loss. If the stock rallies to 50 more slowly, but still before April expiration, it is possible that the spread will not have changed much. Using the same example, suppose that XYZ ral­ lies to 50 with only a few weeks of life remaining in the April 50 calls. Then the April 50 calls might be selling at l ½ while the July 50 call might be selling at 3. The ratio spread could be closed for even money at that point; the cost of buying back the 2 April 50's would equal the credit received from selling the one July 50. He would thus make½ point, less commissions, on the entire spread transaction. Finally, at the expi­ ration date of the April 50 calls, one can estimate where he would break even. Suppose one estimated that the July 50 call would be selling for 5½ points if XYZ were at 53 at April expiration. Since the April 50 calls would be selling for 3 at that ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:253 SCORE: 0.00 ================================================================================ Chapter 12: Combining Calendar and Ratio Spreads 227 itself is a rather high-probability event, because the stock is initially below the strik­ ing price. In addition, the spread can make large potential profits if the stock rallies after the near-term calls expire. Although this is a much less probable event, the prof­ its that can accrue add to the expected return of the spread. The only time the spread loses is when the stock rallies quickly, and the strategist should close out the spread in that case to limit losses. Although Table 12-2 is not mathematically definitive, it can be seen that this strategy has a positive expected return. Small profits occur more frequently than small losses do, and sometimes large profits can occur. These expected outcomes, when coupled with the fact that the strategist may utilize collateral such as stocks, bonds, or government securities to set up these spreads, demonstrate that this is a viable strategy for the advanced investor. TABLE 12-2. Profitability of ratio calendar spreading. Event Stock never rallies above strike Stock rallies above strike in a short time Stock rallies above strike after near-term call expires Outcome Small profit. Small loss if defensive action employed Large potential profit DELTA-NEUTRAL CALENDAR SPREADS Probability Large probability Small probability Small probability The preceding discussion dealt with a specific kind of ratio calendar spread, the out­ of-the-money call spread. A more accurate ratio can be constructed using the deltas of the calls involved, similar to the ratio spreads in Chapter 11. The spread can be created with either out-of-the-money calls or in-the-money calls. The former has naked calls, while the latter has extra long calls. Both types of ratio calendars are described. In either case, the number of calls to sell for each one purchased is determined by dividing the delta of the long call by the delta of the short call. This is the same for any ratio spread, not just calendars. Example: Suppose XYZ is trading at 45 and one is considering using the July 50 call and the April 50 call to establish a ratio calendar spread. This is the same situation ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:254 SCORE: 16.00 ================================================================================ 228 Part II: Call Option Strategies that was described earlier in this chapter. Furthermore, assume that the deltas of the calls in question are .25 for the July and .15 for the April. Given that information, one can compute the neutral ratio to be 1.667 to 1 (.25/.15). That is, one would sell 1.667 calls for each one he bought; restated, he would sell 5 for each 3 bought. This out-of-the-money neutral calendar is typical. One normally sells more calls than he buys to establish a neutral calendar when the calls are out-of-the-money. The ramifications of this strategy have already been described in this chapter. Follow-up strategy is slightly different, though, and is described later. THE IN-THE-MONEY CALENDAR SPREAD When the calls are in-the-money, the neutral spread has a distinctly different look. An example will help in describing the situation. Example: XYZ is trading at 49, and one wants to establish a neutral calendar spread using the July 45 and April 45 calls. The deltas of these in-the-money calls are .8 for the April and .7 for the July. Note that for in-the-rrwney calls, a shorter-term call has a higher delta than a longer-term call. The neutral ratio for this in-the-money spread would be .875 to 1 (.7/.8). This means that .875 calls would be sold for each one bought; restated, 7 calls would be sold and 8 bought. Thus, the spreader is buying more calls than he is selling when establishing an in-the-money neutral calendar. In some sense, one is establishing some "regular'' calendar spreads (seven of them, in this example) and simultaneous­ ly buying a few extra long calls to go along with them ( one extra long call, in this example). This type of position can be quite attractive. First of all, there is no risk to the upside as there is with the out-of-the-money calendar; the in-the-money calendar would make money, because there are extra long calls in the position. Thus, if there were to be a large gap to the upside in XYZ perhaps caused by a takeover attempt - the in-the-money calendar would make money. If, on the other hand, XYZ stays in the same area, then the regular calendar spread portion of the strategy will make money. Even though the extra call would probably lose some time value premium in that event, the other seven spreads would make a large enough profit to easily com­ pensate for the loss on the one long call. The least desirable result would be for XYZ to drop precipitously. However, in that case, the loss is limited to the amount of the initial debit of the spread. Even in the case of XYZ dropping, though, follow-up action can be taken. There are no naked calls to margin with this strategy, making it attractive to many smaller investors. In the above example, one would need to pay for the entire debit of the position, but there would be no further requirements. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:255 SCORE: 0.00 ================================================================================ Chapter 12: Combining Calendar and Ratio Spreads FOLLOW-UP ACTION 229 If one decides to preserve a neutral strategy with follow-up action in either type of ratio call calendar, he would merely need to look at the deltas of the calls and keep the ratio neutral. Doing so might mean that one would switch from one type of cal­ endar spread to the other, from the out-of-the-money with naked calls to the in-the­ money with extra long calls, or vice versa. For example, if XYZ started at 45, as in the first example, one would have sold more calls than he bought. If XYZ then rallied above 50, he would have to move his position into the in-the-money ratio and get long more calls than he is short. While such follow-up action is strategically correct maintaining the neutral ratio - it might not make sense practically, especially if the size of the original spread were small. If one had originally sold 5 and bought 3, he would be better to adhere to the follow-up strategy outlined earlier in this chapter. The spread is not large enough to dictate adjusting via the delta-neutral ratios. If, however, a large trader had originally sold 500 calls and bought 300, then he has enough profitability in the spread to make several adjustments along the way. In a similar manner, the spreader who had established a small in-the-money cal­ endar might decide not to bother rationing the spread if the stock dropped below the strike. He knows his risk is limited to his initial debit, and that would be small for a small spread. He might not want to introduce naked options into the position if XYZ declines. However, if the same spread were established by a large trader, it should be adjusted because of the greater tolerance of the spread to being adjusted, merely because of its size. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:256 SCORE: 12.00 ================================================================================ Reverse Spreads In general, when a strategy has the term "reverse" in its name, the strategy is the opposite of a more commonly used strategy. The reader should be familiar with this nomenclature from the earlier discussions comparing ratio writing (buying stock and selling calls) with reverse hedging (shorting stock and buying calls). If the reverse strategy is sufficiently well-known, it usually acquires a name of its own. For exam­ ple, the bear spread is really the reverse of the bull spread, but the bear spread is a popular enough strategy in its own right to have acquired a shorter, unique name. REVERSE CALENDAR SPREAD The reverse calendar spread is an infrequently used strategy, at least for public cus­ tomers trading stock or index options, because of the margin requirements. However, even then, it does have a place in the arsenal of the option strategist. Meanwhile, pro­ fessionals and futures option traders use the strategy with more frequency because the margin treatment is more favorable for them. As its name implies, the reverse calendar spread is a position that is just the opposite of a "normal" calendar spread. In the reverse calendar spread, one sells a long-term call option and simultaneously buys a shorter-term call option. The spread can be constructed with puts as well, as will be shown in a later chapter. Both calls have the same striking price. This strategy will make money if one of two things happens: Either (1) the stock price moves away from the striking price by a great deal, or (2) the inplied volatility of the options involved in the spread shrinks. For readers familiar with the "normal" calendar spread strategy, the first way to profit should be obvious, because a "normal" 230 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:257 SCORE: 24.00 ================================================================================ Chapter 13: Reverse Spreads 231 calendar spread makes the most money if the stock is right at the strike price at expi­ ration, and it loses money if the stock rises or falls too far. As with any spread involving options expiring in differing months, it is common practice to look at the profitability of the position at or before the near-term expira­ tion. An example will show how this strategy can profit. Example: Suppose the current month is April and that XYZ is trading at 80. Furthermore, suppose that XYZ's options are quite expensive, and one believes the underlying stock will be volatile. A reverse calendar spread would be a way to profit from these assumptions. The following prices exist: XYZ December 80 call: 12 XYZ July 80 call: 7 A reverse calendar spread is established by selling the December 80 call for 12 points, and buying the July 80 call for 7, a net credit of 5 points for the spread. If, later, XYZ falls dramatically, both call options will be nearly worthless and the spread could be bought back for a price well below 5. For example, if XYZ were to fall to 50 in a month or so, the July 80 call would be nearly worthless and the December 80 call could be bought back for about a point. Thus, the spread would have shrunk from its initial price of 5 to a price of about 1, a profit of 4 points. The other way to make money would be for implied volatility to decrease. Suppose implied volatility dropped after a month had passed. Then the spread might be worth something like 4 points - an unrealized profit of about 1 point, since it was sold for a price of 5 initially. The profit graph in Figure 13-1 shows the profitability of the reverse calendar. There are two lines on the graph, both of which depict the results at the expiration of the near-term option (the July 80 call in the above example). The lower line shows where profits and losses would occur if implied volatility remained unchanged. You can see that the position could profit if XYZ were to rise above 98 or fall below 70. In addition, the higher curve on the graph shows where profits would lie if implied volatility fell prior to expiration of the near-term options. In that case, additional prof­ its would accrue, as depicted on the graph. So there are two ways to make money with this strategy, and it is therefore best to establish it when implied volatility is high and the underlying has a tendency to be volatile. The problem with this spread, for stock and index option traders, is that the call that is sold is considered to be naked. This is preposterous, of course, since the short­ term call is a perfectly valid hedge until it expires. Yet the margin requirements remain onerous. When they were overhauled recently, this glaring inefficiency was ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:258 SCORE: 12.00 ================================================================================ 232 Part II: Call Option Strategies Figure 13-1 • Calendar spread sale at near-term expiration. $400 $300 Implied Volatility Lower $200 \ f/) $100 f/) 0 ~ $0 50 60 110 120 a. -$100 -$200 -$300 Implied Volatility -$400 Remains High -$500 Underlying Price allowed to stand because none of the member firms cared about changing it. Still, if one has excess collateral - perhaps from a large stock portfolio - and is interested in generating excess income in a hedged manner, then the strategy might be applicable for him as well. Futures option traders receive more favorable margin requirements, and it thus might be a more economical strategy for them. REVERSE RATIO SPREAD (BACKSPREAD) A more popular reverse strategy is the reverse ratio call spread, which is comrrwnly known as a backspread. In this type of spread, one would sell a call at one striking price and then would buy several calls at a higher striking price. This is exactly the opposite of the ratio spread described in Chapter 11. Some traders refer to any spread with unlimited profit potential on at least one side as a backspread. Thus, in most backspreading strategies, the spreader wants the stock to rrwve dramatically. He does not generally care whether it moves up or down. Recall that in the reverse hedge strategy (similar to a straddle buy) described in Chapter 4, the strategist had the potential for large profits if the stock moved either up or down by a great deal. In the backspread strategy discussed here, large potential profits exist if the stock moves up dramatically, but there is limited profit potential to the downside. Example: XYZ is selling for 43 and the July 40 call is at 4, with the July 45 call at l. A reverse ratio spread would be established as follows: · ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:259 SCORE: 8.00 ================================================================================ Chapter 13: Reverse Spreads Buy 2 July 45 calls at 1 each Sell 1 July 40 call at 4 Net 2 debit 4 credit 2 credit 233 These spreads are generally established for credits. In fact, if the spread cannot be initiated at a credit, it is usually not attractive. If the underlying stock drops in price and is below 40 at July expiration, all the calls will expire worthless and the strategist will make a profit equal to his initial credit. The maximum downside poten­ tial of the reverse ratio spread is equal to the initial credit received. On the other hand, if the stock rallies substantially, the potential upside profits are unlimited, since the spreader owns more calls than he is short. Simplistically, the investor is bullish and is buying out-of the-money calls but is simultaneously hedging himself by selling another call. He can profit if the stock rises in price, as he thought it would, but he also profits if the stock collapses and all the calls expire worthless. This strategy has limited risk. With most spreads, the maximum loss is attained at expiration at the striking price of the purchased call. This is a true statement for backspreads. Example: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth­ less for a loss of $200 and the July 40 call will have to be bought back for 5 points, a $100 loss on that call. The total loss would thus be $300, and this is the most that can be lost in this example. If the underlying stock should rally dramatically, this strategy has unlimited profit potential, since there are two long calls for each short one. In fact, one can always compute the upside break-even point at expiration. That break­ even point happens to be 48 in this example. At 48 at July expiration, each July 45 call would be worth 3 points, for a net gain of $400 on the two of them. The July 40 call would be worth 8 with the stock at 48 at expiration, representing a $400 loss on that call. Thus, the gain and the loss are offsetting and the spread breaks even, except for commissions, at 48 at expiration. If the stock is higher than 48 at July expiration, profits will result. Table 13-1 and Figure 13-2 depict the potential profits and losses from this example of a reverse ratio spread. Note that the profit graph is exactly like the prof­ it graph of a ratio spread that has been rotated around the stock price axis. Refer to Figure 11-1 for a graph of the ratio spread. There is actually a range outside of which profits can be made - below 42 or above 48 in this example. The maximum loss occurs at the striking price of the purchased calls, or 45, at expiration. There are no naked calls in this strategy, so the investment is relatively small. The strategy is actually a long call added to a bear spread. In this example, the bear ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:262 SCORE: 4.00 ================================================================================ CH.APTER 14 Diagonalizing a Spread When one uses both different striking prices and different expiration dates in a spread, it is a diagonal spread. Generally, the long side of the spread would expire later than the short side of the spread. Note that this is within the definition of a spread for margin purposes: The long side must have a maturity equal to or longer than the maturity of the short side. With the exception of calendar spreads, all the previous chapters on spreads have described ones in which the expiration dates of the short call and the long call were the same. However, any of these spreads can be diag­ onalized; one can replace the long call in any spread with one expiring at a later date. In general, diagonalizing a spread in this manner makes it slightly rrwre bear­ ish at near-term expiration. This can be seen by observing what would happen if the stock fell or rose substantially. If the stock falls, the long side of the spread will retain some value because of its longer maturity. Thus, a diagonal spread will generally do better to the downside than will a regular spread. If the stock rises substantially, all calls will come to parity. Thus, there is no advantage in the long-term call; it will be selling for approximately the same price as the purchased call in a normal spread. However, since the strategist had to pay more originally for the longer-term call, his upside profits would not be as great. A diagonalized position has an advantage in that one can reestablish the posi­ tion if the written calls expire worthless in the spread. Thus, the increased cost of buying a longer-term call initially may prove to be a savings if one can write against it twice. These tactics are described for various spread strategies. THE DIAGONAL BULL SPREAD A vertical call bull spread consists of buying a call at a lower striking price and sell­ ing a call at a higher striking price, both with the same expiration date. The diagonal 236 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:263 SCORE: 20.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:264 SCORE: 12.00 ================================================================================ 238 Part II: Call Option Strategies TABLE 14-1. Comparison of spreads at expiration. Vertical Bull XYZ Price at April 30 April 35 July 30 Spread Diagonal April Expiration Price Price Price Profit Spread Profit 20 0 0 0 -$200 -$300 24 0 0 1/2 - 200 - 250 27 0 0 1 - 200 - 200 30 0 0 2 - 200 - 100 32 2 0 3 0 0 35 5 0 51/2 + 300 + 250 40 10 5 10 + 300 + 200 45 15 10 15 + 300 + 200 spread will actually widen to more than 5 points. Thus, the maximum area of profit at April expiration for the diagonal spread is to have the stock near the striking price of the written call. The figures demonstrate that the diagonal spread gives up a small portion of potential upside profits to provide a hedge to the downside. Once the April 35 call expires, the diagonal spread can be closed. However, if the stock is below 35 at that time, it may be more prudent to then sell the July 35 call against the July 30 call that is held long. This would establish a normal bull spread for the 3 months remaining until July expiration. Note that ifXYZ were still at 32 at April expiration, the July 35 call might be sold for 1 point if the stock's volatility was about the same. This should be true, since the April 35 call was worth 1 point with the stock at 32 three months before expiration. Consequently, the strategist who had pursued this course of action would end up with a normal July bull spread for a net debit of 2 points: He originally paid 4 for the July 30 call, but then sold the April 35 for 1 point and subsequently sold the July 35 for 1 point. By looking at the table of prices for the first example in this chapter, the reader can see that it would have cost 2½ points to set up the normal July bull spread originally. Thus, by diagonalizing and having the near-term call expire worthless, the strategist is able to acquire the normal July bull spread at a cheaper cost than he could have originally. This is a specific example of how the diagonalizing effect can prove beneficial if the writer is able to write against the same long call two times, or three times if he originally purchased the longest­ term call. In this example, if XYZ were anywhere between 30 and 35 at April expira­ tion, the spread would be converted to a normal July bull spread. If the stock were above 35, the spread should be closed to take the profit. Below 30, the July 30 call would probably be closed or left outright long. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:265 SCORE: 8.00 ================================================================================ Chapter 14: Diagonalizing a Spread 239 In summary, the diagonal bull spread may often be an improvement over the normal bull spread. The diagonal spread is an improvement when the stock remains relatively unchanged or falls, up until the near-term written call expires. At that time, the spread can be converted to a normal bull spread if the stock is at a favorable price. Of course, if at any time the underlying stock rises above the higher striking price at an expiration date, the diagonal spread will be profitable. OWNING A CALL FOR "FREE" Diagonalization can be used in other spread strategies to accomplish much the same purposes already described; but in addition, it may also be possible for the spreader to wind up owning a long call at a substantially reduced cost, possibly even for free. The easiest w~y to see this would be to consider a diagonal bear spread. Example: XYZ is at 32 and the near-term April 30 call is selling for 3 points while the longer-term July 35 call is selling for 1 ½ points. A diagonal bear spread could be established by selling the April 30 and buying the July 35. This is still a bear spread, because a call with a lower striking price is being sold while a call at a higher strike is being purchased. However, since the purchased call has a longer maturity date than the written call, the spread is diagonalized. This diagonal bear spread will make money ifXYZ falls in price before the near­ term April call expires. For example, ifXYZ is at 29 at expiration, the written call will expire worthless and the July 35 will still have some value, perhaps ½. Thus, the prof­ it would be 3 points on the April 30, less a 1-point loss on the July 35, for an overall profit of 2 points. The risk in the position lies to the upside, just as in a regular bear spread. If XYZ should advance by a great deal, both options would be at parity and the spread would have widened to 5 points. Since the initial credit was 1 ½ points, the loss would be 5 minus 1 ½, or 3½ points in that case. As in all diagonal spreads, the spread will do slightly better to the downside because the long call will hold some value, but it will do slightly worse to the upside if the underlying stock advances sub­ stantially. The reason that a strategist might attempt a diagonal bear spread would not be for the slight downside advantage that the diagonalizing effect produces. Rather it would be because he has a chance of owning the July 35 call - the longer-term call - for a substantially reduced cost. In the example, the cost of the July 35 call was 1 ½ points and the premium received from the sale of the April 30 call was 3 points. If the spreader can make 1 ½ points from the sale of the April 30 call, he will have com­ pletely covered the cost of his July option. He can then sit back and hope for a rally ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:266 SCORE: 4.00 ================================================================================ 240 Part II: Call Option Strategies by the underlying stock. If such a rally occurred, he could make unlimited profits on the long side. If it did not, he loses nothing. Example: Assume that the same spread was established as in the last example. Then, if XYZ is at or below 31 ½ at April expiration, the April 30 call can be purchased for 1 ½ points or less. Since the call was originally sold for 3, this would represent a prof­ it of at least 1 ½ points on the April 30 call. This profit on the near-term option cov­ ers the entire cost of the July 35. Consequently, the strategist owns the July 35 for free. If XYZ never rallies above 35, he would make nothing from the overall trade. However, if XYZ were to rally above 35 after April expiration (but before July expi­ ration, of course), he could make potentially large profits. Thus, when one establish­ es a diagonal spread for a credit, there is always the potential that he could own a call for free. That is, the profits from the sale of the near-term call could equal or exceed the original cost of the long call. This is, of course, a desirable position to be in, for if the underlying stock should rally substantially after profits are realized on the short side, large profits could accrue. DIAGONAL BACKSPREADS In an analogous strategy, one might buy more than one longer-term call against the short-term call that is sold. Using the foregoing prices, one might sell the April 30 for 3 points and buy 2 July 35's at 1 ½ points each. This would be an even money spread. . The credits equal the debits when the position is established. If the April 30 call expires worthless, which would happen if the stock was below 30 in April, the spread­ er would own 2 July 35 calls for free. Even if the April 30 does not expire totally worthless, but if some profit can be made on the sale of it, the July 35's will be owned at a reduced cost. In Chapter 13, when reverse spreads were discussed, the strategy in which one sells a call with a lower strike and then buys more calls at a higher strike was termed a reverse ratio spread, or backspread. The strategy just described is merely the diagonalizing of a backspread. This is a strategy that is favored by some professionals, because the short call reduces the risk of owning the longer-term calls if the underlying stock declines. Moreover, if the underlying stock advances, the pre­ ponderance of long calls with a longer maturity will certainly outdistance the losses on the written call. The worst situation that could result would be for the underlying stock to rise very slightly by near-term expiration. If this happened, it might be pos­ sible to lose money on both sides of the spread. This would have to be considered a rather low-probability event, though, and would still represent a limited loss, so it does not substantially offset the positive aspects of the strategy. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:267 SCORE: 21.00 ================================================================================ 0.,ter 14: Diagonalizing a Spread 241 Any type of spread may be diagonalized. There are some who prefer to diago­ nalize even butterfly spreads, figuring that the extra time to maturity in the purchased calls will be of benefit. Overall, the benefits of diagonalizing can be generalized by recalling the way in which the decay of the time value premium of a call takes place. Recall that it was determined that a call loses most of its time value premium in the last stages of its life. When it is a very long-term option, the rate of decay is small. Knowing this fact, it makes sense that one would want to sell options with a short life remaining, so that the maximum benefit of the decay could be obtained. Correspondingly, the purchase of a longer-term call would mean that the buyer is not subjecting himself to a substantial loss in time value premium, at least over the first three months of ownership. A diagonal spread encompasses both of these features - selling a short-term call to try to obtain the maximum rate of time decay, while buy­ ing a longer-term call to try to lessen the effect of time decay on the long side. CALL OPTION SUMMARY This concludes the description of strategies that utilize only call options. The call option has been seen to be a vehicle that the astute strategist can use to set up a wide variety of positions. He can be bullish or bearish, aggressive or conservative. In addi­ tion, he can attempt to be neutral, trying to capitalize on the probability that a stock will not move very far in a short time period. The investor who is not familiar with options should generally begin with a sim­ ple strategy, such as covered call writing or outright call purchases. The simplest types of spreads are the bull spread, the bear spread, and the calendar spread. The more sophisticated investor might consider using ratios in his call strategies - ratio writing against stock or ratio spreading using only calls. Once the strategist feels that he understands the risk and reward relationships between longer-term and short-term calls, between in-the-money and out-of-the­ money calls, and between long calls and short calls, he could then consider utilizing the most advanced types of strategies. This might include reverse ratio spreads, diag­ onal spreads, and more advanced types of ratios, such as the ratio calendar spread. A great deal of information, some of it rather technical in detail, has been pre­ sented in preceding chapters. The best pattern for an investor to follow would be to attempt only strategies that he fully comprehends. This does not mean that he mere­ ly understands the profitability aspects (especially the risk) of the strategy. One must also be able to readily understand the potential effects of early assignments, large div­ idend payments, striking price adjustments, and the like, if he is going to operate advanced strategies. Without a full understanding of how these things might affect one's position, one cannot operate an advanced strategy correctly. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:273 SCORE: 0.00 ================================================================================ CHAPTER 15 Put Option Basics Much of the same terminology that is applied to call options also pertains to put options. Underlying security, striking price, and expiration date are all terms that have the same meaning for puts as they do for calls. The expiration dates of listed put options agree with the expiration dates of the calls on the same underlying stock. In addition, puts and calls have the same striking prices. This means that if there are options at a certain strike, say on a particular underlying stock that has both listed puts and calls, both calls at 50 and puts at 50 will be trading, regardless of the price of the underlying stock. Note that it is no longer sufficient to describe an option as an "XYZ July 50." It must also be stated whether the option is a put or a call, for an XYZ July 50 call and an XYZ July 50 put are two different securities. In many respects, the put option and its associated strategies will be very near­ ly the opposite of corresponding call-oriented strategies. However, it is not correct to say that the put is exactly the opposite of a call. In this introductory section on puts, the characteristics of puts are described in an attempt to show how they are similar to calls and how they are not. PUT STRATEGIES In the simplest terms, the outright buyer of a put is hopingfor a stock price decline in order for his put to become more valuable. If the stock were to decline well below the striking price of the put option, the put holder could make a profit. The holder of the put could buy stock in the open market and then exercise his put to sell that stock for a profit at the striking price, which is higher. Example: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, for the put grants the holder the right to sell XYZ at 50 10 points above its current 245 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:274 SCORE: 36.00 ================================================================================ 246 Part Ill: Put Option Strategies price. On the other hand, if the stock price were above the striking price of the put option at expiration, the put would be worthless. No one would logically want to exer­ cise a put option to sell stock at the striking price when he could merely go to the open market and sell the stock for a higher price. Thus, as the price of the underly­ ing stock declines, the put becomes more valuable. This is, of course, the opposite of a call option's price action. The meaning of in-the-money and out-of-the-money are altered when one is speaking of put options. A put is considered to be in-the-money when the underlying stock is below the striking price of the put option; it is out-of the-money when the stock is above the striking price. This, again, is the opposite of the call option. IfXYZ is at 45, the XYZ July 50 put is in-the-money and the XYZ July 50 call is out-of-the­ money. However, ifXYZ were at 55, the July 50 put would be out-of-the-money while the July 50 call would be in-the-money. The broad definition of an in-the-money option as "an option that has intrinsic value" would cover the situation for both puts and calls. Note that a put option has intrinsic value when the underlying stock is below the striking price of the put. That is, the put has some "real" value when the stock is below the striking price. The intrinsic value of an in-the-money put is merely the difference between the striking price and the stock price. Since the put is an option (to sell), it will gen­ erally sell for more than its intrinsic value when there is time remaining until the expiration date. This excess value over its intrinsic value is referred to as the time value premium, just as is the case with calls. Example: XYZ is at 47 and the XYZ July 50 put is selling for 5, the intrinsic value is 3 points (50- 47), so the time value premium must be 2 points. The time value pre­ mium of an in-the-money put option can always be quickly computed by the follow­ ing formula: Time value premium p . S k · St "ki · • ) == ut option + toe pnce - n ng pnce (m-the-money put This is not the same formula that was applied to in-the-money call options, although it is always true that the time value premium of an option is the excess value over intrinsic value. Time value premium Call ti S ·ki · St k · . all == op on + tn ng pnce - oc pnce (m-the-money c ) If the put is out-of-the-money, the entire premium of the put is composed of time value premium, for the intrinsic value of an out-of-the-money option is always zero. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:275 SCORE: 32.00 ================================================================================ O.,,ter 15: Put Option Basks 247 The time value premium of a put is largest when the stock is at the striking price of the put. As the option becomes deeply in-the-money or deeply out-of-the-money, the time value premium will shrink substantially. These statements on the magnitude of the time value premium are true for both puts and calls. Table 15-1 will help to illus­ trate the relationship of stock price and option price for both puts and calls. The reader may want to refer to Table 1-1, which described the time value premium rela­ tionship for calls. Table 15-1 describes the prices of an XYZ July 50 call option and an XYZ July 50 put option. Table 15-1 demonstrates several basic facts. As the stock drops, the actual price of a call option decreases while the value of the put option increases. Conversely, as the stock rises, the call option increases in value and the put option decreases in value. Both the put and the call have their maximum time value premium when the stock is exactly at the striking price. However, the call will generally sell for rrwre than the put when the stock is at the strike. Notice in Table 15-1 that, with XYZ at 50, the call is worth 5 points while the put is worth only 4 points. This is true in general, except in the case of a stock that pays a large dividend. This phenomenon has to do with the cost of carrying stock. More will be said about this effect later. Table 15-1 also describes an effect of put options that normally holds true: An in-the-rrwney put ( stock is below strike) loses time value premium rrwre quickly than an in-the-rrwney call does. Notice that with XYZ at 43 in Table 15-1, the put is 7 points in-the-money and has lost all its time value premium. But when the call is 7 points in-the-money, XYZ at 57, the call still has 2 points of time value premium. Again, this is a phenom­ enon that could be affected by the dividend payout of the underlying stock, but is true in general. PRICING PUT OPTIONS The same factors that determine the price of the call option also determine the price of the put option: price of the underlying stock, striking price of the option, time remaining until expiration, volatility of the underlying stock, dividend rate of the underlying stock, and the current risk-free interest rate (Treasury bill rate, for exam­ ple). Market dynamics - supply, demand, and investor psychology - play a part as well. Without going into as much detail as was shown in Chapter 1, the pricing curve of the put option can be developed. Certain facts remain true for the put option as they did for the call option. The rate of decay of the put option is not linear; that is, the time value premium will decay more rapidly in the weeks immediately preced­ ing expiration. The more volatile the underlying stock, the higher will be the price ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:276 SCORE: 40.00 ================================================================================ 248 Part Ill: Put Option Strategies TABLE 15-1. Call and put options compared. XYZ XYZ Coll Coll XYZ Put Put Stock July 50 Intrinsic Time Value July 50 Intrinsic Time Value Price Coll Price Value Premium Put Price Value Premium 40 1/2 0 1/2 93/4 10 -1/4* 43 1 0 1 7 7 0 45 2 0 2 6 5 47 3 0 3 5 3 2 50 5 0 5 4 0 4 53 7 3 4 3 0 3 55 8 5 3 2 0 2 57 9 7 2 0 60 101/2 10 1/2 1/2 0 l/2 70 193/4 20 -1/4 * 1/4 0 1/4 * A deeply in-the-money option may actually trade at a discount from intrinsic value in advance of expiration. of its options, both puts and calls. Moreover, the marketplace may at any time value options at a higher or lower volatility than the underlying stock actually exhibits. This is called implied volatility, as distinguished from actual volatility. Also, the put option is usually worth at least its intrinsic value at any time, and should be worth exactly its intrinsic value on the day that it expires. Figure 15-1 shows where one might expect the XYZ July 50 put to sell, for any stock price, if there are 6 months remaining until expiration. Compare this with the similar pricing curve for the call option (Figure 15-2). Note that the intrinsic value line for the put option faces in the opposite direction from the intrinsic value line for call options; that is, it gains value as the stock falls below the striking price. This put option pricing curve demonstrates the effect mentioned earlier, that a put option loses time value pre­ mium more quickly when it is in-the-money, and also shows that an out-of-the­ money put holds a great deal of time value premium. THE EFFECT OF DIVIDENDS ON PUT OPTION PREMIUMS The dividend of the underlying stock is a negative factor on the price of its call options. The opposite is true for puts. The larger the dividend, the nwre valuable the puts will be. This is true because, as the stock goes ex-dividend, it will be reduced in ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:277 SCORE: 4.00 ================================================================================ Cl,opter 15: Put Option Basics FIGURE 1 5-1. Put option price curve. ~ it C: .Q a. 0 FIGURE 1 5-2. Call option price curve. ~ ct C: 0 11 10 9 8 7 6 a 5 Striking Price (50) Greatest Value for Time Value Stock Price 0 4 ---------------------- 3 2 1 0 40 45 represents the option's time value premium. ________ L ________ _ 50\ 55 60 Stock Price Intrinsic value remains at zero until striking price is passed. 249 price by the amount of the dividend. That is, the stock will decrease in price and therefore the put will become more valuable. Consequently, the buyer of the put will be willing to pay a higher price for the put and the seller of the put will also demand a higher price. As with listed calls, listed puts are not adjusted for the payment of cash dividends on the underlying stock. However, the price of the option itself will reflect the dividend payments on the stock. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:279 SCORE: 4.00 ================================================================================ 0.,ter 15: Put Option Basics 251 ly sell stock in the open market to offset the purchase that he is forced to make via the put assignment. Finally, he may decide to retain the stock that is delivered to him; he merely keeps the stock in his portfolio. He would, of course, have to pay for ( or margin) the stock if he decides to keep it. The mechanics as to how the put holder wants to deliver the stock and how the put writer wants to receive the stock are relatively simple. Each one merely notifies his brokerage firm of the way in which he wants to operate and, provided that he can meet the margin requirements, the exercise or assignment will be made in the desired manner. ANTICIPATING ASSIGNMENT The writer of a put option can anticipate assignment in the same way that the writer of a call can. When the time value premium of an in-the-money put option disappears, there is a risk of assignment, regardless of the time remaining until expiration. In Chapter 1, a form of arbitrage was described in which market-makers or firm traders, who pay little or no commissions, can take advantage of an in-the-money call selling at a discount to parity. Similarly, there is a method for these traders to take advantage of an in-the-money put selling at a discount to parity. Example: XYZ is at 40 and an XYZ July 50 put is selling for 9¾ a ¼ discount from parity. That is, the option is selling for ¼ point below its intrinsic value. The arbi­ trageur could take advantage of this situation through the following actions: 1. Buy the July put at 9¾. 2. Buy XYZ common stock at 40. 3. Exercise the put to sell XYZ at 50. The arbitrageur makes 10 points on the stock portion of the transaction, buying the common at 40 and selling it at 50 via exercise of his put. He paid 9¾ for the put option and he loses this entire amount upon exercise. However, his overall profit is thus ¼ point, the amount of the original discount from parity. Since his commission costs are minimal, he can actually make a net profit on this transaction. As was the case with deeply in-the-money calls, this type of arbitrage with deeply in-the-money puts provides a secondary market that might not otherwise exist. It allows the public holder of an in-the-money put to sell his option at a price near its intrinsic value. Without these arbitrageurs, there might not be a reasonable secondary market in which public put holders could liquidate. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:280 SCORE: 12.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:281 SCORE: 0.00 ================================================================================ O.,ter 15: Put Option Basics POSITION LIMITS 253 Recall that the position limit rule states that one cannot have a position of more than the limit of options on the same side of the market in the same underlying security. The limit varies depending on the trading activity and volatility of the underlying stock and is set by the exchange on which the options are traded. The actual limits are 13,500, 22,500, 31,500, 60,000, or 75,000 contracts, depending on these factors. One cannot have more than 75,000 option contracts on the bullish side of the market - long calls and/or short puts - nor can he have more than 75,000 contracts on the bearish side of the market - short calls and/or long puts. He may, however, have 75,000 con­ tracts on each side of the market; he could simultaneously be long 75,000 calls and long 75,000 puts. For the following examples, assume that one is concerned with an underlying stock whose position limit is 75,000 contracts. Long 75,000 calls, long 75,000 puts - no violation; 75,000 contracts bullish (long calls) and 75,000 contracts bearish (long puts). Long 38,000 calls, short 37,000 puts - no violation; total of 75,000 contracts bullish. Long 38,000 calls, short 38,000 puts - violation; total of 76,000 contracts bullish. Money managers should be aware that these position limits apply to all "related" accounts, so that someone managing several accounts must total all the accounts' positions when considering the position limit rule. CONVERSION Many of the relationships between call prices and put prices relate to a process known as a conversion. This term dates back to the over-the-counter option days when a dealer who owned a put ( or could buy one) was able to satisfy the needs of a potential call buyer by "converting" the put to a call. This terminology is somewhat confusing, and the actual position that the dealer would take is little more than an arbitrage position. In the listed market, arbitrageurs and firm traders can set up the same position that the converter did. The actual details of the conversion process, which must include the carrying cost of owning stock and the inclusion of all dividends to be paid by the stock during the time the position is held, are described later. However, it is important for the put option trader to understand what the arbitrageur is attempting to do in order for him to fully understand the relationship between put and call prices in the listed option market. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:286 SCORE: 0.00 ================================================================================ 258 Part Ill: Put Option Strategies chase can achieve. If the underlying stock remains relatively unchanged, the short seller would do better because he does not risk losing his entire investment in a lim­ ited amount of time if the underlying stock changes only slightly in price. However, if the underlying stock should rise dramatically, the short seller can actually lose more than his initial investment. The short sale of stock has theoretically unlimited risk. Such is not true of the put option purchase, whereby the risk is limited to the amount of the initial investment. One other point should be made when comparing the pur­ chase of a put and the short sale of stock: The short seller of stock is obligated to pay the dividends on the stock, but the put option holder has no such obligation. This is an additional advantage to the holder of the put. TABLE 16-2. Results of selling short. XYZ Price at Put Option Expiration Short Sale Purchase 20 + $3,000 (+ 120%) +$2,500 (+ 500%) 30 + 2,000 (+ 80%) + 1,500 (+ 300%) 40 + 1,000 (+ 40%) + 500 (+ 100%) 45 + 500(+ 20%) 0( 0%) 48 + 200(+ 80%) 300 (- 60%) 50 0( 0%) 500 (- 100%) 60 - 1,000 (- 40%) 500 (- 100%) 75 - 2,500 (- 100%) 500 (- 100%) 100 - 5,000 (- 200%) 500 (- 100%) SELECTING WHICH PUT TO BUY Many of the same types of analyses that the call buyer goes through in deciding which call to buy can be used by the prospective put buyer as well. First, when approach­ ing put buying as a speculative strategy, one should not place more than 15% of his risk capital in the strategy. Some investors participate in put buying to add some amount of downside protection to their basically bullishly-oriented common stock portfolios. More is said in Chapter 17 about buying puts on stocks that one actually owns. The out-ofthe-nwney put offers both higher reward potentials and higher risk potentials than does the in-the-nwney put. If the underlying stock drops substantial- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:287 SCORE: 12.00 ================================================================================ G,pter 16: Put Option Buying 259 ly, the percentage returns from having purchased a cheaper, out-of-the-money put will be greater. However, should the underlying stock decline only moderately in price, the in-the-rrwney put will often prove to be the better choice. In fact, since a put option tends to lose its time value premium quickly as it becomes an in-the­ money option, there is an even greater advantage to the purchase of the in-the­ money put. Example: XYZ is at 49 and the following prices exist: XYZ, 49; XYZ July 45 put, l; and XYZ July 50 put, 3. If the underlying stock were to drop to 40 by expiration, the July 45 put would be worth 5 points, a 400% profit. The July 50 put would be worth 10 points, a 233% profit over its initial purchase price of 3. Thus, in a substantial downward move, the out-of-the-money put purchase provides higher reward potential. However, if the underlying stock drops only moderately, say to t:15, the purchaser of the July 45 put would lose his entire investment, since the put would be worthless at expiration. The purchaser of the in-the-money July 50 put would have a 2-point profit with XYZ at 45 at expiration. The preceding analysis is based on holding the put until expiration. For the option buyer, this is generally an erroneous form of analysis, because the buyer generally tends to liquidate his option purchase in advance of expiration. When considering what happens to the put option in advance of expiration, it is helpful to remember that an in-the-money put tends to lose its time premium rather quickly. In the example above, the July 45 put is completely composed of time value pre­ mium. If the underlying stock begins to drop below 45, the price of the put will not increase as rapidly as would the price of a call that is going into-the-money. Example: If XYZ fell by 5 points to 44, definitely a move in the put buyer's favor, he may fmd that the July 45 put has increased in value only to 2 or 2½ points. This is somewhat disappointing because, with call options, one would expect to do signifi­ cantly better on a 5-point stock movement in his favor. Thus, when purchasing put options for speculation, it is generally best to concentrate on in-the-rrwney puts unless a very substantial decline in the price of the underlying stock is anticipated. Once the put option is in-the-money, the time value premium will decrease even in the longer-term series. Since this time premium is small in all series, the put ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:288 SCORE: 8.00 ================================================================================ 260 Part Ill: Put Option Strategies buyer can often purchase a longer-term option for very little extra money, thus gain­ ing more time to work with. Call option buyers are generally forced to avoid the longer-term series because the extra cost is not worth the risk involved, especially in a trading situation. However, the put buyer does not necessarily have this disadvan­ tage. If he can purchase the longer-term put for nearly the same price as the near­ term put, he should do so in case the underlying stock takes longer to drop than he had originally anticipated it would. It is not uncommon to see such prices as the following: XYZ common, 46: XYZ April 50 put, 4; XYZ July 50 put, 4½; and XYZ October 50 put, 5. None of these three puts have much time value premium in their prices. Thus, the buyer might be willing to spend the extra 1 point and buy the longest-term put. If the underlying stock should drop in price immediately, he will profit, but not as much as if he had bought one of the less expensive puts. However, should the underlying stock rise in price, he will own the longest-term put and will therefore suffer less of a loss, percentagewise. If the underlying stock rises in price, some amount of time value premium will come back into the various puts, and the longest-term put will have the largest amount of time premium. For example, if the stock rises back to 50, the fol­ lowing prices might exist: XYZ common, 50; XYZ April 50 put, l; XYZ July 50 put, 2½; and XYZ October 50 put, 3½. The purchase of the longer-term October 50 put would have suffered the least loss, percentagewise, in this event. Consequently, when one is purchasing an in-the­ money put, he may often want to consider buying the longest-term put if the time value premium is small when compared to the time premium in the nearer-term puts. In Chapter 3, the delta of an option was described as the amount by which one might expect the option will increase or decrease in price if the underlying stock moves by a fixed amount (generally considered to be one point, for simplicity). Thus, if XYZ is at 49 and a call option is priced at 3 with a delta of ½, one would expect the call to sell for 3½ with XYZ at 50 and to sell at 2¼ with XYZ at 48. In reality, the delta ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:296 SCORE: 0.00 ================================================================================ 268 TABLE 16-6. Summary of rolling-up transactions. Original trade: Later: Net position: Buy 1 October 45 put for 3 with XYZ at 45 With XYZ at 48, sell 2 October 45's for 11/2 each and buy l October 50 put for 3 Long 1 October 50 put Short 1 October 45 put Part Ill: Put Option Strategies $300 debit $300 credit $300 debit $300 debit The effect of creating this spread is that the investor has not increased his risk at all, but has raised the break-even point for his position. That is, if XYZ merely falls a small distance, he will be able to get out even. Without the effect of creating the spread, the put holder would need XYZ to fall back to 42 at expiration in order for him to break even, since he originally paid 3 points for the October 45 put. His orig­ inal risk was $300. IfXYZ continues to rise in price and the puts in the spread expire worthless, the net loss will still be only $300 plus additional commissions. Admittedly, the commissions for the spread will increase the loss slightly, but they are small in comparison to the debit of the position ($300). On the other hand, if the stock should fall back only slightly, to 47 by expiration, the spread will break even. At expiration, with XYZ at 47, the in-the-money October 50 put will be worth 3 points and the out­ of-the-money October 45 put will expire worthless. Thus, the investor will recover his $300 cost, except for commissions, with XYZ at 47 at expiration. His break-even point is raised from 42 to 47, a substantial improvement of his chances for recovery. The implementation of this spread strategy reduces the profit potential of the position, however. The maximum potential of the spread is 2 points. If XYZ is any­ where below 45 at expiration, the spread will be worth 5 points, since the October 50 put will sell for 5 points more than the October 45 put. The investor has limited his potential profit to 2 points - the 5-point maximum width of the spread, less the 3 points that he paid to get into the position. He can no longer gain substantially on a large drop in price by the underlying stock. This is normally of little concern to the put holder faced with an unrealized loss and the potential for a total loss. He gener­ ally would be appreciative of getting out even or of making a small profit. The cre­ ation of the spread accomplishes this objective for him. It should also be pointed out that he does not incur the maximum loss of his entire debit plus commissions, unless XYZ closes above 50 at expiration. If XYZ is ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:297 SCORE: 12.00 ================================================================================ O,apter 16: Put Option Buying 269 anywhere below 50, the October 50 will have some value and the investor will be able to recover something from the position. This is distinctly different from the original put holding of the October 45, whereby the maximum loss would be incurred unless the stock were below 45 at expiration. Thus, the introduction of the spread also reduces the chances of having to realize the maximum loss. In summary, the put holder faced with an unrealized loss may be able to create a spread by selling twice the number of puts that he is currently long and simultane­ ously buying the put at the next higher strike. This action should be used only if the spread can be transacted at a small debit or, preferably, at even money (zero debit). The spread position offers a much better chance of breaking even and also reduces the possibility of having to realize the maximum loss in the position. However, the introduction of these loss-limiting measures reduces the maximum potential of the position if the underlying stock should subsequently decline in price by a significant amount. Using this spread strategy for puts would require a margin account, just as calls do. THE CALENDAR SPREAD STRATEGY Another strategy is sometimes available to the put holder who has an unrealized loss. If the put that he is holding has an intermediate-term or long-term expiration date, he might be able to create a calendar spread by selling the near-term put against the put that he currently holds. Example: An investor bought an XYZ October 45 put for 3 points when the stock was at 45. The stock rises to 48, moving in the wrong direction for the put buyer, and his put falls in value to 1 ½. He might, at that time, consider selling the near-term July 45 put for 1 point. The ideal situation would be for the July 45 put to expire worth­ less, reducing the cost of his long put by 1 point. Then, if the underlying stock declined below 45, he could profit after July expiration. The major drawback to this strategy is that little or no profit will be made - in fact, a loss is quite possible - if the underlying stock falls back to 45 or below before the near-term July option expires. Puts display different qualities in their time value premiums than calls do, as has been noted before. With the stock at 45, the differ­ ential between the July 45 put and the October 45 put might not widen much at all. This would mean that the spread has not gained anything, and the spreader has a loss equal to his commissions plus the initial unrealized loss. In the example above, ifXYZ dropped quickly back to 45, the July 45 might be worth 1 ½ and the October worth 2½. At this point, the spreader would have a loss on both sides of his spread: He sold the July 45 put for 1 and it is now 1 ½; he bought the October 45 for 3 and it is now ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:298 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:302 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:303 SCORE: 15.00 ================================================================================ G,pter 17: Put Buying in Conjunction with Common Stock Ownership TAX CONSIDERATIONS 275 Although tax considerations are covered in detail in a later chapter, an important tax law concerning the purchase of puts against a common stock holding should be men­ tioned at this time. If the stock owner is already a long-term holder of the stock at the time that he buys the put, the put purchase has no effect on his tax status. Similarly, if the stock buyer buys the stock at the time that he buys the put and identifies the position as a hedge, there is no effect on the tax status of his stock. However, if one Is currently a short-tenn holder of the common stock at the time that he buys a put, he eliminates any accrued holding period on his common stock. Moreover, the hold­ ing period for that stock does not begin again until the put is sold. Example: Assume the long-term holding period is 6 months. That is, a stock owner must own the stock for 6 months before it can be considered a long-term capital gain. An investor who bought the stock and held it for 5 months and then purchased a put would wipe out his entire holding period of 5 months. Suppose he then held the put and the stock simultaneously for 6 months, liquidating the put at the end of 6 months. His holding period would start all over again for that common stock. Even though he has owned the stock for 11 months - 5 months prior to the put purchase and 6 months more while he simultaneously owned the put - his holding period for tax pur­ poses is considered to be zero! This law could have important tax ramifications, and one should consult a tax advisor if he is in doubt as to the effect that a put purchase might have on the taxability of his common stock holdings. PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER Since put purchases afford protection to the owner of common stock, some investors naturally feel that the same protective feature could be used to limit their downside risk in the covered call writing strategy. Recall that the covered call writing strategy involves the purchase of stock and the sale of a call option against that stock. The cov­ ered write has limited upside profit potential and offers protection to the downside in the amount of the call premium. The covered writer will make money if the stock falls a little, remains unchanged, or rises by expiration. The covered writer can actually lose money only if the stock falls by more than the call premium received. He has poten­ tially large downside losses. This strategy is known as a protective collar or, more sim­ ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.) ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:304 SCORE: 0.00 ================================================================================ 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 stiike 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 nwney 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 ovvnership 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 1isk 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:305 SCORE: 15.00 ================================================================================ 0.,,,,, I 7: Put Buying in Conjundion with Common Stock Ownership JAX CONSIDERATIONS 275 Although tax considerations are covered in detail in a later chapter, an important tax law concerning the purchase of puts against a common stock holding should be men­ tioned at this time. If the stock owner is already a long-term holder of the stock at the time that he buys the put, the put purchase has no effect on his tax status. Similarly, if the stock buyer buys the stock at the time that he buys the put and identifies the position as a hedge, there is no effect on the tax status of his stock. However, if one is currently a short-term holder of the comrrwn stock at the time that he buys a put, he eliminates any accrued holding period on his comrrwn stock. Moreover, the hold­ ing period for that stock does not begin again until the put is sold. Example: Assume the long-term holding period is 6 months. That is, a stock owner must own the stock for 6 months before it can be considered a long-term capital gain. An investor who bought the stock and held it for 5 months and then purchased a put would wipe out his entire holding period of 5 months. Suppose he then held the put and the stock simultaneously for 6 months, liquidating the put at the end of 6 months. His holding period would start all over again for that common stock. Even though he has owned the stock for 11 months - 5 months prior to the put purchase and 6 months more while he simultaneously owned the put - his holding period for tax pur­ poses is considered to be zero! This law could have important tax ramifications, and one should consult a tax advisor if he is in doubt as to the effect that a put purchase might have on the taxability of his common stock holdings. PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER Since put purchases afford protection to the owner of common stock, some investors naturally feel that the same protective feature could be used to limit their downside risk in the covered call writing strategy. Recall that the covered call writing strategy involves the purchase of stock and the sale of a call option against that stock. The cov­ ered write has limited upside profit potential and offers protection to the downside in the amount of the call premium. The covered writer will make money if the stock falls a little, remains unchanged, or rises by expiration. The covered writer can actually lose money only if the stock falls by more than the call premium received. He has poten­ tially large downside losses. This strategy is known as a protective collar or, more sim­ ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.) ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:306 SCORE: 10.00 ================================================================================ 276 Part Ill: Put Option Strategies The purchase of an out-of the-money put option can eliminate the risk of large potential losses for the covered write, although the money spent for the put purchase will reduce the overall return from the covered write. One must therefore include the put cost in his initial calculations to determine if it is worthwhile to buy the put. Example: X'YZ is at 39 and there is an XYZ October 40 call selling for 3 points and an XYZ October 35 put selling for ½ point. A covered write could be established by buy­ ing the common at 39 and selling the October 40 call for 3. This covered write would have a maximum profit potential of 4 points if XYZ were anywhere above 40 at expi­ ration. The write would lose money if XYZ were anywhere below 36, the break-even point, at October expiration. By also purchasing the October 35 put at the time the covered write is initiated, the covered writer will limit his profit potential slightly, but will also greatly reduce his risk potential. If the put purchase is added to the covered write, the maximum profit potential is reduced to 3½ points at October expiration. The break-even point moves up to 36½, and the writer will experience some loss if XYZ is below 36½ at expiration. However, the most that the writer could lose would be 1 ¼ points if XYZ were below 35 at expiration. The purchase of the put option produces this loss-limiting effect. Table 17-2 and Figure 17-2 depict the profitability of both the regular covered write and the covered write that is protected by the put purchase. Commissions should be carefully included in the covered writer's return calcula­ tions, as well as the cost of the put. It was demonstrated in Chapter 2 that the covered writer must include all commissions and margin interest expenses as well as all divi­ dends received in order to produce an accurate "total return" picture of the covered write. Figure 17-2 shows that the break-even point is raised slightly and the overall prof­ it potential is reduced by the purchase of the put. However, the maximum risk is quite small and the writer need never be forced to roll down in a disadvantageous situation. Recall that the covered writer who does not have the protective put in place is forced to roll down in order to gain increased downside protection. Rolling down merely means that he buys back the call that is currently written and writes another call, with a lower striking price, in its place. This rolling-down action can be helpful if the stock stabilizes after falling; but if the stock reverses and climbs upward in price again, the covered writer who rolled down would have limited his gains. In fact, he may even have "locked in" a loss. The writer who has the protective put need not be bothered with such things. He never has to roll down, for he has a limited maximum loss. Therefore, he should never get into a "locked-in" loss situation. This can be a great advantage, especially from an emotional viewpoint, because the writer is never forced to make a decision as to the future price of the stock in the middle of the stock's decline. With the put in place, he can feel free to take no action at all, since his overall loss is limited. If the stock should rally upward later, he will still be in a position to make his maximum profit. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:307 SCORE: 0.00 ================================================================================ Chapter 17: Put Buying in Conjundion with Common Stock Ownership TABLE 17·2. Comparison of regular and protected covered writes. XYZ Price at Stock October 40 October 35 Expiration Profit Call Profit Put Profit 25 -$1,400 +$300 +$950 30 900 + 300 + 450 35 400 + 300 - 50 36.50 250 + 300 - 50 38 100 + 300 - 50 40 + 100 + 300 - 50 45 + 600 - 200 - 50 50 + 1,100 - 700 - 50 FIGURE 17-2. Covered call write protected by a put purchase. C 0 e ·5. X LU co $0 CJ) CJ) 0 .J 0 ~ -$150 a.. ,, },.,,' ; ,, Regular Covered ,,' Write/ 36 / , , ; ,,' +$400 ,----------➔ ,,,' _____ ...,.. , +$350 ,,,' 40 Stock Price at Expiration 277 Total Profit -$150 - 150 - 150 0 + 150 + 350 + 350 + 350 The longer-term effects of buying puts in combination with covered writes are not easily definable, but it would appear that the writer reduces his overall rate of return slightly by buying the puts. This is because he gives something away if the stock falls slightly, remains unchanged, or rises in price. He only "gains" something if the stock falls heavily. Since the odds of a stock falling heavily are small in compari­ son to the other events (falling slightly, remaining unchanged, or rising), the writer will be gaining something in only a small percentage of cases. However, the put buy­ ing strategy may still prove useful in that it removes the emotional uncertainty of ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:324 SCORE: 0.00 ================================================================================ CH.APTER 19 The Sale of a Put The buyer of a put stands to profit if the underlying stock drops in price. As might then be expected, the seller of a put will make money if the underlying stock increas­ es in price. The uncovered sale of a put is a more common strategy than the covered sale of a put, and is therefore described first. It is a bullishly-oriented strategy. THE UNCOVERED PUT SALE Since the buyer of a put has a right to sell stock at the striking price, the writer of a put is obligating himself to buy that stock at the striking price. For assuming this obli­ gation, he receives the put option premium. If the underlying stock advances and the put expires worthless, the put writer will not be assigned and he could make a maxi­ mum profit equal to the premium received. He has large downside risk, since the stock could fall substantially, thereby increasing the value of the written put and caus­ ing large losses to occur. An example will aid in explaining these general statements about risk and reward. Example: XYZ is at 50 and a 6-month put is selling for 4 points. The naked put writer has a fixed potential profit to the upside - $400 in this example and a large poten­ tial loss to the downside (Table 19-1 and Figure 19-1). This downside loss is limited only by the fact that a stock cannot go below zero. The collateral requirement for writing naked puts is the same as that for writ­ ing naked calls. The requirement is equal to 20% of the current stock price plus the put premium minus any out-of-the-money amount. Example: If XYZ is at 50, the collateral requirement for writing a 4-point put with a striking price of 50 would be $1,000 (20% of 5,000) plus $400 for the put premium 292 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:325 SCORE: 10.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:326 SCORE: 53.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:327 SCORE: 38.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:328 SCORE: 5.00 ================================================================================ 296 Part Ill: Put Option Strategies other available put writing positions before deciding to write another put on the sam<' underlying stock. His commission costs are the same if he remains in XYZ stock or if he goes on to a put writing position in a different stock. EVALUATING A NAKED PUT WRITE The computation of potential returns from a naked put write is not as straightforward as were the computations for covered call writing. The reason for this is that the col­ lateral requirement changes as the stock moves up or down, since any naked option position is marked to the market. The most conservative approach is to allow enough collateral in the position in case the underlying stock should fall, thus increasing the requirement. In this way, the naked put writer would not be forced to prematurely close a position because he cannot maintain the margin required. Example: XYZ is at 50 and the October 50 put is selling for 4 points. The initial col­ lateral requirement is 20% of 50 plus $400, or $1,400. There is no additional require­ ment, since the stock is exactly at the striking price of the put. Furthermore, let us assume that the writer is going to close the position should the underlying stock fall to 43. To maintain his put write, he should therefore allow enough margin to collat­ eralize the position if the stock were at 43. The requirement at that stock price would be $1,560 (20% of 43 plus at least 7 points for the in-the-money amount). Thus, the put writer who is establishing this position should allow $1,560 of collateral value for each put written. Of course, this collateral requirement can be reduced by the amount of the proceeds received from the put sale, $400 per put less commissions in this example. If we assume that the writer sells 5 puts, his gross premium inflow would be $2,000 and his commission expense would be about $75, for a net premi­ um of $1,925. Once this information has been determined, it is a simple matter to determine the maximum potential return and also the downside break-even point. To achieve the maximum potential return, the put would expire worthless with the underlying stock above the striking price. Therefore, the maximum potential profit is equal to the net premium received. The return is merely that profit divided by the collateral used. In the example above, the maximum potential profit is $1,925. The collateral required is $1,560 per put (allowing for the stock to drop to 43) or $7,800 for 5 puts, reduced by the $1,925 premium received, for a total requirement of $5,875. The potential return is then $1,925 divided by $5,875, or 32.8%. Table 19-2 summarizes these calculations. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:334 SCORE: 20.00 ================================================================================ CHAPTER 20 The Sale of a Straddle Selling a straddle involves selling both a put and a call with the same terms. As with any type of option sale, the straddle sale may be either covered or uncovered. Both uses are fairly common. The covered sale of a straddle is very similar to the covered call writing strategy and would generally appeal to the same type of investor. The uncovered straddle write is more similar to ratio call writing, and is attractive to the more aggressive strategist who is interested in selling large amounts of time premi­ um in hopes of collecting larger profits if the underlying stock remains fairly stable. THE COVERED STRADDLE WRITE In this strategy, one owns the underlying stock and simultaneously writes a straddle on that stock. This may be particularly appealing to investors who are already involved in covered call writing. In reality, this position is not totally covered - only the sale of the call is covered by the ownership of the stock. The sale of the put is uncovered. However, the name "covered straddle" is generally used for this type of position in order to distinguish it from the uncovered straddle write. Example: XYZ is at 51 and an XYZ January 50 call is selling for 5 points while an XYZ January 50 put is selling for 4 points. A covered straddle write would be established by buying 100 shares of the underlying stock and simultaneously selling one put and one call. The similarity between this position and a covered call writer's position should be obvious. The covered straddle write is actually a covered write - long 100 shares of XYZ plus short one call - coupled with a naked put write. Since the naked put write has already been shown to be equivalent to a covered call write, this posi­ tion is quite similar to a 200-share covered call write. In fact, all the profit and loss 302 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:335 SCORE: 20.00 ================================================================================ er 20: The Sale of a Straddle 303 aracteristics of a covered call write are the same for the covered straddle write. There is limited upside profit potential and potentially large downside risk. Readers will remember that the sale of a naked put is equivalent to a covered call write. Hence, a covered straddle write can be thought of either as the equivalent of a 200-share covered call write, or as the sale of two uncovered puts. In fact, there •• some merit to the strategy of selling two puts instead of establishing a covered straddle write. Commission costs would be smaller in that case, and so would the ini­ tial investment required (although the introduction of leverage is not always a good tlting). The maximum profit is attained if XYZ is anywhere above the striking price of 50 at expiration. The amount of maximum profit in this example is $800: the premi­ um received from selling the straddle, less the 1-point loss on the stock if it is called 11way at 50. In fact, the maximum profit potential of a covered straddle write is quick­ ly computed using the following formula: Maximum profit = Straddle premium + Striking price - Initial stock price The break-even point in this example is 46. Note that the covered writing por­ tion of this example buying stock at 51 and selling a call for 5 points - has a break­ even point of 46. The naked put portion of the position has a break-even point of 46 as well, since the January 50 put was sold for 4 points. Therefore, the combined posi­ tion - the covered straddle write - must have a break-even point of 46. Again, this observation is easily defined by an equation: B ak . Stock price + Strike price - Straddle premium re -even pnce = 2 Table 20-1 and Figure 20-1 compare the covered straddle write to a 100-share cov­ ered call write of the XYZ January 50 at expiration. The attraction for the covered call writer to become a covered straddle writer is that he may be able to increase his return without substantially altering the parame­ ters of his covered call writing position. Using the prices in Table 20-1, if one had decided to establish a covered write by buying XYZ at 51 and selling the January 50 call at 5 points, he would have a position with its maximum potential return anywhere above 50 and with a break-even point of 46. By adding the naked put to his covered call position, he does not change the price parameters of his position; he still makes his maximum profit anywhere above 50 and he still has a break-even point of 46. Therefore, he does not have to change his outlook on the underlying stock in order to become a covered straddle writer. The investment is increased by the addition of the naked put, as are the poten­ tial dollars of profit if the stock is above 50 and the potential dollars of loss if the stock ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:336 SCORE: 5.00 ================================================================================ 304 Part Ill: Put Option Strategies TABLE 20-1. Results at expiration of covered straddle write. Stock (A) 100-Shore (8) Put Price Covered Write Write 35 40 46 50 60 FIGURE 20-1. -$1, 100 600 0 + 400 + 400 Covered straddle write. +$800 § +$400 e ·5. ~ al en $0 en 0 ...J c5 e a. ~, ,,' ,, ,, ,, ,, ,, ,, ,, -$1, 100 600 0 + 400 + 400 100-Share Covered Call Write ~-----------------► , 46 50 Stock Price at Expiration Covered Straddle Write (A+ 8) -$2,200 - 1,200 0 + 800 + 800 is below 46 at expiration. The covered straddle writer loses money twice as fast on the downside, since his position is similar to a 200-share covered write. Because the commissions are smaller for the naked put write than for the covered call write, the covered call writer who adds a naked put to his position will generally increase his return somewhat. Follow-up action can be implemented in much the same way it would be for a covered call write. Whenever one would normally roll his call in a covered situation, ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:337 SCORE: 23.00 ================================================================================ t,r 20: The Sale ol a Straddle 305 now rolls the entire straddle - rolling down for protection, rolling up for an ease in profit potential, and rolling forward when the time value premium of the die dissipates. Rolling up or down would probably involve debits, unless one led to a longer maturity. Some writers might prefer to make a slight adjustment to the covered straddle ting strategy. Instead of selling the put and call at the same price, they prefer to ell an out-of-the-money put against the covered call write. That is, if one is buying XYZ at 50 and selling the call, he might then also sell a put at 45. This would increase his upside profit potential and would allow for the possibility of both options expir­ ing worthless if XYZ were anywhere between 45 and 50 at expiration. Such action would, of course, increase the potential dollars of risk if XYZ fell below 45 by expira­ tion, but the writer could always roll the call down to obtain additional downside pro­ tection. One final point should be made with regard to this strategy. The covered call writer who is writing on margin and is fully utilizing his borrowing power for call writ­ ing will have to add additional collateral in order to write covered straddles. This is because the put write is uncovered. However, the covered call writer who is operat­ ing on a cash basis can switch to the covered straddle writing strategy without put­ ting up additional funds. He merely needs to move his stock to a margin account and use the collateral value of the stock he already owns in order to sell the puts neces­ sary to implement the covered straddle writes. THE UNCOVERED STRADDLE WRITE In an uncovered straddle write, one sells the straddle without owning the underlying stock. In broad terms, this is a neutral strategy with limited profit potential and large risk potential. However, the probability of making a profit is generally quite large, and methods can be implemented to reduce the risks of the strategy. Since one is selling both a put and a call in this strategy, he is initially taking in large amounts of time value premium. If the underlying stock is relatively unchanged at expiration, the straddle writer will be able to buy the straddle back for its intrinsic value, which would normally leave him with a profit. Example: The following prices exist: XYZ common, 45; XYZ January 45 call, 4; and XYZ January 45 put, 3. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:338 SCORE: 0.00 ================================================================================ 306 Part Ill: Put Option Strategies A straddle could be sold for 7 points. If the stock were above 38 and below 52 at expi­ ration, the straddle writer would profit, since the in-the-money option could ht· bought back for less than 7 points in that case, while the out-of-the-money option expires worthless (Table 20-2). TABLE 20-2. The naked straddle write. XYZ Price at Call Put Total Expiration Profit Profit Profit 30 +$ 400 -$1,200 -$800 35 + 400 700 - 300 38 + 400 400 0 40 + 400 200 + 200 45 + 400 + 300 + 700 50 100 + 300 + 200 52 300 + 300 0 55 600 + 300 - 300 60 - 1,100 + 300 - 800 Notice that Figure 20-2 has a shape like a roof. The maximum potential profit point is at the striking price at expiration, and large potential losses exist in either direction if the underlying stock should move too far. The reader may recall that the ratio call writing strategy - buying 100 shares of the underlying stock and selling two calls - has the same profit graph. These two strategies, the naked straddle write and the ratio call write, are equivalent. The two strategies do have some differences, of course, as do all equivalent strategies; but they are similar in that both are highly probabilistic strategies that can be somewhat complex. In addition, both have large potential risks under adverse market conditions or if follow-up strategies are not applied. The investment required for a naked straddle is the greater of the requirement on the call or the put. In general, this means that the margin requirement is equal to the requirement for the in-the-money option in a simple naked write. This require­ ment is 20% of the stock price plus the in-the-money option premium. The straddle writer should allow enough collateral so that he can take whatever follow-up actions he deems necessary without having to incur a margin call. If he is intending to close out the straddle if the stock should reach the upside break-even point - 52 in the example above - then he should allow enough collateral to finance the position with ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:339 SCORE: 4.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:340 SCORE: 12.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:341 SCORE: 4.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:369 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:370 SCORE: 16.00 ================================================================================ 334 Part Ill: Put Option Strategies In a neutral calendar spread, one sets up the spread with the idea of closing the spread when the near-term call or put expires. In this type of spread, the maximum profit will be realized if the stock is exactly at the striking price at expiration. The spreader is merely attempting to capitalize on the fact that the time value premium disappears more rapidly from a near-term option than it does from a longer-term one. Example: XYZ is at 50 and a January 50 put is selling for 2 points while an April 50 put is selling for 3 points. A neutral calendar spread can be established for a 1-point debit by selling the January 50 put and buying the April 50 put. The investment required for this position is the amount of the net debit, and it must be paid for in full. If XYZ is exactly at 50 at January expiration, the January 50 put will expire worth­ less and the April 50 put will be worth about 2 points, assuming other factors are the same. The neutral spreader would then sell the April 50 put for 2 points and take his profit. The spreader's profit in this case would be one point before commissions, because he originally paid a 1-point debit to set up the spread and then liquidates the position by selling the April 50 put for 2 points. Since commission costs can cut into available profits substantially, spreads should be established in a large enough quan­ tity to minimize the percentage cost of commissions. This means that at least 10 spreads should be set up initially. In any type of calendar spread, the risk is limited to the amount of the net debit. This maximum loss would be realized if the underlying stock moved substantially far away from the striking price by the time the near-term option expired. If this hap­ pened, both options would trade at nearly the same price and the differential would shrink to practically nothing, the worst case for the calendar spreader. For example, if the underlying stock drops substantially, say to 20, both the near-term and the long­ term put would trade at nearly 30 points. On the other hand, if the underlying stock rose substantially, say to 80, both puts would trade at a very low price, say 1/15 or 1/s, and again the spread would shrink to nearly zero. Neutral call calendar spreads are generally superior to neutral put calendar spreads. Since the amount of time value premium is usually greater in a call option (unless the underlying stock pays a large dividend), the spreader who is interested in selling time value would be better off utilizing call options. The second philosophy of calendar spreading is a more aggressive one. With put options, a bearish strategy can be constructed using a calendar spread. In this case, one would establish the spread with out-of-the-money puts. Example: With XYZ at 55, one would sell the January 50 put for 1 point and buy the April 50 put for 1 ½ points. He would then like the underlying stock to remain above the striking price until the near-term January put expires. If this happens, he would ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:371 SCORE: 12.00 ================================================================================ Chapter 22: Basic Put Spreads 335 make the I-point profit from the sale of that put, reducing his net cost for the April 50 put to ½ point. Then, he would become bearish, hoping for the underlying stock to decline in price substantially before April expiration in order that he might be able to generate large profits on the April 50 put he holds. Just as the bullish calendar spread with calls can be a relatively attractive strat­ egy, so can the bearish calendar spread with puts. Granted, two criteria have to be fulfilled in order for the position to work to the optimum: The near-term put must expire worthless, and then the underlying stock must drop in order to generate prof­ its on the long side. Although these conditions may not occur frequently, one prof­ itable situation can more than make up for several losing ones. This is true because the initial debit for a bearish calendar spread is small, ½ point in the example above. Thus, the losses will be small and the potential profits could be very large if things work out right. The aggressive spreader must be careful not to "leg out" of his spread, since he could generate a large loss by doing so. The object of the strategy is to accept a rather large number of small losses, with the idea that the infrequent large profits will more than offset the sum of the losses. If one generates a large loss somewhere along the way, this may ruin the overall strategy. Also, if the underlying stock should fall to the striking price before the near-term put expires, the spread will normally have widened enough to produce a small profit; that profit should be taken by closing the spread at that time. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:372 SCORE: 0.00 ================================================================================ Spreads Cotnbining Calls and Puts Certain types of spreads can be constructed that utilize both puts and calls. One of these strategies has been discussed before: the butterfly spread. However, other strategies exist that off er potentially large profits to the spreader. These other strate­ gies are all variations of calendar spreads and/or straddles that involve both put and call options. THE BUTTERFLY SPREAD This strategy has been described previously, although its usage in Chapter 10 was restricted to constructing the spread with calls. Recall that the butterfly spread is a neutral position that has limited risk as well as limited profits. The position involves three striking prices, utilizing a bull spread between the lower two strikes and a bear spread between the higher two strikes. The maximum profit is realized at the middle strike at expiration, and the maximum loss is realized if the stock is above the higher strike or below the lower strike at expiration. Since either a bull spread or a bear spread can be constructed with puts or calls, it should be obvious that a butterfly spread ( consisting of both a bull spread and a bear spread) can be constructed in a number of ways. In fact, there are four ways in which the spread can be established. If option prices are fairly balanced - that is, the arbitrageurs are keeping prices in line - any of the four ways will have the same potential profits and losses at expiration of the options. However, because of the ways in which puts and calls behave prior to their expiration, certain advantages or disad- 336 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:376 SCORE: 4.00 ================================================================================ 340 Part Ill: Put Option Strategies to look at it is this: The sale of the put spread reduces the call price down to a more moderate level, one that might be in line with its "theoretical value." In other words, the call would not be considered expensive if it were priced at 7 instead of 10. The sale of the put spread can be considered a way to reduce the overall cost of the call. Of course, the sale of the put spread brings some extra risk into the position because, if the stock were to fall dramatically, the put spread could lose 7 points ( the width of the strikes in the spread, 10 points, less the initial credit received, 3 points). This, added to the call's cost of 10 points, means that the entire risk here is 17 points. In fact, that is the margin required for this spread as well. Thus, the overall spread still has limited risk, because both the call purchase and the put credit spread are lim­ ited-risk strategies. However, the total risk of the two combined is larger than for either one separately. Remember that one must be bullish on the underlying in order to employ this strategy. So, if his analysis is correct, the upside is what he wants to maximize. If he is wrong on his outlook for the stock, then he needs to employ some sort of stop-loss measures before the maximum risk of the position is realized. The resulting position is shown in Figure 23-1, along with two other plots. The straight line marked "Spread at expiration" shows how the profitability of the call pur­ chase combined with a bull spread would look at December expiration. In addition, there is a plot with straight lines of the purchase of the December 100 call for 10 points. That plot can be compared with the three-way spread to see where extra risk and reward occur. Note that the three-way spread does better than the outright pur­ chase of the December 100 call as long as the stock is higher than 87 at expiration. Since the stock is initially at 100 and,since one is initially bullish on the stock, one would have to surmise that the odds of it falling to 87 are fairly small. Thus, the three­ way spread outperforms the outright purchase of the call over a large range of stock prices. The final plot in Figure 23-1 is that of the three-way spread's profit and losses halfway to the expiration date. You can see that it looks much like the profitability of merely owning a call: The curve has the same shape as the call pricing curve shown in Chapter 1. Hence, this three-way strategy can often be more attractive and more profitable than merely owning a call option. Remember, though, that it does increase risk and require a larger collateral deposit than the outright purchase of the at-the-money call would. One can experiment with this strategy, too, in that he might consider buying an out-of-the-money call and selling a put spread that brings in enough credit to com­ pletely pay for the call. In that way, he would have no risk as long as the stock remained above the higher striking price used in the put credit spread. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:377 SCORE: 12.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:378 SCORE: 0.00 ================================================================================ 342 Part Ill: Put Option Strategies FIGURE 23-2. Put buy and call credit (bear) spread. +$1,000 Halfway to Expiration / Stock 0 60 110 -e a. -$1,000 At Expiration -$2,000 The curved line on Figure 23-2 shows how the three-way spread would behave if one looked at it halfway to its expiration date. In that case, it has a curved appear­ ance much like the outright purchase of a put option. Thus, this strategy could be appealing to bearishly-oriented traders, especially when the options are expensive. It might have certain advantages over an outright put purchase in that case, but it does require a larger margin investment and has theo­ retically larger risk. A SIMPLE FOLLOW-UP ACTION FOR BULL OR BEAR SPREADS Another way of combining puts and calls in a spread can sometimes be used when one has a bull or bear spread already in place. Suppose that one owns a call bull spread and the underlying stock has advanced nicely. In fact, it is above both of the strikes used in the spread. However, as is often the case, the bull spread may not have widened out to its maximum profit potential. One can use the puts for two purposes at this point: (1) to determine whether the call spread is trading at a "reasonable" value, and (2) to try to lock in some profits. First, let's look at an example of the "rea­ sonable value" verification. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:380 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:381 SCORE: 12.00 ================================================================================ Chapter 23: Spreads Combining Calls and Puts 345 THREE USEFUL BUT COMPLEX STRATEGIES The three strategies presented in this section are all designed to limit risk while allowing for large potential profits if correct market conditions develop. Each is a combination strategy - that is, it involves both puts and calls and each is a calendar strategy, in which near-term options are sold and longer-term options are bought. (A fourth strategy that is similar in nature to those about to be discussed is presented in the next chapter.) Although all of these are somewhat complex and are for the most advanced strategist, they do provide attractive risk/reward opportunities. In addition, the strategies can be employed by the public customer; they are not designed strict­ ly for professionals. All three strategies are described conceptually in this section; specific selection criteria are presented in the next section. A TWO-PRONGED ATTACK {THE CALENDAR COMBINATION} A bullish calendar spread was shown to be a rather attractive strategy. A bullish call calendar spread is established with out-of-the-money calls for a relatively small debit. If the near-term call expires worthless and the stock then rises substantially before the longer-term call expires, the profits could potentially be large. In any case, the risk is limited to the small debit required to establish the spread. In a similar man­ ner, the bearish calendar spread that uses put options can be an attractive strategy as well. In this strategy, one would set up the spread with out-of-the-money puts. He would then want the near-term put to expire worthless, followed by a substantial drop in the stock price in order to profit on the longer-term put. Since both strategies are attractive by themselves, the combination of the two should be attractive as well. That is, with a stock midway between two striking prices, one might set up a bullish out-of-the-money call calendar spread and simultaneously establish a bearish out-of-the-money put calendar spread. If the stock remains rela­ tively stable, both near-term options would expire worthless. Then a substantial stock price movement in either direction could produce large profits. With this strategy, the spreader does not care which direction the stock moves after the near options expire worthless; he only hopes that the stock becomes volatile and moves a large dis­ tance in either direction. Example: Suppose that the following prices exist three months before the January options expire: January 70 call: 3 April 70 call: 5 XYZ common: 65 January 60 put: 2 April 60 put: 3 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:382 SCORE: 0.00 ================================================================================ 346 Part Ill: Put Option Strategies The bullish portion of this combination of calendar spreads would be set up by sell­ ing the shorter-term January 70 call for 3 points and simultaneously buying the longer-term April 70 call for 5 points. This portion of the spread requires a 2-point debit. The bearish portion of the spread would be constructed using the puts. The near-term January 60 put would be sold for 2 points, while the longer-term April 60 put would be bought for 3. Thus, the put portion of the spread is a I-point debit. Overall, then, the combination of the calendar spreads requires a 3-point debit, plus commissions. This debit is the required investment; no additional collateral is required. Since there are four options involved, the commission cost will be large. Again, establishing the spreads in quantity can reduce the percentage cost of com­ missions. Note that all the options involved in this position are initially out-of-the-money. The stock is below the striking price of the calls and is above the striking price of the puts. One has sold a near-term put and call combination and purchased a longer-term combination. For nomenclature purposes, this strategy is called a "calendar combi­ nation." There are a variety of possible outcomes from this position. First, it should be understood that the risk is limited to the amount of the initial debit, 3 points in this example. If the underlying stock should rise dramatically or fall dramatically before the near-term options expire, both the call spread and the put spread will shrink to nearly nothing. This would be the least desirable result. In actual practice, the spread would probably have a small positive differential left even after a premature move by the underlying stock, so that the probability of a loss of the entire debit would be small. If the near-term options both expire worthless, a profit will generally exist at that time. Example: IfXYZ were still at 65 at January expiration in the prior example, the posi­ tion should be profitable at that time. The January call and put would expire worth­ less with XYZ at 65, and the April options might be worth a total of 5 points. The spread could thus be closed for a profit with XYZ at 65 in January, since the April options could be sold for 5 points and the initial "cost" of the spread was only 3 points. Although commissions would substantially reduce this 2-point gross profit, there would still be a good percentage profit on the overall position. If the strategist decides to take his profit at this time, he would be operating in a conservative manner. However, the strategist may want to be more aggressive and hold onto the April combination in hopes that the stock might experience a substantial movement before those options expire. Should this occur, the potential profits could be quite large. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:384 SCORE: 8.00 ================================================================================ 348 Part Ill: Put Option Strategies In summary, this is a reasonable strategy if one operates it over a period of time long enough to encompass several market cycles. The strategist must be careful not to place a large portion of his trading capital in the strategy, however, since even though the losses are limited, they still represent his entire net investment. A varia­ tion of this strategy, whereby one sells more options than he buys, is described in the next chapter. THE CALENDAR STRADDLE Another strategy that combines calendar spreads on both put and call options can be constructed by selling a near-term straddle and simultaneously purchasing a longer­ term straddle. Since the time value premium of the near-term straddle will decrease more rapidly than that of the longer-term straddle, one could make profits on a lim­ ited investment. This strategy is somewhat inferior to the one described in the pre­ vious section, but it is interesting enough to examine. Example: Suppose that three months before January expiration, the following prices exist: XYZ common: 40 January 40 straddle: 5 April 40 straddle: 7 A calendar spread of the straddles could be established by selling the January 40 straddle and simultaneously buying the April 40 straddle. This would involve a cost of 2 points, or the debit of the transaction, plus commissions. The risk is limited to the amount of this debit up until {he time the near-term straddle expires. That is, even if XYZ moves up in price by a substantial amount or declines in price by a substantial amount, the worst that can happen is that the dif­ ference between the straddle prices shrinks to zero. This could cause one to lose an amount equal to his original debit, plus commissions. This limit on the risk applies only until the near-term options expire. If the strategist decides to buy back the near­ term straddle and continue to hold the longer-term one, his risk then increases by the cost of buying back the near-term straddle. Example: XYZ is at 43 when the January options expire. The January 40 call can now be bought back for 3 points. The put expires worthless; so the whole straddle was closed out for 3 points. The April 40 straddle might be selling for 6 points at that time. If the strategist wants to hold on to the April straddle, in hopes that the stock might experience a large price swing, he is free to do so after buying back the January ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:385 SCORE: 24.00 ================================================================================ Chapter 23: Spreads Combining Calls and Puts 349 40 straddle. However, he has now invested a total of 5 points in the position: the orig­ inal 2-point debit plus the 3 points that he paid to buy back the January 40 straddle. Hence, his risk has increased to 5 points. If XYZ were to be at exactly 40 at April expi­ ration, he would lose the entire 5 points. While the probability of losing the entire 5 points must be considered small, there is a substantial chance that he might lose more than 2 points his original debit. Thus, he has increased his risk by buying back the near-term straddle and continuing to hold the longer-term one. This is actually a neutral strategy. Recall that when calendar spreads were dis­ cussed previously, it was pointed out that one establishes a neutral calendar spread with the stock near the striking price. This is true for either a call calendar spread or a put calendar spread. This strategy - a calendar spread with straddles is merely the combination of a neutral call calendar spread and a neutral put calendar spread. Moreover, recall that the neutral calendar spreader generally establishes the position with the intention of closing it out once the near-term option expires. He is mainly interested in selling time in an attempt to capitalize on the fact that a near-term option loses time value premium more rapidly than a longer-term option does. The straddle calendar spread should be treated in the same manner. It is generally best to close it out at near-term expiration. If the stock is near the striking price at that time, a profit will generally result. To verify this, refer again to the prices in the pre­ ceding paragraph, with XYZ at 43 at January expiration. The January 40 straddle can be bought back for 3 points and the April 40 straddle can be sold for 6. Thus, the dif­ ferential between the two straddles has widened to 3 points. Since the original dif­ ferential was 2 points, this represents a profit to the strategist. The maximum profit would be realized if XYZ were exactly at the striking price at near-term expiration. In this case, the January 40 straddle could be bought back for a very small fraction and the April 40 straddle might be worth about 5 points. The differential would have widened from the original 2 points to nearly 5 points in this case. This strategy is inferior to the one described in the previous section (the "calen­ dar combination"). In order to have a chance for unlimited profits, the investor must increase his net debit by the cost of buying back the near-term straddle. Consequently, this strategy should be used only in cases when the near-term straddle appears to be extremely overpriced. Furthermore, the position should be closed at near-term expiration unless the stock is so close to the striking price at that time that the near-term straddle can be bought back for a fractional price. This fractional buy­ back would then give the strategist the opportunity to make large potential profits with only a small increase in his risk. This situation of being able to buy back the near­ term straddle at a fractional price will occur very infrequently, much more infre- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:386 SCORE: 0.00 ================================================================================ 350 Part Ill: Put Option Strategies quently than the case in which both the out-of-the-money put and call expire worth­ less in the previous strategy. Thus, the "calendar combination" strategy will afford the spreader more opportunities for large profits, and will also never force him to increase his risk. OWNING A ✓,,FREE" COMBINATION (THE ""DIAGONAL BUTTERFLY SPREAD") The strategies described in the previous sections are established for debits. This means that even if the near-term options expire worthless, the strategist still has risk. The long options he then holds could proceed to expire worthless as well, thereby leaving him with an overall loss equal to his original debit. There is another strategy involving both put and call options that gives the strategist the opportunity to own a "free" combination. That is, the profits from the near-term options could equal or exceed the entire cost of his long-term options. This strategy consists of selling a near-term straddle and simultaneously pur­ chasing both a longer-term, out-of the-money call and a longer-term, out-of the­ money put. This differs from the protected straddle write previously described in that the long options have a more distant maturity than do the short options. Example: XYZ common: 40 April 35 put: January 40 straddle: April 45 call: If one were to sell the short-term January 40 straddle for 7 points and simultaneous­ ly purchase the out-of-the-money put and call combination -April 35 put and April 45 call - he would establish a credit spread. The credit for the position is 3 points less commissions, since 7 points are brought in from the straddle sale and 4 points are paid for the out-of-the-money combination. Note that the position technically con­ sists of a bearish spread in the calls - buy the higher strike and sell the lower strike - coupled with a bullish spread in the puts - buy the lower strike and sell the higher strike. The investment required is in the form of collateral since both spreads are credit spreads, and is equal to the differential in the striking prices, less the net cred­ it received. In this example, then, the investment would be 10 points for the striking price differential (5 points for the calls and 5 points for the puts) less the 3-point credit received, for a total collateral requirement of $700, plus commissions. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:396 SCORE: 4.00 ================================================================================ 360 FIGURE 24-1. Ratio put spread. +$500 C: 0 ~ ·5. X w iil (/) $0 (/) 0 ....I 0 e a. Part Ill: Put Option Strategies Stock Price at Expiration price, plus the premium, minus the amount by which the option is out-of-the-money, the actual dollar requirement in this example would be $700 (20% of $5,000, plus the $200 premium, minus the $500 by which the January 45 put is out-of-the-money). As with all types of naked writing positions, the strategist should allow enough collater­ al for an adverse stock move to occur. This will allow enough room for stock move­ ment without forcing early liquidation of the position due to a margin call. If, in this example, the strategist felt that he might stay with the position until the stock declined to 39, he should allow $1,380 in collateral (20% of $3,900 plus the $600 in­ the-money amount). The ratio put spread is generally most attractive when the underlying stock is initially between the two striking prices. That is, if XYZ were somewhere between 45 and 50, one might find the ratio put spread used in the example attractive. If the stock is initially below the lower striking price, a ratio put spread is not as attractive, since the stock is already too close to the downside risk point. Alternatively, if the stock is too far above the striking price of the written calls, one would normally have to pay a large debit to establish the position. Although one could eliminate the debit by writing four or five short options to each put bought, large ratios have extraordi­ narily large downside risk and are therefore very aggressive. Follow-up action is rather simple in the ratio put spread. There is very little that one need do, except for closing the position if the stock breaks below the downside break-even point. Since put options tend to lose time value premium rather quickly after they become in-the-money options, there is not normally an opportunity to roll ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:397 SCORE: 16.00 ================================================================================ 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- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:398 SCORE: 4.00 ================================================================================ 362 Part Ill: Put Option Strategies less. Also, the position should be established for a credit, such that the money brought in from the sale of the near-term puts more than covers the cost of the longer-term put. If this is done and the near-term puts expire worthless, the strate­ gist will then own the longer-term put free, and large profits could result if the stock subsequently experiences a sizable downward movement. Example: If XYZ were at 55, and the January 50 put was at 1 ½ with the April 50 at 2, one could establish a ratio put calendar spread by buying the April 50 and selling two January 50 puts. This is a credit position, because the sale of the two January 50 puts would bring in $300 while the cost of the April 50 put is only $200. If the stock remains above 50 until January expiration, the January 50 puts will expire worthless and the April 50 put will be owned for free. In fact, even if the April 50 put should then expire worthless, the strategist will make a small profit on the overall position in the amount of his original credit - $100 - less commissions. However, after the Januarys have expired worthless, if XYZ should drop dramatically to 25 or 20, a very large profit would accrue on the April 50 put that is still owned. The risk in the position could be very large if the stock should drop well below 50 before the January puts expire. For example, if XYZ fell to 30 prior to January expiration, one would have to pay $4,000 to buy back the January 50 puts and would receive only $2,000 from selling out his long April 50 put. This would represent a rather large loss. Of course, this type of tragedy can be avoided by taking appropri­ ate follow-up action. Nomwlly, one would close the position if the stock fell rrwre than 8 to 10% below the striking price before the near-term puts expire. As with any type of ratio position, naked options are involved. This increases the collateral requirement for the position and also means that the strategist should allow enough collateral in order for the follow-up action point to be reached. In this exam­ ple, the initial requirement would be $750 (20% of $5,500, plus the $150 January premium, less the $500 by which the naked January 50 put is out-of-the-money). However, if the strategist decides that he will hold the position until XYZ falls to 46, he should allow $1,320 in collateral (20% of $4,600 plus the $400 in-the-money amount). Of course, the $100 credit, less commissions, generated by the initial posi­ tion can be applied against these collateral requirements. This strategy is a sensible one for the investor who is willing to accept the risk of writing a naked put. Since the position should be established with the stock above the striking price of the put options, there is a reasonable chance that the near-term puts will expire worthless. This means that some profit will be generated, and that the profit could be large if the stock should then experience a large downward move before the longer-term puts expire. One should take care, however, to limit his losses ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:434 SCORE: 4.00 ================================================================================ 394 Part Ill: Put Option Strategies Downside Protection. The actual downside break-even point might enter into one's thinking as well. A downside break-even point of 40.3 is available by using the LEAPS write, and that is a known quantity. No matter how far XYZ might fall, as long as it can recover to slightly over 40 by expiration two years from now, the investment will at least break even. A problem arises if XYZ falls to 40 quickly. If that happened, the LEAPS call would still have a significant amount of time value premium remain­ ing on it. Thus, if the investor attempted to sell his stock at that time and buy back his call, he would have a loss, not a break-even situation. The short-term write offers downside protection only to a stock price of 46.2. Of course, repeated writes of 6-month calls over the next 2 years would lower the break-even point below that level. The problem is that if XYZ declines and one is forced to keep selling 6-month calls every 6 months, he may be forced to use a lower striking price, thereby locking in a smaller profit ( or possibly even a loss) if premium levels shrink. The concepts of rolling down are described in detail in Chapter 2. A further word about rolling down may be in order here. Recall that rolling down means buying back the call that is currently written and selling another one with a lower striking price. Such action always reduces the profitability of the over­ all position, although it may be necessary to prevent further downside losses if the common stock keeps declining. Now that LEAPS are available, the short-term writer faced with rolling down may look to the LEAPS as a means of bringing in a healthy premium even though he is rolling down. It is true that a large premium could be brought into the account. But remember that by doing so, one is committing himself to sell the stock at a lower price than he had originally intended. This is why the rolling down reduces the original profit potential. If he rolls down into a LEAPS call, he is reducing his maximum profit potential for a longer period of time. Consequently, one should not always roll dm,vn into an option with a longer maturi­ ty. Instead, he should carefully analyze whether he wants to be committed for an even longer time to a position in which the underlying common stock is declining. To summarize, the large absolute premiums available in LEAPS calls may make a covered write of those calls seem unusually attractive. However, one should calcu­ late the returns available and decide whether a short-term write might not serve his purpose as well. Even though the large LEAPS premium might reduce the initial investment to a mere pittance, be aware that this creates a great amount of leverage, and leverage can be a dangerous thing. The large amount of downside protection offered by the LEAPS call is real, but if the stock falls quickly, there would definitely be a loss at the calculated downside break-even point. Finally, one cannot always roll down into a LEAPS call if trouble develops, because he will be committing himself for an even longer period of time to sell his stock at a lower price than he had originally intended. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:435 SCORE: 20.00 ================================================================================ Chapter 25: LEAPS 39S ✓,,FREE" COVERED CALL WRITES In Chapter 2, a strategy of writing expensive LEAPS options was briefly described. In this section, a more detailed analysis is offered. A certain type of covered call write, one in which the call is quite expensive, sometimes attracts traders looking for a "free ride." To a certain extent, this strategy is something of a free ride. As you might imagine, though, there can be major problems. The investment required for a covered call write on margin is 50% of the stock price, less the proceeds received from selling the call. In theory, it is possible for an option to sell for more than 50% of the stock cost. This is a margin account, a cov­ ered write could be established for "free." Let's discuss this in terms of two types of calls: the in-the-money call write and the out-of-the-money call write. Out-of-the-Money Covered Call Write. This is the simplest way to approach the strategy. One may be able to find LEAPS options that are just slightly out-of-the­ money, which sell for 50% of the stock price. Understandably, such a stock would be quite volatile. Example: GOGO stock is selling for $38 per share. GOGO has listed options, and a 2-year LEAPS call with a striking price of 40 is selling for $19. The requirement for this covered write would be zero, although some commission costs would be involved. The debit balance would be 19 points per share, the amount the broker loans you on margin. Certain brokerage firms might require some sort of minimum margin deposit, but technically there is no further requirement for this position. Of course, the leverage is infinite. Suppose one decided to buy 10,000 shares of GOGO and sell 100 calls, covered. His risk is $190,000 if the stock falls to zero! That also happens to be the debit balance in his account. Thus, for a minimal investment, one could lose a for­ tune. In addition, if the stock begins to fall, one's broker is going to want maintenance margin. He probably wouldn't let the stock slip more than a couple of points before asking for margin. If one owns 10,000 shares and the broker wants two points main­ tenance margin, that means the margin call would be $20,000. The profits wouldn't be as big as they might at first seem. The maximum gross profit potential is $210,000 if the 10,000 shares are called away at 40. The covered write makes 21 points on each share - the $40 sale price less the original cost of $19. However, one will have had to pay interest on the debit balance of $190,000 for two years. At 10%, say, that's a total of $38,000. There would also be commissions on the purchase and the sale. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:436 SCORE: 25.00 ================================================================================ 396 Part Ill: Put Option Strategies In summary, this is a position with tremendous, even dangerous, leverage. In-the-Money Covered Call Write. The situation is slightly different if the option is in-the-money to begin with. The above margin requirements actually don't quite accurately state the case for a margined covered call write. When a covered call is written against the stock, there is a catch: Only 50% of the stock price or the strike price, whichever is less, is available for "release." Thus, one will actually be required to put up more than 50% of the stock price to begin with. Example: XYZ is trading at 50, and there is a 2-year LEAPS call with a strike price of 30, selling for 25 points. One might think that the requirement for a covered call write would be zero, since the call sells for 50% of the stock price. But that's not the case with in-the-money covered calls. Margin requirement: Buy stock: 50 points Less option proceeds -25 Less margin release* -15* Net requirement: 10 points * 50% of the strike price or 50% of stock price, whichever is less. This position still has a lot ofleverage: One invests 10 points in hopes of making 5, if the stock is called away at 30. One also would have to pay interest on the 15-point debit balance, of course, for the two-year duration of the position. Furthermore, should the stock fall below the strike price, the broker would begin to require main­ tenance margin. Note that the above "formula" for the net requirement works equally well for the out-of-the-money covered call write, since 50% of the stock price is always less than 50% of the strike price in that case. To summarize this "free ride" strategy: If one should decide to use this strate­ gy, he must be extremely aware of the dangers of high leverage. One must not risk more money than he can afford to lose, regardless of how small the initial investment might be. Also, he must plan for some method of being able to make the margin pay­ ments along the way. Finally, the in-the-money alternative is probably better, because there is less probability that maintenance margin will be asked for. SELLING UNCOVERED LEAPS Uncovered option selling can be a viable strategy, especially if premiums are over­ priced. LEAPS options may be sold uncovered with the same margin requirements as short-term options. Of course, the particular characteristics of the long-term option may either help or hinder the uncovered writer, depending on his objective. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:437 SCORE: 5.00 ================================================================================ Chapter 25: LEAPS 397 Uncovered Put Selling. Naked put selling is addressed first because, as a strat­ egy, it is equivalent to covered writing, and covered writing was just discussed. Two strategies are equivalent if they have the same profit picture at expiration. Naked put selling and covered call writing are equivalent because they have the profit picture depicted in Graph I, Appendix D. Both have limited upside profit potential and large loss exposure to the downside. In general, when two strategies are equivalent, one of the two has certain advantages over the other. In this case, naked put selling is normally the more advantageous of the two because of the way margin requirements are set. One need not actually invest cash in the sale of a naked put; the margin requirement that is asked for may be satisfied with collateral. This means the naked put writer may use stocks, bonds, T-bills, or money market funds as collateral. Moreover, the actual amount of collateral that is required is less than the cash or margin investment required to buy stock and sell a call. This means that one could operate his portfolio normally - buying stock, then selling it and putting the proceeds in a Treasury bill or perhaps buying another stock - without disturbing his naked put position, as long as he maintained the collateral requirement. Consequently, the strategist who is buying stock and selling calls should probably be selling naked puts instead. This does not apply to covered writers who are writing against existing stock or who are using the incremental return concept of covered writ­ ing, because stock ownership is part of their strategy. However, the strategist who is looking to take in premium to profit if the underlying stock remains relatively unchanged or rises, while having a modicum of downside protection ( which is the definition of both naked put writing and covered writing), should be selling naked puts. As an example of this, consider the LEAPS covered write discussed previously. Example: XYZ is selling at 50. The investor is debating between a 500-share covered write using 2-year LEAPS calls or selling five 2-year LEAPS puts. The January 50 LEAPS call sells for 8½ and has two years of life, while the January 50 LEAPS put sells for 3½. Further assume that XYZ pays a dividend of $0.25 per quarter. The net investment required for the covered write is calculated as it was before. Net Investment Required - Covered Write Stock cost (500 shares @ 50) Plus stock commission Less option premiums received Plus option commissions Net cash investment + $25,000 300 - 4,250 + 100 $21,150 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:438 SCORE: 0.00 ================================================================================ 398 Part Ill: Put Option Strategies The collateral requirement for the naked put write is the same as that for any naked equity option: 20% of the stock price, plus the option price, less any out-of­ the-money amount, with an absolute minimum requirement of 15% of the stock price. Collateral Requirement - Naked Put 20% of stock price (.20 x 500 x $50) Plus option premium Less out-of-the-money amount Total collateral requirement $5,000 1,750 0 $6,750 Note that the actual premium received by the naked put seller is $1,750 less com­ missions of $100, for example, or $1,650. This net premium could be used to reduce the total collateral requirement. Now one can compare the profitability of the two investments: Return If Stock Over 50 at Expiration Stock sale {500 @ 50) Less stock commission Plus dividends earned until expiration Less net investment Net profit if exercised Net put premium received Dividends received Net profit Covered Write $25,000 300 + 1,000 - 21,150 $ 4,55_0 Naked Put Sole $1,650 0 $1,650 Now the returns can be compared, if XYZ is over 50 at expiration of the LEAPS: Return if XYZ over 50 (net profit/net investment) Naked put sale: 24.4% Covered write: 21 .5% The naked put write has a better rate of return, even before the following fact is considered. The strategist who is using the naked put write does not have to spend the $6,750 collateral requirement in the form of cash. That money can be kept in a ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:439 SCORE: 14.00 ================================================================================ Chapter 25: LEAPS 399 Treasury bill and earn interest over the two years that the put write is in place. Even if the T-bill were earning only 4% per year, that would increase the overall two-year return for the naked put sale by 8%, to 32.4%. This should make it obvious that naked put selling is rrwre strategically advantageous than covered call writing. Even so, one might rightfully wonder if LEAPS put selling is better than selling shorter-term equity puts. As was the case with covered call writing, the answer depends on what the investor is trying to accomplish. Short-term puts will not bring as much premium into the account, so when they expire, one will be forced to find another suitable put sale to replace it. On the other hand, the LEAPS put sale brings in a larger premium and one does not have to find a replacement until the longer­ term LEAPS put expires. The negative aspect to selling the LEAPS puts is that time decay won't help much right away and, even if the stock moves higher (which is ostensibly good for the position), the put won't decline in price by a large amount, since the delta of the put is relatively small. One other factor might enter in the decision regarding whether to use short­ term puts or LEAPS puts. Some put writers are actually attempting to buy stock below the market price. That is, they would not mind being assigned on the put they sell, meaning that they would buy stock at a net cost of the striking price less the pre­ mium they received from the sale of the put. If they don't get assigned, they get to keep a profit equal to the premium they received when they first sold the put. Generally, a person would only sell puts in this manner on a stock that he had faith in, so that if he was assigned on the put, he would view that as a buying opportunity in the underlying stock. This strategy does not lend itself well to LEAPS. Since the LEAPS puts will carry a significant amount of time premium, there is little (if any) chance that the put writer will actually be assigned until the life of the put shortens substantially. This means that it is unlikely that the put writer will become a stock owner via assignment at any time in the near future. Consequently, if one is attempt­ ing to wTite puts in order to eventually buy the common stock when he is assigned, he would be better served to write shorter-term puts. UNCOVERED CALL SELLING There are very few differences between using LEAPS for naked call selling and using shorter-term calls, except for the ones that have been discussed already with regard to selling uncovered LEAPS: Time value decay occurs more slowly and, if the stock rallies and the naked calls have to be covered, the call writer will normally be paying more time premium than he is used to when he covers the call. Of course, the rea­ son that one is engaged in naked call writing might shed some more light on the use of LEAPS for that purpose. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:440 SCORE: 0.00 ================================================================================ 400 Part Ill: Put Option Strategies The overriding reason that most strategists sell naked calls is to collect the time premium before the stock can rise above the striking price. These strategists gener­ ally have an opinion about the stock's direction, believing that it is perhaps trapped in a trading range or even headed lower over the short term. This strategy does not lend itself well to using LEAPS, since it would be difficult to project that the stock would remain below the strike for so long a period of time. Short LEAPS Instead of Short Stock. Another reason that naked calls are sold is as a strategy akin to shorting the common stock. In this case, in-the-money calls are sold. The advantages are threefold: l. The amount of collateral required to sell the call is less than that required to sell stock short. 2. One does not have to borrow an option in order to sell it short, although one must borrow common stock in order to sell it short. 3. An uptick is not required to sell the option, but one is required in order to sell stock short. For these reasons, one might opt to sell an in-the-money call instead of shorting stock. The profit potentials of the two strategies are different. The short seller of stock has a very large profit potential if the stock declines substantially, while the seller of an in-the-money call can collect only the call premium no matter how far the stock drops. Moreover, the call's price decline will slow as the stock nears the strike. Another way to express this is to say that the delta of the call shrinks from a number close to l (which means the call mirrors stock movements closely) to something more like 0.50 at the strike (which means that the call is only declining half as quickly as the stock). Another problem that may occur for the call seller is early assignment, a topic that is addressed shortly. One should not attempt this strategy if the underlying stock is not borrowable for ordinary short sales. If the underlying stock is not available for borrowing, it generally means that extraneous forces are at work; perhaps there is a tender offer or exchange offer going on, or some form of convertible arbitrage is tak­ ing place. In any case, if the underlying stock is not borrowable, one should not be deluded into thinking that he can sell an in-the-money call instead and have a worry­ free position. In these cases, the call will normally have little or no time premium and may be subject to early assignment. If such assignment does occur, the strategist will become short the stock and, since it is not borrowable, will have to cover the stock. At the least, he will cost himself some commissions by this unprofitable strategy; and at worst, he will have to pay a higher price to buy back the stock as well. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:441 SCORE: 32.00 ================================================================================ Chapter 25: LEAPS 401 LEAPS calls may help to alleviate this problem. Since they are such long-term calls, they are likely to have some time value premium in them. In-the-money calls that have time value premium are not normally assigned. As an alternative to shorting a stock that is not borrowable, one might try to sell an in-the-money LEAPS call, but only if it has time value premium remaining. Just because the call has a long time remaining until expiration does not mean that it must have time value premium, as will be seen in the following discussion. Finally, if one does sell the LEAPS call, he must realize that if the stock drops, the LEAPS call will not follow it completely. As the stock nears the strike, the amount of time value premium will build up to an even greater level in the LEAPS. Still, the naked call seller would make some profit in that case, and it presents a better alternative than not being able to sell the stock short at all. Early Assignment. An American-style option is one that can be exercised at any time during its life. All listed equity options, LEAPS included, are of this variety. Thus, any in-the-money option that has been sold may become subject to early assignment. The clue to whether early assignment is imminent is whether there is time value premium in the option. If the option has no time value premium - in other words, it is trading at parity or at a discount then assignment may be close at hand. The option writer who does not want to be assigned would want to cover the option when it no longer carries time premium. LEAPS may be subject to early assignment as well. It is possible, albeit far less likely, that a long-term option would lose all of its time value premium and therefore be subject to early assignment. This would certainly happen if the underlying stock were being taken over and a tender off er were coming to fruition. However, it may also occur because of an impending dividend payment, or more specifically, because the stock is about to go ex-dividend. Recall that the call owner, LEAPS calls includ­ ed, is not entitled to any dividends paid by the underlying stock. So if the call owner wants the dividend, he exercises his call on the day before the stock goes ex-dividend. This makes him an owner of the common stock just in the nick of time to get the div­ idend. What economic factors motivate him to exercise the call? If there is any time value premium at all in the call, the call holder would be better off selling the call in the open market and then purchasing the stock in the open market as well. In this manner, he would still get the dividend, but he would get a better price for his call when he sold it. If, however, there is no time value premium in the call, he does not have to bother with two transactions in the open market; he merely exercises his call in order to buy stock. All well and good, but what makes the call sell at parity before expiration? It has to do with the arbitrage that is available for any call option. In this case, the arbitrage ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:442 SCORE: 12.00 ================================================================================ 402 Part Ill: Put Option Strategies is not the simple discount arbitrage that was discussed in Chapter l when this topic was covered. Rather, it is a more complicated form that is discussed in greater detail in Chapter 28. Suffice it to say that if the dividend is larger than the interest that can be earned from a credit balance equal to the striking price, then the time value pre­ mium will disappear from the call. Example: XYZ is a $30 stock and about to go ex-dividend 50 cents. The prevailing short-term interest rate is 5% and there are LEAPS with a striking price of 20. A 50-cent quarterly dividend on a striking price of 20 is an annual dividend rate (on the strike) of 10%. Since short-term rates are much lower than that, arbitrageurs economically cannot pay out 10% for dividends and earn 5% for their credit balances. In this situation, the LEAPS call would lose its time value premium and would be a candidate for early exercise when the stock goes ex-dividend. In actual practice, the situation is more complicated than this, because the price of the puts comes into play; but this example shows the general reasoning that the arbitrageur must go through. Certain arbitrageurs construct positions that allow them to earn interest on a credit balance equal to the striking price of the call. This position involves being short the underlying stock and being long the call. Thus, when the stock goes ex-dividend, the arbitrageur will owe the dividend. If, however, the amount of the dividend is more than he vvill earn in interest from his credit balance, he will merely exercise his call to cover his short stock. This action will prevent him from having to pay out the dividend. The arbitrageur's exercise of the call means that someone is going to be assigned. If you are a writer of the call, it could be you. It is not important to under­ stand the arbitrage completely; its effect will be reflected in the marketplace in the form of a call trading at parity or a discount. Thus, even a LEAPS call with a sub­ stantial anwunt of time rernaining may be assigned if it is trading at parity. STRADDLE SELLING Straddle selling is equivalent to ratio writing and is a strategy whereby one attempts to sell ( overpriced) options in order to produce a range of stock prices within which the option seller can profit. The strategy often involves follow-up action as the stock moves around, and the strategist feels that he must adjust his position in order to pre­ vent large losses. LEAPS puts and calls might be used for this strategy. However, their long-term nature is often not conducive to the aims of straddle selling. First, consider the effect of time decay. One might normally sell a three-month straddle. If the stock "behaves" and is relatively unchanged after two months have ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:443 SCORE: 4.00 ================================================================================ Chapter 25: LEAPS 403 passed, the straddle seller could reasonably expect to have a profit of about 40% of the original straddle price. However, if one had sold a 2-year LEAPS straddle, and the stock were relatively unchanged after two months, he would only have a profit of about 7% of the original sale price. This should not be surprising in light of what has been demonstrated about the decaying of long-term options. It should make the straddle seller somewhat leery of using LEAPS, however, unless he truly thinks the options are overpriced. Second, consider follow-up action. Recall that in Chapter 20, it was shown that the bane of the straddle seller was the whipsaw. A whipsaw occurs when one makes a follow-up protective action on one side (for instance, he does something bullish because the underlying stock is rising and the short calls are losing money), only to have the stock reverse and come crashing back down. Obviously, the more time left until expiration, the more likely it is that a whipsaw will occur after any follow-up action, and the more expensive it will be, since there will be a lot of time value pre­ mium left in the options that are being repurchased. This makes LEAPS straddle selling less than attractive. LEAPS straddles may look expensive because of their large absolute price, and therefore may appear to be attractive straddle sale candidates. However, the price is often justified, and the seller of LEAPS straddles will be fighting sudden stock move­ ments without getting much benefit from the passage of time. The best time to sell LEAPS straddles is when short-term rates are high and volatilities are high as well (i.e., the options are overpriced). At least, in those cases, the seller will derive some real benefit if rates or volatilities should drop. SPREADS USING LEAPS Any of the spread strategies previously discussed can be implemented with LEAPS as well, if one desires. The margin requirements are the same for LEAPS spreads as they are for ordinary equity option spreads. One general category of spread lends itself well to using LEAPS: that of buying a longer-term option and selling a short­ term one. Calendar spreads, as well as diagonal spreads, fall into that category. The combinations are myriad, but the reasoning is the same. One wants to own the option that is not so subject to time decay, while simultaneously selling the option that is quite subject to time decay. Of course, since LEAPS are long-term and therefore expensive, one is generally taking on a large debit in such a spread and may have substantial risk if the stock performs adversely. Other risks may be pres­ ent as well. As a means of demonstrating these facts, let us consider a simple bull spread using calls. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:445 SCORE: 8.00 ================================================================================ Chapter 25: LEAPS FIGURE 25-7. Bull spread comparison at April expiration. Stock Price 405 The diagonal spread is different, however. Typically, the maximum profit poten­ tial of a bull spread is the difference in the strikes less the initial debit paid. For this diagonal spread, that would be $1,000 minus $2,050, a loss! Obviously, this simple formula is not applicable to diagonal spreads, because the purchased option still has time value premium when the written option expires. The profit graph shows that indeed the diagonal spread is the most bullish of the three. It makes its best profit at the strike of the written option - a standard procedure for any spread - and that prof­ it is greater than either of the other two spreads at April expiration ( under the sig- TABLE 25-4. Bull spread comparison at April expiration. Stock Price Short-Term Diagonal LEAPS 80 -500 -1, 100 -200 90 -500 - 600 -150 100 -500 50 - 25 110 500 750 50 120 500 550 150 140 500 150 250 160 500 50 350 180 500 - 350 450 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:446 SCORE: 32.00 ================================================================================ 406 Part Ill: Put Option Strategies nificant assumption that volatility and interest rates are unchanged). If XYZ trades higher than llO, the diagonal spread will lose some of its profit; in fact, if XYZ were to trade at a very high price, the diagonal spread would actually have a loss (see Table 25-4). Whenever the purchased LEAPS call loses its time value premium, the diag­ onal spread will not perform as well. If the common stock drops in price, the diagonal spread has the greatest risk in dollar terms but not in percentage terms, because it has the largest initial debit. If XYZ falls to 80 in three months, the spread will lose about $1,100, just over half the initial $2,050 debit. Obviously, the short-term spread would have lost 100% of its ini­ tial debit, which is only $500, at that same point in time. The diagonal spread presents an opportunity to earn more money if the under­ lying common is near the strike of the written option when the written option expires. However, if the common moves a great deal in either direction, the diagonal spread is the worst of the three. This means that the diagonal spread strategy is a neutral strategy: One wants the underlying common to remain near the written strike until the near-term option expires. This is a true statement even if the diagonal spread is under the guise of a bullish spread, as in the previous example. Many traders are fond of buying LEAPS and selling an out-of-the-money near­ term call as a hedge. Be careful about doing this. If the underlying common rises too fast and/or interest rates fall and/or volatility decreases, this could be a poor strategy. There is really nothing quite as psychologically damaging as being right about the stock, but being in the wrong option strategy and therefore losing money. Consider the above examples. Ostensibly, the spreader was bullish on XYZ; that's why he chose bull spreads. If XYZ became a wildly bullish stock and rose from 100 to 180 in three months, the diagonal spreader would have lost money. He couldn't have been happy - no one would be. This is something to keep in mind when diagonalizing a LEAPS spread. The deltas of the options involved in the spread will give one a good clue as to how it is going to perform. Recall that a short-term, in-the-money option acquires a rather high delta, especially as expiration draws nigh. However, an in-the-money LEAPS call will not have an extremely high delta, because of the vast amount of time remaining. Thus, one is short an option with a high delta and long an option with a smaller delta. These deltas indicate that one is going to lose money if the underlying stock rises in price. Consider the following situation: XYZ Stock, 120: Call Long 1 January LEAPS 100 call: Short 1 April 110 call: Position Delta 0.70 -0.90 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:447 SCORE: 12.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:448 SCORE: 4.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:505 SCORE: 0.00 ================================================================================ Chapter 28: Mathematical Applications TABLE 28-3. Distance weighting factors. 465 Option Distonce from Stock Price Distance Weighting Factor January 30 January 35 April 35 April 40 TABLE 28-4. Option's implied volatility. .091 (3/33) .061 (2/33) .061 (2/33) .212 (7 /33) .41 .57 .57 .02 Volume Distance Option's Implied Option Factor Factor Volotility January 30 .25 .41 .34 January 35 .45 .57 .28 April 35 .275 .57 .30 April40 .025 .02 .38 Implied = .25 x .41 x .34 + .45 x .57 x .28 + .275 x .57 x .30 + .025 x .02 x .38 volatility. .25 x .41 + .45 x .57 + .275 x .57 + .025 x .02 = .298 ual option's implied volatilities. Rather, it is a composite figure that gives the most weight to the heavily traded, near-the-money options, and very little weight to the lightly-traded (5 contracts), deeply out-of-the-money April 40 call. This implied volatility is still a form of standard deviation, and can thus be used whenever a stan­ dard deviation volatility is called for. This method of computing volatility is quite accurate and proves to be sensitive to changes in the volatility of a stock. For example, as markets become bullish or bearish (generating large rallies or declines), most stocks will react in a volatile man­ ner as well. Option premiums expand rather quickly, and this method of implied volatility is able to pick up the change quickly. One last bit of fine-tuning needs to be done before the final volatility of the stock is arrived at. On a day-to-day basis, the implied volatility for a stock - especially one whose options are not too active may fluctuate more than the strategist would like. A smoothing effect can be obtained by ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:506 SCORE: 20.00 ================================================================================ 466 Part IV: Additional Considerations taking a moving average of the last 20 or 30 days' implied volatilities. An alternative that does not require the saving of many previous days' worth of data is to use a momentum calculation on the implied volatility. For example, today's final volatility might be computed by adding 5% of today's implied volatility to 95% of yesterday's final volatility. This method requires saving only one previous piece of data - yester­ day's final volatility - and still preserves a "smoothing" effect. Once this implied volatility has been computed, it can then be used in the Black-Scholes model ( or any other model) as the volatility variable. Thus one could compute the theoretical value of each option according to the Black-Scholes formu­ la, utilizing the implied volatility for the stock. Since the implied volatility for the stock will most likely be somewhat different from the implied volatility of this par­ ticular option, there will be a discrepancy between the option's actual closing price and the theoretical price as computed by the model. This differential represents the amount by which the option is theoretically overpriced or underpriced, compared to other options on that same stock. EXPECTED RETURN Certain investors will enter positions only when the historical percentages are on their side. When one enters into a transaction, he normally has a belief as to the pos­ sibility of making a profit. For example, when he buys stock he may think that there is a "good chance" that there will be a rally or that earnings will increase. The investor may consciously or unconsciously evaluate the probabilities, but invariably, an invest­ ment is made based on a positive expectation of profit. Since options have fixed terms, they lend themselves to a more rigorous computation of expected profit than the aforementioned intuitive appraisal. This more rigorous approach consists of com­ puting the expected return. The expected retum is nothing more than the retum that the position should yield over a large number of cases. A simple example may help to explain the concept. The crucial variable in com­ puting expected return is to outline what the chances are of the stock being at a cer­ tain price at some future time. Example: XYZ is selling at 33, and an investor is interested in determining where XYZ will be in 6 months. Assume that there is a 20% chance of XYZ being below 30 in 6 months, and that there is a 40% chance that XYZ will be above 35 in 6 months. Finally, assume that XYZ has an equal 10% chance of being at 31, 32, 33, or 34 in 6 months. All other prices are ignored for simplification. Table 28-5 summarizes these assumptions. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:507 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:511 SCORE: 0.00 ================================================================================ 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 computeecurrence, 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:670 SCORE: 15.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:671 SCORE: 15.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:672 SCORE: 0.00 ================================================================================ 624 Part V: Index Options and Futures FIGURE 32-6. PERCS price estimate versus common stock. 44 (I) iii 39 6 Months E ~ w (I) u ct 34 Cf) (.) a: w a. 29 0 1-.J. ____ ,__ ___ ...._ ___ _._ ___ __._ ___ _.__ 25 30 35 40 Stock Price 45 50 First, consider the out-of-the-money situation. If the underlying common declines in price, the PERCS will not decline as fast because the additional dividends will provide yield support. The PER CS will therefore trade at a higher price than the common. Howeve1~ as the maturity date nears and the remaining number of addi­ tional dividends dwindles to a small amount, then the PER CS price and the common price will converge. The opposite effect occurs if the underlying common moves higher. The PERCS will trade at a lower price than the common when the common trades above the issue price. In fact, since there is a redemption price on the PERCS, it will not trade higher than the redemption price. The common, however, has no such restric­ tion, so it could continue to trade at prices significantly higher than the PERCS does. These points are illustrated in Figure 32-6, which contains the price curves of two PER CS: one at issuance, thus having three years remaining, and the other with just six months remaining until the maturity of the PERCS. For purposes of comparison, it was assumed that there is no sliding redemption feature involved. Several significant points can be made from the figure. First, notice that the PERCS and the common._ tend to sell at approximately the same price at the point labeled "I." This would be the price at which the PER CS are issued. This issue price must be below the redemption price of the PERCS. More will be said later about how this price is determined. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:690 SCORE: 4.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:691 SCORE: 16.00 ================================================================================ Chapter 33: Mathematical Considerations for Index Products 643 For index futures options, there is no risk when the underlying closes near the strike, since they settle for cash. One is not forced to make a choice as to whether to exercise his calls. (See Chapter 27 on arbitrage for a description of risks at expiration when trading reversals or conversions.) In actual practice, floor traders may attempt to establish conversions in futures options for small increments - perhaps 5 or 10 cents in S&P futures, for example. The arbitrageur should note that futures options do actually create a credit or debit in the account. That is, they are like stock options in that respect, even though the underlying instrument is not. This means that if one is using a deep in-the-money option in the conversion, there will actually be some carrying cost involved. Example: An index future is trading at 179.00 and one is going to price the December 190 conversion, assuming that December expiration is 50 days away. Assume that the current carrying cost of money is 10% annually. Finally, assume that the December 190 call is selling for 1.00, and the December 190 put is selling for 11.85. Note that the put has a time value premium of only 85 cents, less than the pre­ mium of the call. The reason for this is that one would have to pay a carrying cost to do the December 190 conversion. If one established the 190 conversion, he would buy the futures (no credit or debit to the account), buy the put (a debit of 11.85), and sell the call (a credit of 1.00). Thus, the account actually incurs a debit of 10.85 from the options. The carrying cost for 10.85 at 10% for 50 days is 10.85 x 10% x 50/365 = 0.15. This indicates that the converter is willing to pay 15 cents less time premium for the put (or conversely that the reversal trader is willing to sell the put for 15 cents less time premium). Instead of the put trading with a time value premium equal to the call price, the put will trade with a premium of 15 cents less. Thus, the time premium of the put is 85 cents, rather than being equal to the price of the call, 1.00. BOX SPREADS Recall that a "box" consists of a bullish vertical spread involving two striking prices, and a bearish vertical spread using the same two strikes. One spread is constructed with puts and the other with calls. The profitability of the box is the same regardless of the price of the underlying security at expiration. Box arbitrage with equity options involves trying to buy the box for less than the difference in the striking prices, for ~ple, trying to buy a box in which the strikes are 5 points apart for 4. 75. Selling the box for more than 5 points would represent arbitrage as well. In fact, even selling the box at exactly 5 points would produce a profit for the arbitrageur, since he earns interest on the credit from the sale. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:692 SCORE: 0.00 ================================================================================ 644 Part V: Index Options and Futures These same strategies apply to options on futures. However, boxes on cash­ based options involve another consideration. It is often the case with cash-based options that the box sells for more than the difference in the strikes. For example, a box in which the strikes are 10 points apart might sell for 10.50, a substantial premi­ um over the striking price differential. The reason that this happens is because of the possibility of early assignment. The seller of the box assumes that risk and, as a result, demands a higher price for the box. If he sells the box for half a point more than the striking price differential, then he has a built-in cushion of .50 point of index movement if he were to be assigned early. In general, box strategies are not particularly attractive. However, if the pre­ mium being paid for the box is excessively high, then one should consider selling the box. Since there are four commissions involved, this is not normally a retail strategy. MATHEMATICAL APPLICATIONS The following material is intended to be a companion to Chapter 28 on mathemati­ cal applications. Index options have a few unique properties that must be taken into account when trying to predict their value via a model. The Black-Scholes model is still the model of choice for options, even for index options. Other models have been designed, but the Black-Scholes model seems to give accurate results without the extreme complications of most of the other models. FUTURES Modeling the fair value of most futures contracts is a difficult task. The Black-Scholes model is not usable for that task. Recall that we saw earlier that the fair value of a future contract on an index could be calculated by computing the pres­ ent value of the dividend and also knowing the savings in carrying cost of the futures contract versus buying the actual stocks in the index. CASH-BASED INDEX OPTIONS The futures fair value model for a capitalization-weighted index requires knowing the exact dividend, dividend payment date, and capitalization of each stock in the index (for price-weighted indices, the capitalization is unnecessary). This is the only way of getting the accurate dividend for use in the model. The same dividend calculation must be done for any other index before the Black-Scholes formula can be applied. In the actual model, the dividend for cash-based index options is used in much the same way that dividends are used for stock options: The present value of the div- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:739 SCORE: 0.00 ================================================================================ Chapter 34: Futures and Futures Options FIGURE 34-2. January soybean, ratio spread. 90 80 70 60 50 :!:: 40 0 ... a.. 30 0 20 .le C 10 ~ 0 -10 -20 -30 575 625 650 At Expiration Futures Price Points of maximum profit = Maximum downside loss + Difference in strikes x Number of calls owned =-4½ + 50 X 2 =95½ Upside break-even price = Higher striking price 700 + Maximum profit/Net number of naked calls = 650 + 95½/3 = 681.8 689 These are the significant points of profitability at expiration. One does not care what the unit of trading is (for example, cents for soybeans) or how many dollars are involved in one unit of trading ($50 for soybeans and soybean options). He can con­ duct his analysis strictly in terms of points, and he should do so. Before proceeding into the comparisons beleen the backspread and the ratio spread as they apply to mispriced futures options, it should be pointed out that the seri­ ous strategist should analyze how his position will perform over the short term as well as at expiration. These analyses are presented in Chapter 36 on advanced concepts. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:740 SCORE: 12.00 ================================================================================ 690 Part V: Index Options and Futures WHICH STRATEGY TO USE The profit potential of the put backspread is obviously far different from that of the call ratio spread. They are similar in that they both offer the strategist the opportu­ nity to benefit from spreading mispriced options. Choosing which one to implement (assuming liquidity in both the puts and calls) may be helped by examining the tech­ nical picture ( chart) of the futures contract. Recall that futures traders are often more technically oriented than stock traders, so it pays to be aware of basic chart patterns, because others are watching them as well. If enough people see the same thing and act on it, the chart pattern will be correct, if only from a "self-fulfilling prophecy" viewpoint if nothing else. Consequently, if the futures are locked in a (smooth) downtrend, the put strat­ egy is the strategy of choice because it offers the best downside profit. Conversely, if the futures are in a smooth uptrend, the call strategy is best. The worst result will be achieved if the strategist has established the call ratio spread, and the futures have an explosive rally. In certain cases, very bullish rumors - weather predictions such as drought or El Nifio, foreign labor unrest in the fields or mines, Russian buying of grain - will produce this mispricing phenomenon. The strategist should be leery of using the call ratio spread strategy in such situations, even though the out-of-the-money calls look and are ridiculously expensive. If the rumors prove true, or if there are too many shorts being squeezed, the futures can move too far, too fast and seriously hurt the spreader who has the ratio call spread in place. His margin requirements will escalate quickly as tl1e futures price moves high­ er. The option premiums will remain high or possibly even expand if the futures rally quickly, thereby overriding the potential benefit of time decay. Moreover, if the fun­ damentals change immediately - it rains; the strike is settled; no grain credits are offered to the Russians - or rumors prove false, the futures can come crashing back down in a hurry. Consequently, if rumors of fundamentals have introduced volatility in the futures rnarket, implement the strategy with the put backspread. The put backspread is geared to taking advantage of volatility, and this fundamental situation as described is certainly volatile. It may seem that because the market is exploding to the upside, it is a waste of time to establish the put spread. Still, it is the wisest choice in a volatile market, and there is always the chance that an explosive advance can turn into a quick decline, especially when the advance is based on rumors or fundamentals that could change overnight. There are a few "don'ts" associated with the ratio call spread. Do not be tempt­ ed to use the ratio spread strategy in volatile situations such as those just described; it works best in a slowly rising market. Also, do not implement the ratio spread with ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:741 SCORE: 0.00 ================================================================================ Chapter 34: Futures and Futures Options 691 ridiculously far out-of-the-money options, as one is wasting his theoretical advantage if the futures do not have a realistic chance to climb to the striking price of the writ­ ten options. Finally, do not attempt to use overly large ratios in order to gain the most theoretical advantage. This is an important concept, and the next example illustrates it well. Example: Assume the same pricing pattern for January soybean options that has been the basis for this discussion. January beans are trading at 583. The (novice) strategist sees that the slightly in-the-money January 575 call is the cheapest and the deeply out-of-the-money January 675 call is the most expensive. This can be verified from either of two previous tables: the one showing the actual price as compared to the "theoretical" price, or Table 34-2 showing the implied volatilities. Again, one would use the deltas (see Table 34-2) to create a neutral spread. A neutral ratio of these two would involve selling approximately six calls for each one purchased. Buy 1 January bean 575 call at 191/z Sell 6 January bean 675 calls at 21/4 Net position: 191/z DB 131/z CR 6 Debit Figure 34-3 shows the possible detrimental effects of using this large ratio. While one could make 94 points of profit if beans were at 675 at January expiration, he could lose that profit quickly if beans shot on through the upside break-even point, which is only 693.8. The previous formulae can be used to verify these maxi­ mum profit and upside break-even point calculations. The upside break-even point is too close to the striking price to allow for reasonable follow-up action. Therefore, this would not be an attractive position from a practical viewpoint, even though at first glance it looks attractive theoretically. It would seem that neutral spreading could get one into trouble if it "recom­ mends" positions like the 6-to-l ratio spread. In reality, it is the strategist who is get­ ting into trouble if he doesn't look at the whole picture. The statistics are just an aid - a tool. The strategist must use the tools to his advantage. It should be pointed out as well that there is a tool missing from the toolkit at this point. There are statistics that will clearly show the risk of this type of high-rati<,Yspread. In this case, that tool is the gamma of the option. Chapter 40 covers the -Lise of gamma and other more advanced statistical tools. This same example is expanded in that chapter to include the gamma concept. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:742 SCORE: 0.00 ================================================================================ 692 Part V: Index Options and Futures FIGURE 34-3. January soybean, heavily ratioed spread. 90 60 30 - 0 e 575 625 650 675 725 a. -30 0 .1!l -60 C ~ -90 -120 At Expiration -150 -180 Futures Price FOLLOW-UP ACTION The same follow-up strategies apply to these futures options as did for stock options. They will not be rehashed in detail here; refer to earlier chapters for broader expla­ nations. This is a summary of the normal follow-up strategies: Ratio call spread: Follow-up action in strategies with naked options, such as this, generally involves taking or limiting losses. A rising market will produce a negative EFP. Neutralize a negative EFP by: Buying futures Buying some calls Limit upside losses by placing buy stop orders for futures at or near the upside break-even point. Put backspread: Follow-up action in strategies with an excess of long options generally involves taking or protecting profits. A falling market will produce a negative EFP. Neutralize a negative EFP by: Buying futures Selling some puts ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:743 SCORE: 16.00 ================================================================================ Chapter 34: Futures and Futures Options 693 The reader has seen these follow-up strategies earlier in the book. However, there is one new concept that is important: The mispricing continues to propagate itself no matter what the price of the underlying futures contract. The at-the-money options will always be about fairly priced; they will have the average implied volatility. Example: In the previous examples, January soybeans were trading at 583 and the implied volatility of the options with striking price 575 was 15%, while those with a 600 strike were 17%. One could, therefore, conclude that the at-the-money January soybean options would exhibit an implied volatility of about 16%. This would still be true if beans were at 525 or 675. The mispricing of the other options would extend out from what is now the at-the-money strike. Table 34-3 shows what one might expect to see if January soybeans rose 75 cents in price, from 583 to 658. Nate that the same mispricing properties exist in both the old and new situa­ tions: The puts that are 58 points out-of-the-money have an implied volatility of only 12%, while the calls that are 92 points out-of-the-money have an implied volatility of 23%. TABLE 34-3. Propagation of volatility skewing. Original Situation January beans: 583 Implied Strike Volatility 525 12% 550 13% 575 15% 600 17% 625 19% 650 21% 675 23% New Situation January beans: 658 Strike 600 625 650 675 700 725 750 This example is not meant to infer that the volatility of an at-the-money soybean futures option will always be 16%. It could be anything, depending on the historical and implied volatility of the futures contract itself. However, the volatility skewing will still persist even if the futures rally or decline. This fact will affect how these strategies behave as the(linderlying futures con­ tract moves. It is a benefit to both strategies. First, look at the put backspread when the stock falls to the striking price of the purchased puts. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:744 SCORE: 12.00 ================================================================================ 694 Part V: Index Options and Futures Example: The put backspread was established under the following conditions: Strike 550 600 Put Price Theoretical Put Price 5.4 27.6 Implied Volatility 13% 17% If January soybean futures should fall to 550, one would expect the implied volatility of the January 550 puts that are owned to be about 16% or 17%, since they would be at-the-money at that time. This makes the assumption that the at-the­ money puts will have about a 17% implied volatility, which is what they had when the position was established. Since the strategy involves being long a large quantity of January 550 puts, this increase in implied volatility as the futures drop in price will be of benefit to the spread. Note that the implied volatility of the January 600 puts would increase as well, which would be a small negative aspect for the spread. However, since there is only one put short and it is quite deeply in the money with the futures at 550, this nega­ tive cannot outweigh the positive effect of the expansion of volatility on the long January 550 puts. In a similar manner, the call spread would benefit. The implied volatility of the written options would actually drop as the futures rallied, since they would be less far out-of-the-money than they originally were when the spread was established. While the same can be said of the long options in the spread, the fact that there are extra, naked, options means the spread will benefit overall. In summary, the futures option strategist should be alert to mispricing situations like those described above. They occur frequently in a few commodities and occa­ sionally in others. The put backspread strategy has limited risk and might therefore be attractive to more individuals; it is best used in downtrending and/or volatile mar­ kets. However, if the futures are in a smooth uptrend, not a volatile one, a ratio call spread would be better. In either case, the strategist has established a spread that is statistically attractive because he has sold options that are expensive in relation to the ones that he has bought. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:745 SCORE: 0.00 ================================================================================ Chapter 34: Futures and Futures Options 695 SUMMARY This chapter presented the basics of futures and futures options trading. The basic differences between futures options and stock or index options were laid out. In a certain sense, a futures option is easier to utilize than is a stock option because the effects of dividends, interest rates, stock splits, and so forth do not apply to futures options. However, the fact that each underlying physical commodity is completely different from most other ones means that the strategist is forced to familiarize him­ self with a vast array of details involving striking prices, trading units, expiration dates, first notice days, etc. More details mean there could be more opportunities for mistakes, most of which can be avoided by visualizing and analyzing all positions in terms of points and not in dollars. Futures options do not create new option strategies. However, they may afford one the opportunity to trade when the futures are locked limit up. Moreover, the volatility skewing that is present in futures options will offer opportunities for put backspreads and call ratio spreads that are not normally present in stock options. Chapter 35 discusses futures spreads and how one can use futures options with those spreads. Calendar spreads are discussed as well. Calendar spreads with futures options are different from calendar spreads using stock or index options. These are important concepts in the futures markets - distinctly different from an option spread - and are therefore significant for the futures option trader. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:753 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:754 SCORE: 16.00 ================================================================================ 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, ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:755 SCORE: 24.00 ================================================================================ Chapter 35: Futures Option Strategies for Futures Spreads 705 there is a major difference between the futures option calendar spread and the stock option calendar spread. That difference is that a calendar spread using futures options involves two separate underlying instruments, while a calendar spread using stock options does not. When one buys the May soybean 600 call and sells the March soybean 600 call, he is buying a call on the May soybean futures contract and selling a call on the March soybean futures contract. Thus, the futures option calendar spread involves two separate, but related, underlying futures contracts. However, if one buys the IBM May 100 call and sells the IBM March 100 call, both calls are on the same underlying instrument, IBM. This is a major difference between the two strategies, although both are called "calendar spreads." To the stock option trader who is used to visualizing calendar spreads, the futures option variety may confound him at first. For example, a stock option trader may conclude that if he can buy a four-month call for 5 points and sell a two-month call for 2 points, he has a good calendar spread possibility. Such an analysis is mean­ ingless with futures options. If one can buy the May soybean 600 call for 5 and sell the March soybean 600 call for 3, is that a good spread or not? It's impossible to tell, unless you know the relationship between May and March soybean futures contracts. Thus, in order to analyze the futures option calendar spread, one must not only ana­ lyze the options' relationship, but the two futures contracts' relationship as well. Simply stated, when one establishes a futures option calendar spread, he is not only spreading time, as he does with stock options, he is also spreading the relationship between the underlying futures. Example: A trader notices that near-term options in soybeans are relatively more expensive than longer-term options. He thinks a calendar spread might make sense, as he can sell the overpriced near-term calls and buy the relatively cheaper longer­ term calls. This is a good situation, considering the theoretical value of the options involved. He establishes the spread at the following prices: Soybean Trading Contract Initial Price Position March 600 call 14 Sell 1 May 600 call 21 Buy 1 March future 594 none May future 598 none The May/March 600 call calendar spread is established for 7 points debit. March expiration is two months away. At the current time, the May futures are trad­ ing at a 4-point premium to March futures. The spreader figures that if March ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:756 SCORE: 16.00 ================================================================================ 706 Part V: Index Options and Futures futures are approximately unchanged at expiration of the March options, he should profit handsomely, because the March calls are slightly overpriced at the current time, plus they will decay at a faster rate than the May calls over the next two months. Suppose that he is correct and March futures are unchanged at expiration of the March options. This is still no guarantee of profit, because one must also determine where May futures are trading. If the spread between May and March futures behaves poorly (May declines with respect to March), then he might still lose money. Look at the following table to see how the futures spread between March and May futures affects the profitability of the calendar spread. The calendar spread cost 7 debit when the futures spread was +4 initially. Futures Calendar Futures Prices Spread May 600 Call Spread March/May Price Price Profit/Loss 594/570 -24 4 -3 cents 594/580 -14 61/2 _1/2 594/590 -4 10 +3 594/600 +6 141/2 +71/2 Thus, the calendar spread could lose money even with March futures unchanged, as in the top two lines of the table. It also could do better than expected if the futures spread widens, as in the bottom line of the table. The profitability of the calendar spread is heavily linked to the futures spread price. In the above example, it was possible to lose money even though the March futures contract was unchanged in price from the time the calendar spread was initially established. This would never happen with stock options. If one placed a calendar spread on IBM and the stock were unchanged at the expiration of the near­ term option, the spread would make money virtually all of the time ( unless implied volatility had shrunk dramatically). The futures option calendar spreader is therefore trading two spreads at once. The first one has to do with the relative pricing differentials (implied volatilities, for example) of the two options in question, as well as the passage of time. The second one is the relationship between the two underlying futures contracts. As a result, it is difficult to draw the ordinary profit picture. Rather, one must approach the problem in this manner: 1. Use the horizontal axis to represent the futures spread price at the expiration of the near-term option. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:757 SCORE: 4.00 ================================================================================ Chapter 35: Futures Option Strategies for Futures Spreads 707 2. Draw several profit curves, one for each price of the near-term future at near­ term expiration. Example: Expanding on the above example, this method is demonstrated here. Figure 35-1 shows how to approach the problem. The horizontal axis depicts the spread between March and May soybean futures at the expiration of the March futures options. The vertical axis represents the profit and loss to be expected from the calendar spread, as it always does. The major difference between this profit graph and standard ones is that there are now several sets of profit curves. A separate one is drawn for each price of the March futures that one wants to consider in his analysis. The previous example showed the profitability for only one price of the March futures - unchanged at 594. However, one cannot rely on the March futures to remain unchanged, so he must view the profitability of the calendar spread at various March futures prices. The data that is plotted in the figure is summarized in Table 35-4. Several things are readily apparent. First, if the futures spread improves in price, the calendar spread will generally make money. These are the points on the far right of the figure and on the bottom line of Table 35-4. Second, if the futures spread behaves miser- FIGURE 35-1. Soybean futures calendar spreads, at March expiration. gj 20 16 12 .3 8 ::.: 0 ct 4 0 -8 March/May Spread March =604 March =594 March= 614 March =584 March= 574 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:758 SCORE: 28.00 ================================================================================ 708 Part V: Index Options and Futures ably, the calendar spread will almost certainly lose money (points on the left-hand side of the figure, or top line of the table). Third, if March futures rise in price too far, the calendar spread could do poor­ ly. In fact, if March futures rally and the futures spread worsens, one could lose more than his initial debit (bottom left-hand point on figure). This is partly due to the fact that one is buying the March options back at a loss if March futures rally, and may also be forced to sell his May options out at a loss if May futures have fallen at the same time. Fourth, as might be expected, the best results are obtained if March futures rally slightly or remain unchanged and the futures spread also remains relatively unchanged (points in the upper right-hand quadrant of the figure). In Table 35-4, the far right-hand column shows how a futures spreader would have fared if he had bought May and sold March at 4 points May over March, not using any options at all. TABLE 35-4. Profit and loss from soybean call calendar. All Prices at March Option Expiration Futures Future Spread Calendar Spread Profit Spread (May-March) March Future Price: 574 584 594 604 614 Profit -24 -5.5 - 4.5 -3 -4.5 -11.5 -28 -14 -4.5 3 -0.5 -1 -7 -18 -4 -2.5 0 +3 +3.5 -1 - 8 6 0 + 3 +7.5 +9 +5.5 + 2 16 +7 + 11 +17 +19 +13 +12 This example demonstrates just how powerful the influence of the futures spread is. The calendar spread profit is predominantly a function of the futures spread price. Thus, even though the calendar spread was attractive from the theo­ retical viewpoint of the option's prices, its result does not seem to reflect that theo­ retical advantage, due to the influence of the futures spread. Another important point for the calendar spreader used to dealing with stock options to remember is that one can lose more than his initial debit in a futures calendar spread if the spread between the underlying futures inverts. There is another way to view a calendar spread in futures options, however, and that is as a substitute or alternative to an intramarket spread in the futures contracts themselves. Look at Table 35-4 again and notice the far right-hand column. This is ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:759 SCORE: 24.00 ================================================================================ Chapter 35: Futures Option Strategies for Futures Spreads 709 the profit or loss that would be made by an intramarket soybean spreader who bought May and sold March at the initial prices of 598 and 594, respectively. The calendar spread generally outperforms the intramarket spread for the prices shown in this example. This is where the true theoretical advantage of the calendar spread comes in. So, if one is thinking of establishing an intrarnarket spread, he should check out the calendar spread in the futures options first. If the options have a theoretical pric­ ing advantage, the calendar spread may clearly outperform the standard intramarket spread. Study Table 35-4 for a moment. Note that the intramarket spread is only better when prices drop but the spread widens (lower left comer of table). In all other cases, the calendar spread strategy is better. One could not always expect this to be true, of course; the results in the example are partly due to the fact that the March options that were sold were relatively expensive when compared with the May options that were bought. In summary, the futures option calendar spread is more complicated when compared to the simpler stock or index option calendar spread. As a result, calendar spreading with futures options is a less popular strategy than its stock option coun­ terpart. However, this does not mean that the strategist should overlook this strate­ gy. As the strategist knows, he can often find the best opportunities in seemingly complex situations, because there may be pricing inefficiencies present. This strate­ gy's main application may be for the intramarket spreader who also understands the usage of options. LONG COMBINATIONS Another attractive use of options is as a substitute for two instruments that are being traded one against the other. Since intermarket and intramarket futures spreads involve two instruments being traded against each other, futures options may be able to work well in these types of spreads. You may recall that a similar idea was pre­ sented with respect to pairs trading, as well as certain risk arbitrage strategies and index futures spreading. In any type of futures spread, one might be able to substitute options for the actual futures. He might buy calls for the long side of the spread instead of actually buying futures. Likewise, he could sell calls or buy puts instead of selling futures for the other side of the spread. In using options, however, he wants to avoid two prob­ lems. First, he does not want to increase his risk. Second, he does not want to pay a lot of time value premium that could waste away, costing him the profits from his spread. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:760 SCORE: 4.00 ================================================================================ 710 Part V: Index Options and Futures Let's spend a short time discussing these two points. First, he does not want to increase his risk. In general, selling options instead of utilizing futures increases one's risk. If he sells calls instead of selling futures, and sells puts instead of buying futures, he could be increasing his risk tremendously if the futures prices moved a lot. If the futures rose tremendously, the short calls would lose money, but the short puts would cease to make money once the futures rose through the striking price of the puts. Therefore, it is not a recommended strategy to sell options in place of the futures in an intramarket or intennarket spread. The next example will show why not. Example: A spreader wants to trade an intramarket spread in live cattle. The con­ tract is for 40,000 pounds, so a one-cent move is worth $400. He is going to sell April and buy June futures, hoping for the spread to narrow between the two contracts. The following prices exist for live cattle futures and options: April future: 78.00 June future: 74.00 April 78 call: 1.25 June 74 put: 2.00 He decides to use the options instead of futures to implement this spread. He sells the April 78 call as an alternative to selling the April future; he also sells the June 74 put as an alternative to buying the June future. Sometime later, the following prices exist: April future: 68.00 June future: 66.00 April 78 call: 0.00 June 74 put: 8.05 The futures spread has indeed narrowed as expected - from 4.00 points to 2.00. However, this spreader has no profit to show for it; in fact he has a loss. The call that he sold is now virtually worthless and has therefore earned a profit of 1.25 points; however, the put that was sold for 2.00 is now worth 8.05 - a loss of 6.05 points. Overall, the spreader has a net loss of 4.80 points since he used short options, instead of the 2.00-point gain he could have had if he had used futures instead. The second thing that the futures spreader wants to ensure is that he does not pay for a lot of time value premium that is wasted, costing him his potential profits. If he buys at- or out-of-the-money calls instead of buying futures, and if he buys at- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:761 SCORE: 12.00 ================================================================================ 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- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:762 SCORE: 8.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:763 SCORE: 12.00 ================================================================================ Chapter 35: Futures Option Strategies for Futures Spreads June T-bill 9450 calls: 0.32 June Euro$ 9450 puts: 0.40 713 The TED spread, basis June, is currently at 0.60 (the difference in price of the two futures). Both futures have in-the-money options with only a small amount of time value premium in them. The June T-bill calls with a striking price of 94.50 are 0.25 in the money and are selling for 0.32. Their time value premium is only 0.07 points. Similarly, the June Eurodollar puts with a striking price of 94.50 are 0.35 in the money and are selling for 0.40. Hence, their time value premium is 0.05. Since the total time value premium - 0.12 ($300) - is small, the strategist decides that the option spread may have an advantage over the futures intermarket spread, so he establishes the following position: Buy one June T-bill call @ 0.40 Buy one June Euro$ put @ 0.32 Total cost: Cost $1,000 $ 800 $1,800 Later, financial conditions in the world are very stable and the TED spread begins to shrink. However, at the same time, rates are being lowered in the United States, and T-bill and Eurodollar prices begin to rally substantially. In May, when the June T-bill options expire, the following prices exist: June T-bill futures: 95.50 June Euro$ futures: 95.10 June T-bill 9450 calls: 1.00 June Euro$ 9450 puts: 0.01 The TED spread has shrunk from 0.60 to only 0.40. Thus, any trader attempt­ ing to buy the TED spread using only futures would have lost $500 as the spread moved against him by 0.20. However, look at the option position. The options are now worth a combined value of 1.01 points ($2,525), and they were bought for 0.72 points ($1,800). Thus, the option strategy has turned a profit of $725, while the futures strategy would have lost money. Any traders who used this option strategy instead of using futures would have enjoyed profits, because as the Federal Reserve lowered rates time after time, the prices of both T-bills and Eurodollars rose far enough to make the option strategist's ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:764 SCORE: 4.00 ================================================================================ 714 Part V: Index Options and Futures calls more profitable than the loss in his puts. This is the advantage of using in-the­ money options instead of futures in futures spreading strategies. In fairness, it should be pointed out that if the futures prices had remained rel­ atively unchanged, the 0.12 points of time value premium ($300) could have been lost, while the futures spread may have been relatively unchanged. However, this does not alter the reasoning behind wanting to use this option strategy. Another consideration that might come into play is the margin required. Recall that the initial margin for implementing the TED spread was $400. However, if one uses the option strategy, he must pay for the options in full - $1,800 in the above example. This could conceivably be a deterrent to using the option strategy. Of course, if by investing $1,800, one can make money instead of losing money with the smaller investment, then the initial margin requirement is irrelevant. Therefore, the profit potential must be considered the more important factor. FOLLOW-UP CONSIDERATIONS When one uses long option combinations to implement a futures spread strategy, he may find that his position changes from a spread to more of an outright position. This would occur if the markets were volatile and one option became deeply in-the­ money, while the other one was nearly worthless. The TED spread example above showed how this could occur as the call wound up being worth 1.00, while the put was virtually worthless. As one side of the option spread goes out-of-the-money, the spread nature begins to disappear and a more outright position takes its place. One can use the deltas of the options in order to calculate just how much exposure he has at any one time. The following examples go through a series of analyses and trades that a strate­ gist might have to face. The first example concerns establishing an intermarket spread in oil products. Example: In late summer, a spreader decides to implement an intermarket spread. He projects that the coming winter may be severely cold; furthermore, he believes that gasoline prices are too high, being artificially buoyed by the summer tourist sea­ son, and the high prices are being carried into the future months by inefficient mar­ ket pricing. Therefore, he wants to buy heating oil futures or options and sell unleaded gasoline futures or options. He plans to be out of the trade, if possible, by early December, when the market should have discounted the facts about the winter. Therefore, he decides to look at January futures and options. The following prices exist: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:776 SCORE: 0.00 ================================================================================ 726 Part VI: Measuring and Trading Volatility So, is there a better alternative? Or should one just pack it in, buy some index funds, and forget it? As an option strategist, one should most certainly believe that there's something better than buying the index fund. The alternative of volatility trad­ ing offers significant advantages in terms of the factors that make directional trading difficult. If one finds that he is able to handle the rigors of directional trading, then stick with that approach. You might want to add some volatility trading to your arsenal, though, just to be safe. However, if one finds that directional trading is just too time­ consuming, or you have trouble utilizing stops properly, or are constantly getting whipsawed, then it's time to concentrate more heavily on volatility trading, preferably in the form of straddle buying. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:777 SCORE: 16.00 ================================================================================ CHAPTER 36 The Basics of Volatility Trading Volatility trading first attracted mathematically oriented traders who noticed that the market's prediction of forthcoming volatility - for example, implied volatility - was substantially out of line with what one might reasonably expect should happen. Moreover, many of these traders (market-makers, arbitrageurs, and others) had found great difficulties with keeping a "delta neutral" position neutral. Seeking a bet­ ter way to trade without having a market opinion on the underlying security, they turned to volatility trading. This is not to suggest that volatility trading eliminates all market risk, turning it all into volatility risk, for example. But it does suggest that a certain segment of the option trading population can handle the risk of volatility with more deference and aplomb than they can handle price risk Simply stated, it seems like a much easier task to predict volatility than to pre­ dict prices. That is said notwithstanding the great bull market of the 1990s, in which every investor who strongly participated certainly feels that he understands how to predict prices. Remember not to confuse brains with a bull market. Consider the chart in Figure 36-1. This seems as if it might be a good stock to trade: Buy it near the lows and sell it near the highs, perhaps even selling it short near the highs and covering when it later declines. It appears to have been in a trading range for a long time, so that after each purchase or sale, it returns at least to the midpoint of its trading range and sometimes even continues on to the other side of the range. There is no scale on the chart, but that doesn't change the fact that it appears to be a tradable entity. In fact, this is a chart of implied volatility of the options on a major U.S. corporation. It really doesn't matter which one (it's IBM), because the implied volatility chart of near­ ly every stock, index, or futures contract has a similar pattern - a trading range. The only time that implied volatility will totally break out of its "normal" range is if some­ thing material happens to change the fundamentals of the way the stock moves - a takeover bid, for example, or perhaps a major acquisition or other dilution of the stock 727 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:778 SCORE: 0.00 ================================================================================ 728 Part VI: Measuring and Trading Volatility FIGURE 36-1. A sample chart. Buy at these points. So, many traders observed this pattern and have become adherents of trying to predict volatility. Notice that if one is able to isolate volatility, he doesn't care where the stock price goes he is just concerned with buying volatility near the bottom of the range and selling it when it gets back to the middle or high end of the range, or vice versa. In real life, it is nearly impossible for a public customer to be able to iso­ late volatility so specifically. He will have to pay some attention to the stock price, but he still is able to establish positions in which the direction of the stock price is irrel­ evant to the outcome of the position. This quality is appealing to many investors, who have repeatedly found it difficult to predict stock prices. Moreover, an approach such as this should work in both bull and bear markets. Thus, volatility trading appeals to a great number of individuals. Just remember that, for you personally to operate a strategy properly, you must find that it appeals to your own philosophy of trading. Trying to use a strategy that you find uncomfortable will only lead to losses and frus­ tration. So, if this somewhat neutral approach to option trading sounds interesting to you, then read on. DEFINITIONS OF VOLATILITY Volatility is merely the term that is used to describe how fast a stock, future, or index changes in price. When one speaks of volatility in connection with options, there are two types of volatility that are important. The first is historical volatility, which is a measure of how fast the underlying instrument has been changing in price. The other is implied volatility, which is the option market's prediction of the volatility of the ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:781 SCORE: 9.00 ================================================================================ Chapter 36: The Basics of Volatility Trading 731 probability models. We need to be able to make volatility estimates in order to deter­ mine whether or not a strategy might be successful, and to determine whether the current option price is a relatively cheap one or a relatively expensive one. For exam­ ple, one can't just say, "I think XYZ is going to rise at least 18 points by February expi­ ration." There needs to be some basis in fact for such a statement and, lacking inside information about what the company might announce between now and February, that basis should be statistics in the form of volatility projections. Historical volatility is, of course, useful as an input to the (Black-Scholes) option model. In fact, the volatility input to any model is crucial because the volatility com­ ponent is such a major factor in determining the price of an option. Furthermore, historical volatility is useful for more than just estimating option prices. It is neces­ sary for making stock price projections and calculating distributions, too, as will be shown when those topics are discussed later. Any time one asks the question, "What is the probability of the stock moving from here to there, or of exceeding a particu­ lar target price?" the answer is heavily dependent on the volatility of the underlying stock (or index or futures). It is obvious from the above example that historical volatility can change dra­ matically for any particular instrument. Even if one were to stick with just one measure of historical volatility ( the 20-day historical is commonly the most popular measure), it changes with great frequency. Thus, one can never be certain that bas­ ing option price predictions or stock price distributions on the current historical volatility will yield the "correct" results. Statistical volatility may change as time goes forward, in which case your projections would be incorrect. Thus, it is impor­ tant to make projections that are on the conservative side. ANOTHER APPROACH: GARCH GARCH stands for Generalized Autoregressive Conditional Heteroskedasticity, which is why it's shortened to GARCH. It is a technique for forecasting volatility that some analysts say produces better projections than using historical volatility alone or implied volatility alone. GARCH was created in the 1980s by specialists in the field of econometrics. It incorporates both historical and implied volatility, plus one can throw in a constant ("fudge factor"). In essence, though, the user of GARCH volatility mod­ els has to make some predictions or decisions about the weighting of the factors used for the estimate. By its very nature, then, it can be just as vague as the situations described in the previous section. The model can "learn," though, if applied correctly. That is, if one makes a volatility prediction for today (using GARCH, let's say), but it turns out that the actu- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:782 SCORE: 15.00 ================================================================================ 732 Part VI: Measuring and Trading Volatility al volatility was lower, then when you make the volatility prediction for tomorrow, you'll probably want to adjust it downward, using the experience of the real world, where you see volatility declining. This also incorporates the common-sense notion that volatility tends to remain the same; that is, tomorrow's volatility is likely to be much like today's. Of course, that's a little bit like saying tomorrow's weather is likely to be the same as today's (which it is, two-thirds of the time, according to statistics). It's just that when a tornado hits, you have to realize that your forecast could be wrong. The same thing applies to GAR CH volatility projections. They can be wrong, too. So, GARCH does not do a perfect job of estimating and forecasting volatility. In fact, it might not even be superior, from a strategist's viewpoint, to using the simple minimum/maximum techniques outlined in the previous section. It is really best geared to predicting short-term volatility and is favored most heavily by dealers in currency options who must adjust their markets constantly. For longer-term volatility projections, which is what a position trader of volatility is interested in, GARCH may not be all that useful. However, it is considered state-of-the-art as far as volatility pre­ dicting goes, so it has a following among theoretically oriented traders and analysts. MOVING AVERAGES Some traders try to use moving averages of daily composite implied volatility read­ ings, or use a smoothing of recent past historical volatility readings to make volatility estimates. As mentioned in the chapter on mathematical applications, once the com­ posite daily implied volatility has been computed, it was recommended that a smoothing effect be obtained by taking a moving average of the 20 or 30 days' implied volatilities. In fact, an exponential moving average was recommended, because it does not require one to keep accessing the last 20 or 30 days' worth of data in order to compute the moving average. Rather, the most recent exponential mov­ ing average is all that's needed in order to compute the next one. IMPLIED VOLATILITY Implied volatility has been mentioned many times already, but we want to expand on its concept before getting deeper into its measure and uses later in this section. Implied volatility pertains only to options, although one can aggregate the implied volatilities of the various options trading on a particular underlying instrument to produce a single number, which is often referred to as the implied volatility of the underlying. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:783 SCORE: 15.00 ================================================================================ 732 Part VI: Measuring and Trading Volatility al volatility was lower, then when you make the volatility prediction for tomorrow, you'll probably want to adjust it downward, using the experience of the real world, where you see volatility declining. This also incorporates the common-sense notion that volatility tends to remain the same; that is, tomorrow's volatility is likely to be much like today's. Of course, that's a little bit like saying tomorrow's weather is likely to be the same as today's (which it is, two-thirds of the time, according to statistics). It's just that when a tornado hits, you have to realize that your forecast could be wrong. The same thing applies to GARCH volatility projections. They can be wrong, too. So, GARCH does not do a perfect job of estimating and forecasting volatility. In fact, it might not even be superior, from a strategist's viewpoint, to using the simple minimum/maximum techniques outlined in the previous section. It is really best geared to predicting short-term volatility and is favored most heavily by dealers in currency options who must adjust their markets constantly. For longer-term volatility projections, which is what a position trader of volatility is interested in, GAR CH may not be all that useful. However, it is considered state-of-the-art as far as volatility pre­ dicting goes, so it has a following among theoretically oriented traders and analysts. MOVING AVERAGES Some traders try to use moving averages of daily composite implied volatility read­ ings, or use a smoothing of recent past historical volatility readings to make volatility estimates. As mentioned in the chapter on mathematical applications, once the com­ posite daily implied volatility has been computed, it was recommended that a smoothing effect be obtained by taking a moving average of the 20 or 30 days' implied volatilities. In fact, an exponential moving average was recommended, because it does not require one to keep accessing the last 20 or 30 days' worth of data in order to compute the moving average. Rather, the most recent exponential mov­ ing average is all that's needed in order to compute the next one. IMPLIED VOLATILITY Implied volatility has been mentioned many times already, but we want to expand on its concept before getting deeper into its measure and uses later in this section. Implied volatility pertains only to options, although one can aggregate the implied volatilities of the various options trading on a particular underlying instrument to produce a single number, which is often referred to as the implied volatility of the underlying. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:784 SCORE: 15.00 ================================================================================ 732 Part VI: Measuring and Trading Volatility al volatility was lower, then when you make the volatility prediction for tomorrow, you'll probably want to adjust it downward, using the experience of the real world, where you see volatility declining. This also incorporates the common-sense notion that volatility tends to remain the same; that is, tomorrow's volatility is likely to be much like today's. Of course, that's a little bit like saying tomorrow's weather is likely to be the same as today's (which it is, two-thirds of the time, according to statistics). It's just that when a tornado hits, you have to realize that your forecast could be wrong. The same thing applies to GARCH volatility projections. They can be wrong, too. So, GAR CH does not do a perfect job of estimating and forecasting volatility. In fact, it might not even be superior, from a strategist's viewpoint, to using the simple minimum/maximum techniques outlined in the previous section. It is really best geared to predicting short-term volatility and is favored most heavily by dealers in currency options who must adjust their markets constantly. For longer-term volatility projections, which is what a position trader of volatility is interested in, GARCH may not be all that useful. However, it is considered state-of-the-art as far as volatility pre­ dicting goes, so it has a following among theoretically oriented traders and analysts. MOVING AVERAGES Some traders try to use moving averages of daily composite implied volatility read­ ings, or use a smoothing of recent past historical volatility readings to make volatility estimates. As mentioned in the chapter on mathematical applications, once the com­ posite daily implied volatility has been computed, it was recommended that a smoothing effect be obtained by taking a moving average of the 20 or 30 days' implied volatilities. In fact, an exponential moving average was recommended, because it does not require one to keep accessing the last 20 or 30 days' worth of data in order to compute the moving average. Rather, the most recent exponential mov­ ing average is all that's needed in order to compute the next one. IMPLIED VOLATILITY Implied volatility has been mentioned many times already, but we want to expand on its concept before getting deeper into its measure and uses later in this section. Implied volatility pertains only to options, although one can aggregate the implied volatilities of the various options trading on a particular underlying instrument to produce a single number, which is often referred to as the implied volatility of the underlying. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:785 SCORE: 16.00 ================================================================================ Chapter 36: The Basics of Volatility Trading 733 At any one point in time, a trader knows for certain the following items that affect an option's price: stock price, strike price, time to expiration, interest rate, and dividends. The only remaining factor is volatility - in fact, implied volatility. It is the big "fudge factor" in option trading. If implied volatility is too high, options will be overpriced. That is, they will be relatively expensive. On the other hand, if implied volatility is too low, options will be cheap or underpriced. The terms "overpriced" and "underpriced" are not really used by theoretical option traders much anymore, because their usage implies that one knows what the option should be worth. In the modem vernacular, one would say that the options are trading with a "high implied volatility" or a "low implied volatility," meaning that one has some sense of where implied volatility has been in the past, and the current measure is thus high or low in comparison. Essentially, implied volatility is the option market's guess at the forthcoming sta­ tistical volatility of the underlying over the life of the option in question. If traders believe that the underlying will be volatile over the life of the option, then they will bid up the option, making it more highly priced. Conversely, if traders envision a non­ volatile period for the stock, they will not pay up for the option, preferring to bid lower; hence the option will be relatively low-priced. The important thing to note is that traders normally do not know the future. They have no way of knowing, for sure, how volatile the underlying is going to be during the life of the option. Having said that, it would be unrealistic to assume that inside information does not leak into the marketplace. That is, if certain people possess nonpublic knowledge about a company's earnings, new product announcement, takeover bid, and so on, they will aggressively buy or bid for the options and that will increase implied volatil­ ity. So, in certain cases, when one sees that implied volatility has shot up quickly, it is perhaps a signal that some traders do indeed know the future - at least with respect to a specific corporate announcement that is about to be made. However, most of the time there is not anyone trading with inside information. Yet, every option trader - market-maker and public alike - is forced to make a "guess" about volatility when he buys or sells an option. That is true because the price he pays is heavily influenced by his volatility estimate ( whether or not he realizes that he is, in fact, making such a volatility estimate). As you might imagine, most traders have no idea what volatility is going to be during the life of the option. They just pay prices that seem to make sense, perhaps based on historic volatility. Consequently, today's implied volatility may bear no resemblance to the actual statistical volatility that later unfolds during the life of the option. For those who desire a more mathematical definition of implied volatility, con­ sider this. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:786 SCORE: 40.00 ================================================================================ 734 Part VI: Measuring and Trading Volatillty Opt price = f(Stock price, Strike price, Time, Risk-free rate, Volatility, Dividends) Furthermore, suppose that one knows the following information: XYZ price: 52 April 50 call price: 6 Time remaining to April expiration: 36 days Dividends: $0.00 Risk-free interest rate: 5% This information, which is available for every option at any time, simply from an option quote, gives us everything except the implied volatility. So what volatility would one have to plug in the Black-Scholes model ( or whatever model one is using) to make the model give the answer 6 (the current price of the option)? That is, what volatility is necessary to solve the equation? 6 = f(52, 50, 36 days, 5%, Volatility, $0.00) Whatever volatility is necessary to make the model yield the current market price (6) as its value, is the implied volatility for the XYZ April 50 call. In this case, if you're interested, the implied volatility is 75.4%. The actual process of determining implied volatility is an iterative one. There is no formula, per se. Rather, one keeps trying var­ ious volatility estimates in the model until the answer is close enough to the market value. THE VOLATILITY OF VOLATILITY In order to discuss the implied volatility of a particular entity - stock, index, or futures contract one generally refers to the implied volatility of individual options or perhaps the composite implied volatility of the entire option series. This is gener­ ally good enough for strategic comparisons. However, it turns out that there might be other ways to consider looking at implied volatility. In paiticular, one might want to consider how wide the range of implied volatility is - that is, how volatile the indi­ vidual implied volatility numbers are. It is often conventional to talk about the percentile of implied volatility. That is a way to rank the current implied volatility reading with past readings for the same underlying instrument. However, a fairly important ingredient is missing when percentiles are involved. One can't really tell if "cheap" options are cheap as a practical matter. That's because one doesn't know how tightly packed together the past implied volatility readings are. For example, if one were to discover that the entire past range of implied volatility for XYZ stretched only from 39% to 45%, then a current reading of 40%, while low, ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:787 SCORE: 31.00 ================================================================================ Chapter 36: The Basics of Volatility Trading 135 might not seem all that attractive. That is, if the first percentile of XYZ options were at an implied volatility reading of 39% and the 100th percentile were at 45%, then a reading of 40% is really quite mundane. There just wouldn't be much room for implied volatility to increase on an absolute basis. Even if it rose to the 100th per­ centile, an individual XYZ option wouldn't gain much value, because its implied volatility would only be increasing from about 40% to 45%. However, if the distribution of past implied volatility is wide, then one can truly say the options are cheap if they are currently in a low percentile. Suppose, rather than the tight range described above, that the range of past implied volatilities for XYZ instead stretched from 35% to 90% - that the first percentile for XYZ implied volatility was at 35% and the 100th percentile was at 90%. Now, if the current read­ ing is 40%, there is a large range above the current reading into which the options could trade, thereby potentially increasing the value of the options if implied volatil­ ity moved up to the higher percentiles. What this means, as a practical matter, is that one not only needs to know the current percentile of implied volatility, but he also needs to know the range of num­ bers over which that percentile was derived. If the range is wide, then an extreme percentile truly represents a cheap or expensive option. But if the range is tight, then one should probably not be overly concerned with the current percentile of implied volatility. Another facet of implied volatility that is often overlooked is how it ranges with respect to the time left in the option. This is particularly important for traders of LEAPS (long-term) options, for the range of implied volatility of a LEAPS option will not be as great as that of a short-term option. In order to demonstrate this, the implied volatilities of $OEX options, both regular and LEAPS, were charted over several years. The resulting scatter diagram is shown in Figure 36-3. Two curved lines are drawn on Figure 36-3. They contain most of the data points. One can see from these lines that the range of implied volatility for near-term options is greater than it is for longer-term options. For example, the implied volatil­ ity readings on the far left of the scatter diagram range from about 14% to nearly 40% (ignore the one outlying point). However, for longer-term options of 24 months or more, the range is about 17% to 32%. While $0EX options have their own idiosyn­ cracies, this scatter diagram is fairly typical of what we would see for any stock or index option. One conclusion that we can draw from this is that LEAPS option implied volatilities just don't change nearly as much as those of short-term options. That can be an important piece of information for a LEAPS option trader especially if he is comparing the LEAPS implied volatility with a composite implied volatility or with the historical volatility of the underlying. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:788 SCORE: 12.00 ================================================================================ 736 Part VI: Measuring and Trading Volatility Once again, consider Figure 36-3. While it is difficult to discern from the graph alone, the 10th percentile of $OEX composite implied volatility, using all of the data points given, is 17%. The line that marks this level (the tenth percentile) is noted on the right side of the scatter diagram. It is quite easy to see that the LEAPS options rarely trade at that low volatility level. In Figure 36-3, the distance between the curved lines is much greater on the left side (i.e., for shorter-term options) than it is on the right side (for longer-term options). Thus, it's difficult for the longer-term options to register either an extreme­ ly high or extremely low implied volatility reading, when all of the options are con­ sidered. Consequently, LEAPS options will rarely appear "cheap" when one looks at their percentile of implied volatility, including all the short-term options, too: One might say that, if he were going to buy long-term options, he should look only at the size of the volatility range on the right side of the scatter diagram. Then, he could make his decision about whether the options are cheap or not by only com­ paring the current reading to past readings of long-term options. This line of think­ ing, though, is somewhat fallacious reasoning, for a couple of reasons: First, if one holds the option for any long period of time, the volatility range will widen out and there is a chance that implied volatility could drop substantially. Second, the long­ term volatility range might be so small that, even though the options are initially cheap, quick increase in implied volatility over several deciles might not translate into much of a gain in price in the short term. FIGURE 36-3. Implied volatilities of $OEX options over several years. 50 45 40 ~ 35 ~ 30 g 25 "O .91 20 C. E 15 -0th 10 5 0 0 10 20 30 40 Time to Expiration (months) ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:789 SCORE: 44.00 ================================================================================ Chapter 36: The Basics ol Volatility Trading 737 It's important for anyone using implied volatility in his trading decisions to understand that the range of past implied volatilities is important, and to realize that the volatility range expands as time shrinks. IS IMPLIED VOLATILITY A GOOD PREDICTOR OF ACTUAL VOLATILITY? The fact that one can calculate implied volatility does not mean that the calculation is a good estimate of forthcoming volatility. As stated above, the marketplace does not really know how volatile an instrument is going to be, any more than it knows the forthcoming price of the stock. There are clues, of course, and some general ways of estimating forthcoming volatility, but the fact remains that sometimes options trade with an implied volatility that is quite a bit out of line with past levels. Therefore, implied volatility may be considered to be an inaccurate estimate of what is really going to happen to the stock during the life of the option. Just remember that implied volatility is a forward-looking estimate, and since it is based on traders' suppositions, it can be wrong - just as any estimate of future events can be in error. The question posed above is one that should probably be asked more often than it is: "Is implied volatility a good predictor of actual volatility?" Somehow, it seems logical to assume that implied and historical (actual) volatility will converge. That's not really true, at least not in the short term. Moreover, even if they do converge, which one was right to begin with - implied or historical? That is, did implied volatil­ ity move to get more in line with actual movements of the underlying, or did the stock's movement speed up or slow down to get in line with implied volatility? To illustrate this concept, a few charts will be used that show the comparison between implied and historical volatility. Figure 36-4 shows information for the $0EX Index. In general, $0EX options are overpriced. See the discussion in Chapter 29. That is, implied volatility of $0EX options is almost always higher than what actual volatility turns out to be. Consider Figure 36-4. There are three lines in the figure: (a) implied volatility, (b) actual volatility, and (c) the difference between the two. There is an important distinction here, though, as to what comprises these curves: (a) The implied volatility curve depicts the 20-day moving average of daily compos­ ite implied volatility readings for $0EX. That is, each day one number is com­ puted as a composite implied volatility for $0EX for that day. These implied volatility figures are computed using the averaging formula shown in the chapter on mathematical applications, whereby each option's implied volatility is weight­ ed by trading volume and by distance in- or out-of-the-money, to arrive at a sin­ gle composite implied volatility reading for the trading day. To smooth out those daily readings, a 20-day simple moving average is used. This daily implied volatil- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:790 SCORE: 19.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:791 SCORE: 28.00 ================================================================================ 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, ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:792 SCORE: 7.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:793 SCORE: 3.00 ================================================================================ Chapter 36: The Basics of Volatility Trading FIGURE 36-7. Implied versus historical volatility of a stock. 120 110 100 90 80 70 60 50 40 30 20 10 01-----------~~r:cr:1--- -10 "O -20 ~ -30"5" F M A M J J A S O N D- Implied minus Actual 1999 FIGURE 36-8. The price graph of the stock • ... : ....... --: ......... : ·······.··········, ····-·-:· ....... : ........ ..; ... . ······: ---:·······•: J. ...... 1 ....... ) ....... --) .... ----1 .).. ! .). ······-·········-··· -.. ;..... : ...... ;.. . : ......... : .... . ...... .: ......... : .......... : .......... : ....... , ......... •. ..... ; ...... ) ....... .L.. ... .L .. Stock· Pri~e ..... ) ...... ) .. . ·······'• ...... _.: ____ .... •. ·······:---- .•.•••• j ' . J F M A M J J A S 0 N D J 1999 Date 27.000 25.000 23.000 21.000 19.000 17.000 15.000 13.000 11.000 9.000 7.000 5.000 741 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:794 SCORE: 22.00 ================================================================================ 742 Part VI: Measuring and Trading Volatility implied volatility was a poor predictor of actual volatility for most of the time on these graphs. Moreover, implied volatility remained low at the right-hand side of the charts (January 2000) even though the stock doubled in the course of a month. The important thing to note from these figures is that they clearly show that implied volatility is really not a very good predictor of the actual volatility that is to follow. If it were, the difference line would hover near zero most of the time. Instead, it swings back and forth wildly, with implied volatility over- or underestimating actu­ al volatility by quite wide levels. Thus, the current estimates of volatility by traders (i.e., implied volatility) can actually be quite wrong. Conversely, one could also say that historical volatility is not a great predictor of volatility that is to follow, either, especially in the short term. No one really makes any claims that it is a good predictor, for historical volatility is merely a reflection of what has happened in the past. All we can say for sure is that implied and historical volatil­ ity tend to trade within a range. One thing that does stand out on these charts is that implied volatility seems to fluctuate less than actual volatility. That seems to be a natural function of the volatil­ ity predictive process. For example, when the market collapses, implied volatilities of options rise only modestly. This can be observed by again referring to Figure 36-4, the $0EX option example. The only shaded area on the graph occurred when the market had a rather sharp sell-off during October 1999. In previous years, when there had been even more severe market declines (October 1997 or August-October 1998) $0EX actual volatility had briefly moved above implied volatility (this data for 1997 and 1998 is shown in Figure 36-9). In other words, option traders and market­ makers are predicting volatility when they price options, and one tends to make a FIGURE 36-9. $OEX implied versus historical volatility, 1997-1998. Actual 40 30 10 0 D J F M A -20 1997 1998 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:795 SCORE: 20.00 ================================================================================ Chapter 36: The Basics of Volatility Trading 743 prediction that is somewhat "middle of the road," since an extreme prediction is more likely to be wrong. Of course, it turns out to be wrong anyway, since actual volatility jumps around quite rapidly. The few charts that have been presented here don't constitute a rigorous study upon which to draw the conclusion that implied volatility is a poor predictor of actu­ al volatility, but it is this author's firm opinion that that statement is true. A graduate student looking for a master's thesis topic could take it from here. VOLATILITY TRADING As a result of the fact that implied volatility can sometimes be at irrational extremes, options may sometimes trade with implied volatilities that are significantly out of line with what one would normally expect. For example, suppose a stock is in a relatively nonvolatile period, like the price of the stock in Figure 36-2, just before point A on the graph. During that time, option sellers would probably become more aggressive while option buyers, who probably have been seeing their previous purchases decay­ ing with time, become more timid. As a result, option prices drop. Alternatively stat­ ed, implied volatility drops. When implied volatilities are decreasing, option sellers are generally happy (and may often become more aggressive), while option buyers are losing money (and may often tend to become more timid). This is just a function of looking at the profit and loss statements in one's option account. But anyone who took a longer backward look at the volatility of the stock in Figure 36-2 would see that it had been much more volatile in the past. Consequently, he might decide that the implied volatility of the options had gotten too low and he would be a buyer of options. It is the volatility trader's objective to spot situations when implied volatility is possibly or probably erroneous and to take a position that would profit when the error is brought to light. Thus, the volatility trader's main objective is spotting situa­ tions when implied volatility is overvalued or undervalued, irrespective of his outlook for the underlying stock itself. In some ways, this is not so different from the funda­ mental stock analyst who is attempting to spot overvalued or undervalued stocks, based on earnings and other fundamentals. From another viewpoint, volatility trading is also a contrarian theory of invest­ ing. That is, when everyone else thinks the underlying is going to be nonvolatile, the volatility trader buys volatility. When everyone else is selling options and option buy­ ers are hard to find, the volatility trader steps up to buy options. Of course, some rig­ orous analysis must be done before the volatility trader can establish new positions, but when those situations come to light, it is most likely that he is taking positions opposite to what "the masses" are doing. He will be buying volatility when the major- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:796 SCORE: 12.00 ================================================================================ 744 Part VI: Measuring and Trading Volatility ity has been selling it (or at least, when the majority is refusing to buy it), and he will be selling volatility when everyone else is panicking to buy options, making them quite expensive. WHY DOES VOLATILITY REACH EXTREMES? One can't just buy every option that he considers to be cheap. There must be some consideration given to what the probabilities of stock movement are. Even more important, one can't just sell every option that he values as expensive. There may be valid reasons why options become expensive, not the least of which is that someone may have inside information about some forthcoming corporate news (a takeover or an earnings surprise, for example). Since options off er a good deal of leverage, they are an attractive vehicle to any­ one who wants to make a quick trade, especially if that person believes he knows something that the general public doesn't know. Thus, if there is a leak of a takeover rumor - whether it be from corporate officers, investment bankers, printers, or accountants - whoever possesses that information may quite likely buy options aggressively, or at least bid for them. Whenever demand for an option outstrips sup­ ply - in this case, the major supplier is probably the market-maker - the options quickly get more expensive. That is, implied volatility increases. In fact, there are financial analysts and reporters who look for large increases in trading volume as a clue to which stocks might be ready to make a big move. Invariably, if the trading volume has increased and if implied volatility has increased as well, it is a good warning sign that someone with inside information is buying the options. In such a case, it might not be a good idea to sell volatility, even though the options are mathematically expensive. Sometimes, even more minor news items are known in advance by a small seg­ ment of the investing community. If those items will be enough to move the stock even a couple of points, those who possess the information may try to buy options in advance of the news. Such minor news items might include the resignation or firing of a high-ranking corporate officer, or perhaps some strategic alliance with another company, or even a new product announcement. The seller of volatility can watch for two things as warning signs that perhaps the options are "predicting" a corporate event (and hence should be avoided as a "volatility sale"). Those two things are a dramatic increase in option volume or a sud­ den jump in implied volatility of the options. One or both can be caused by traders with inside information trying to obtain a leveraged instrument in advance of the actual corporate news item being made public. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:797 SCORE: 9.00 ================================================================================ Chapter 36: The Basics of Volatility Trading 745 A SUDDEN INCREASE IN OPTION VOLUME OR IMPLIED VOLATILITY The symptoms of insider trading, as evidenced by a large increase in option trading activity, can be recognized. Typically, the majority of the increased volume occurs in the near-term option series, particularly the at-the-money strike and perhaps the next strike out-of-the-money. The activity doesn't cease there, however. It propagates out to other option series as market-makers (who by the nature of their job function are short the near-term options that those with insider knowledge are buying) snap up everything on the books that they can find. In addition, the market-makers may try to entice others, perhaps institutions, to sell some expensive calls against a portion of their institutional stock holdings. Activity of this sort should be a warning sign to the volatility seller to stand aside in this situation. Of course, on any given day there are many stocks whose options are extraordi­ narily active, but the increase in activity doesn't have anything to do with insider trad­ ing. This might include a large covered call write or maybe a large put purchase established by an institution as a hedge against an existing stock position, or a rela­ tively large conversion or reversal arbitrage established by an arbitrageur, or even a large spread transaction initiated by a hedge fund. In any of these cases, option vol­ ume would jump dramatically, but it wouldn't mean that anyone had inside knowl­ edge about a forthcoming corporate event. Rather, the increases in option trading volume as described in this paragraph are merely functions of the normal workings of the marketplace. What distinguishes these arbitrage and hedging activities from the machina­ tions of insider trading is: (1) There is little propagation of option volume into other series in the "benign" case, and (2) the stock price itself may languish. However, when true insider activity is present, the market-makers react to the aggressive nature of the call buying. These market-makers know they need to hedge themselves, because they do not want to be short naked call options in case a takeover bid or some other news spurs the stock dramatically higher. As mentioned earlier, they try to buy up any other options offered in "the book," but there may not be many of those. So, as a last result, the way they reduce their negative position delta is to buy stock. Thus, if the options are active and expensive, and if the stock is rising too, you probably have a reasonably good indication that "someone knows something." However, if the options are expensive but none of the other factors are present, espe­ cially if the stock is declining in price - then one might feel more comfortable with a strategy of selling volatility in this case. However, there is a case in which options might be the object of pursuit by someone with insider knowledge, yet not be accompanied by heavy trading volume. This situation could occur with illiquid options. In this case, a floor broker holding ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:798 SCORE: 12.00 ================================================================================ 746 Part VI: Measuring and Trading Volatility the order of those with insider information might come into the pit to buy options, but the market-makers may not sell them many, preferring to raise their offering price rather than sell a large quantity. If this happens a few times in a row, the options will have gotten very expensive as the floor broker raises his bid price repeatedly, but only buys a few contracts each time. Meanwhile, the market-maker keeps raising his offering price. Eventually, the floor broker concludes that the options are too expensive to bother with and walks away. Perhaps his client then buys stock. In any case, what has happened is that the options have gotten very expensive as the bids and offers were repeatedly raised, but not much option volume was actually traded because of the illiquidity of the contracts. Hence the normal warning light associated with a sudden increase in option volume would not be present. In this case, though, a volatility sell­ er should still be careful, because he does not want to step in to sell calls right before some major corporate news item is released. The clue here is that implied volatility literally exploded in a short period of time (one day, or actually less time), and that alone should be enough warning to a volatility seller. The point that should be taken here is that when options suddenly become very expensive, especially if accompanied by strong stock price movement and strong stock volume, there may very well be a good reason why that is happening. That rea­ son will probably become public knowledge shortly in the form of a news event. In fact, a major market-maker once said he believed that rrwst increases in implied volatility were eventually justified - that is, some corporate news item was released that made the stock jump. Hence, a volatility seller should avoid situations such as these. Any sudden increase in implied volatility should probably be viewed as a potential news story in the making. These situations are not what a neutral volatility seller wants to get into. On the other hand, if options have become expensive as a result of corporate news, then the volatility seller can feel more comfortable making a trade. Perhaps the company has announced poor earnings and the stock has taken a beating while implied volatility rose. In this situation, one can assess the information and analyze it clearly; he is not dealing with some hidden facts known to only a few insider traders. With clear analysis, one might be able to develop a volatility selling strategy that is prudent and potentially profitable. Another situation in which options become expensive in the wake of market action is during a bear market in the underlying. This can be true for indices, stocks, and futures contracts. The Crash of '87 is an extreme example, but implied volatility shot through the roof during the crash. Other similar sharp market collapses - such as October 1989, October 1997, and August-September 1998 - caused implied volatility to jump dramatically. In these situations, the volatility seller knows why ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:799 SCORE: 12.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:800 SCORE: 0.00 ================================================================================ 748 Part VI: Measuring and Trading Volatility Sellers of volatility, however, have to be a lot more careful. One mistake could be the last one. Selling naked calls that seem terrifically expensive by historic stan­ dards could be ruinous if a takeover bid subsequently emerges at a large premium to the stock's current price. Even put sellers must be careful, although a lot of traders think that selling naked puts is safe because it's the same as buying stock. But who ever said buying stock wasn't risky? If the stock literally collapses - falling from 80, say, to 15 or 20, as Oxford Health did, or from 30 to 2 as Sunrise Technology did - then a put seller will be buried. Since the risk of loss from naked option selling is large, one could be wiped out by a huge gap opening. That's why it's imperative to study why the options are expensive before one sells them. If it's known, for exam­ ple, that a small biotech company is awaiting FDA trial results in two weeks,~and all the options suddenly become expensive, the volatility seller should not attempt to be a hero. It's obvious that at least some traders believe that there is a chance for the stock to gap in price dramatically. It would be better to find some other situation in which to sell options. The seller of futures options or index options should be cautious too, although there can't be takeovers in those markets, nor can there be a huge earnings surprise or other corporate event that causes a big gap. The futures markets, though do have things like crop reports and government economic data to deal with, and those can create volatile situations, too. The bottom line is that volatility selling - even hedged volatility selling - can be taxing and aggravating if one has sold volatility in front of what turns out to be a news item that justifies the expensive volatility. SUMMARY Volatility trading is a predictable way to approach the market, because volatility almost invariably trades in a range and therefore its value can be estimated with a great deal more precision than can the actual prices of the underlyings. Even so, one must be careful in his approach to volatility trading, because diligent research is needed to determine if, in fact, volatility is "cheap" or "expensive." As with any sys­ tematic approach to the market, if one is sloppy about his research, he cannot expect to achieve superior results. In the next few chapters, a good deal of time will be spent to give the reader a good understanding of how volatility affects positions and how it can be used to construct trades with positive expected rates of return. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:801 SCORE: 12.00 ================================================================================ · GHAR:f ER :8'7 . . - How Volatility Affects Popular Strategies The previous chapter addressed the calculation or interpretation of implied volatili­ ty, and how to relate it to historic volatility. Another, related topic that is important is how implied volatility affects a specific option strategy. Simplistically, one might think that the effect of a change in implied volatility on an option position would be a sim­ ple matter to discern; but in reality, most traders don't have a complete grasp of the ways that volatility affects option positions. In some cases, especially option spreads or more complex positions, one may not have an intuitive "picture" of how his posi­ tion is going to be affected by a change in implied volatility. In this chapter, we'll attempt a relatively thorough review of how implied volatility changes affect most of the popular option strategies. There are ways to use computer analysis to "draw" a picture of this volatiiity effect, of course, and that will be discussed momentarily. But an option strategist should have some idea of the general changes that a position will undergo if implied volatility changes. Before getting into the individual strategies, it is important that one understands some of the basics of the effect of volatility on an option's price. VEGA Technically speaking, the term that one uses to quantify the impact of volatility changes on the price of an option is called the vega of the option. In this chapter, the references will be to vega, but the emphasis here is on practicality, so the descriptions 749 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:802 SCORE: 16.00 ================================================================================ 750 Part VI: Measuring and Trading Volatility of how volatility affects option positions will be in plain English as well as in the more mathematical realm of vega. Having said that, let's define vega so that it is understood for later use in the chapter. Simply stated, vega is the amount by which an option's price changes when volatility changes by one percentage point. Example: XYZ is selling at 50, and the July 50 call is trading at 7.25. Assume that there is no dividend, that short-term interest rates are 5%, and that July expiration is exactly three months away. With this information, one can determine that the implied volatility of the July 50 call is 70%. That's a fairly high number, so one can surmise that XYZ is a volatile stock. What would the option price be if implied volatility were rise to 71 %? Using a model, one can determine that the July 50 call would theoreti­ cally be worth 7.35 if that happened. Hence, the vega of this option is 0.10 (to two decimal places). That is, the option price increased by 10 cents, from 7.25 to 7.35, when volatility rose by one percentage point. (Note that "percentage point" here means a full point increase in volatility, from 70% to 71 %.) What if implied volatility had decreased instead? Once again, one can use the model to determine the change in the option price. In this case, using an implied volatility of 69% and keeping everything else the same, the option would then theo­ retically be worth 7.15- again, a 0.10 change in price (this time, a decrease in price). This example points out an interesting and important aspect of how volatility affects a call option: If implied volatility increases, the price of the option will increase, and if implied volatility decreases, the price of the option will decrease. Thus, there is a direct relationship between an option's price and its implied volatili- ty. Mathematically speaking, vega is the partial derivative of the Black-Scholes model (or whatever model you're using to price options) with respect to volatility. In the above example, the vega of the July 50 call, with XYZ at 50, can be computed to be 0.098 - very near the value of 0.10 that one arrived at by inspection. Vega also has a direct relationship with the price of a put. That is, as implied volatility rises, the price of a put will rise as well. Example: Using the same criteria as in the last example, suppose that XYZ is trading at 50, that July is three months away, that short-term interest rates are 5%, and that there is no dividend. In that case, the following theoretical put and call prices would apply at the stated implied volatilities: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:803 SCORE: 12.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:804 SCORE: 20.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:805 SCORE: 20.00 ================================================================================ Chapter 37: How Volatility Affeds Popular Strategies TABLE 37-3 Implied Stock Price Volatility 50 10% 30% 50% 70% 100% 150% 200% Theoretical Coll Price 1.34 3.31 5.28 7.25 10.16 14.90 19.41 753 Vega 0.097 0.099 0.099 0.098 0.096 0.093 0.088 of a 6-month call option with differing implied volatilities. Suppose one buys an option that currently has implied volatility of 170% (the top curve on the graph). Later, investor perceptions of volatility diminish, and the option is trading with an implied volatility of 140%. That means that the option is now "residing" on the sec­ ond curve from the top of the list. Judging from the general distance between those two curves, the option has probably lost between 5 and 8 points of value due to the drop in implied volatility. Here's another way to think about it. Again, suppose one buys an at-the-money option (stock price = 100) when its implied volatility is 170%. That option value is marked as point A on the graph in Figure 37-1. Later, the option's implied volatility drops to 140%. How much does the stock have to rise in order to overcome the loss of implied volatility? The horizontal line from point A to point B shows that the option value is the same on each line. Then, dropping a vertical line from B down to point C, we see that point C is at a stock price of about 109. Thus, the stock would have to rise 9 points just to keep the option value constant, if implied volatility drops from 170% to 140%. IMPLIED VOLATILITY AND DELTA Figure 37-1 shows another rather unusual effect: When implied volatility gets very high, the delta of the option doesn't change much. Simplistically, the delta of an option measures how much the option changes in price when the stock moves one point. Mathematically, the delta is the first partial derivative of the option model with respect to stock price. Geometrically, that means that the delta of an option is the slope of a line drawn tangent to the curve in the preceding chart. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:806 SCORE: 20.00 ================================================================================ 754 Part VI: Measuring and Trading Volatility FIGURE 37-1. Theoretical option prices at differing implied volatilities (6-month calls). 80 70 Q) 60 (.) ·;::: Cl.. 50 C: 0 ·a 40 0 30 20 10 Stock Price 60 80 100 C 120 140 _JY.._ 170% 140% 110% 80% 50% 20% The bottom line in Figure 37-1 (where implied volatility= 20%) has a distinct curvature to it when the stock price is between about 80 and 120. Thus the delta ranges from a fairly low number (when the stock is near 80) to a rather high number (when the stock is near 120). Now look at the top line on the chart, where implied volatility= 170%. It's almost a straight line from the lower left to the upper right! The slope of a straight line is constant. This tells us that the delta (which is the slope) barely changes for such an expensive option - whether the stock is trading at 60 or it's trading at 150! That fact alone is usually surprising to many. In addition, the value of this delta can be measured: It's 0. 70 or higher from a stock price of 80 all the way up to 150. Among other things, this means that an out~ of-the-money option that has extremely high implied volatility has a fairly high delta - and can be expected to mirror stock price movements more closely than one might think, were he not privy to the delta. Figure 37-2 follows through on this concept, showing how the delta of an option varies with implied volatility. From this chart, it is clear how much the delta of an option varies when the implied volatility is 20%, as compared to how little it varies when implied volatility is extremely high. That data is interesting enough by itself, but it becomes even more thought-pro­ voking when one considers that a change in the implied volatility of his option (vega) also can mean a significant change in the delta of the option. In one sense, it explains why, in the first chart (Figure 37-1), the stock could rise 9 points and yet the option holder made nothing, because implied volatility declined from 170% to 140%. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:807 SCORE: 0.00 ================================================================================ Chapter 37: How Volatility Affects Popular Strategies EFFECTS ON NEUTRALITY 755 A popular concept that uses delta is the "delta-neutral" spread a spread whose prof­ itability is supposedly ambivalent to market movement, at least for short time frames and limited stock price changes. Anything that significantly affects the delta of an option can affect this neutrality, thus causing a delta-neutral position to become unbalanced ( or, more likely, causing one's intuition to be wrong regarding what con­ stitutes a delta-neutral spread in the first place). Let's use a familiar strategy, the straddle purchase, as an example. Simplistically, when one buys a straddle, he merely buys a put and a call with the same terms and doesn't get any fancier than that. However, it may be the case that, due to the deltas of the options involved, that approach is biased to the upside, and a neutral straddle position should be established instead. Example: Suppose that XYZ is trading at 100, that the options have an implied volatility of 40%, and that one is considering buying a six-month straddle with a strik­ ing price of 100. The following data summarize the situation, including the option prices and the deltas: XYZ Common: l 00; Implied Volatility: 40% Option XYZ October l 00 call XYZ October l 00 put FIGURE 37-2. Price 12.00 10.00 Delta 0.60 -0.40 Value of delta of a 6-month option at differing implied volatilities. 90 80 70 .!!l ai 60 Cl C: 50 ,g 8° 40 30 20 10 60 80 100 Stock Price 120 140 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:808 SCORE: 12.00 ================================================================================ 756 Part VI: Measuring and Trading Volatility Notice that the stock price is equal to the strike price (100). However, the deltas are not at all equal. In fact, the delta of the call is 1.5 times that of the put (in absolute value). One must buy three puts and two calls in order to have a delta-neutral posi­ tion. Most experienced option traders know that the delta of an at-the-money call is somewhat higher than that of an at-the-money put. Consequently, they often esti­ mate, without checking, that buying three puts and two calls produces a delta-neu­ tral "straddle buy." However, consider a similar situation, but with a much higher implied volatility- 110%, say. AAA Common: 100; Implied Volatility: 110% Option AAA October 100 call AAA October 1 00 put Price 31.00 28.00 Delta 0.67 -0.33 The delta-neutral ratio here is two-to-one (67 divided by 33), not three-to-two as in the earlier case - even though both stock prices are 100 and both sets of options have six months remaining. This is a big difference in the delta-neutral ratio, espe­ cially if one is trading a large quantity of options. This shows how different levels of implied volatility can alter one's perception of what is a neutral position. It also points out that one can't necessarily rely on his intuition; it is always best to check with a model. Carrying this thought a step further, one must be mindful of a change in implied volatility if he wants to keep his position delta-neutral. If the implied volatility of AAA options should drop significantly, the 2-to-l ratio will no longer be neutral, even if the stock is still trading at 100. Hence, a trader wishing to remain delta-neutral must monitor not only changes in stock price, but changes in implied volatility as well. For­ more complex strategies, one will also find the delta-neutral ratio changing due to a change in implied volatility. The preceding examples summarize the major variables that might affect the vega and also show how vega affects things other than itself, such as delta and, there­ fore, delta neutrality. By the way, the vega of the underlying is zero; an increase in implied volatility does not affect the price of the underlying instrument at all, in the­ ory. In reality, if options get very expensive (i.e., implied volatility spikes up), that usually brings traders into a stock and so the stock price will change. But that's not a mathematical relationship, just a market cause-and-effect relationship. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:809 SCORE: 16.00 ================================================================================ Chapter 37: How Volatility Affects Popular Strategies POSITION VEGA 757 As can be done with delta or with any other of the partial derivatives of the model, one can compute a position vega - the vega of an entire position. The position vega is determined by multiplying the individual option vegas by the quantity of options bought or sold. The "position vega" is merely the quantity of options held, times the vega, times the shares per options ( which is normally 100). Example: Using a simple call spread as an example, assume the following prices exist: Security Position Vega Position Vego XYZ Stock No position XYZ July 50 call Long 3 calls 0.098 +0.294 XYZ July 70 call Short 5 calls 0.076 -0.380 Net Position Vega: -0.086 This concept is very important to a volatility trader, for it tells him if he has con­ structed a position that is going to behave in the manner he expects. For example, suppose that one identifies expensive options, and he figures that implied volatility will decrease, eventually becoming more in line with its historical norms. Then he would want to construct a position with a negative position vega. A negative position vega indicates that the position will profit if implied volatility decreases. Conversely, a buyer of volatility - one who identifies some underpriced situation - would want to construct a position with a positive position vega, for such a position will profit if implied volatility rises. In either case, other factors such as delta, time to expiration, and so forth will have an effect on the position's actual dollar profit, but the concept of position vega is still important to a volatility trader. It does no good to identify cheap options, for example, and then establish some strange spread with a negative position vega. Such a construct would be at odds with one's intended purpose - in this case, buying cheap options. OUTRIGHT OPTION PURCHASES AND SALES Let us now begin to investigate the affects of implied volatility on various strategies, beginning with the simplest strategy of all - the outright option purchase. It was already shown that implied volatility affects the price of an individual call or put in a ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:810 SCORE: 36.00 ================================================================================ 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: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:811 SCORE: 28.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:812 SCORE: 36.00 ================================================================================ 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? It 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: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:813 SCORE: 28.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:814 SCORE: 20.00 ================================================================================ 760 Part VI: Measuring and Trading Volatility Finally, to be able to completely compare this example with the previous one, it is necessary to see what implied volatility would have to rise to in order to offset the effect of yet another month's time decay. It turns out to be over 140%: Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 1 month 140.9% 16.45 Table 37-4 summarizes the results of these examples, showing the levels to which implied volatility would have to rise to maintain the call's value as time passes. Are the volatility increases in the latter example less likely to occur than the ones in the former example? Probably yes - certainly the last one, in which implied volatility would have to increase from 80% to nearly 141 % in order to maintain the call's value. However, in another sense, it may seem more reasonable: Note that the increase in volatility from 20% to 26% is a 30% increase. That is, 20% times 1.30 equals 26%. That's what's required to maintain the call's value for the lower volatility over the first month - an increase in the magnitude of implied volatility of 30%. At the higher volatility, though, an increase in magnitude of only about 25% is required (from 80% to 99%). Thus, in those terms, the two appear on more equal footing. What makes the top line of Table 37-4 appear more likely than the bottom line is merely the fact that an experienced option trader knows that many stocks have implied volatilities that can fluctuate in the 20% to 40% range quite easily. However, there are far fewer stocks that have implied volatilities in the higher range. In fact, until the Internet stocks got hot in the latter portion of the 1990s, the only ones with volatilities like those were very low-priced, extremely volatile stocks. Hence one's experience factor is lower with such high implied volatility stocks, but it doesn't mean that the volatility fluctuations appearing in Table 37-4 are impossible. If the reader has access to a software program containing the Black-Scholes model, he can experiment with other situations to see how powerful the effect of implied volatility is. For example, without going into as much detail, if one takes the case of a 12-month option whose initial implied volatility is 20%, all it takes to main- TABLE 37-4 Initial Implied Volatility 20% 80% Volatility Leveled Required to Maintain Call Value ... ... After One Month ... After Two Months 26% 99% 38% 141% ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:815 SCORE: 28.00 ================================================================================ Chapter 37: How Volatility Affects Popular Strategies 761 tain the call's value over a 6-month time period is an increase in implied volatility to 27%. Taken from the viewpoint of the option seller, this is perhaps most enlighten­ ing: If you sell a one-year (LEAPS) option and six months pass, during which time implied volatility increases from 20% to 27% - certainly quite possible -you will have made nothing! The call will still be selling for the same price, assuming the stock is still selling for the same price. Finally, it was mentioned earlier that implied volatility often explodes during a market crash. In fact, one could determine just how much of an increase in implied volatility would be necessary in a market crash in order to maintain the call's value. This is similar to the first example in this section, but now the stock price will be allowed to decrease as well. Table 37-5, then, shows what implied volatility would be required to maintain the call's initial value (a price of 4.64), when the stock price falls. The other factors remain the same: time remaining (3 months), striking price (100), and interest rate (5% ). Again, this table shows instantaneous price changes. In real life, a slightly higher implied volatility would be necessary, because each market crash could take a day or two. Thus, from Table 37-5, one could say that even if the underlying stock dropped 20 points (which is 20% in this case) in one day, yet implied volatility exploded from 20% to 67% at the same time, the call's value would be unchanged! Could such an outrageous thing happen? It has: In the Crash of '87, the market plummeted 22% in one day, while the Volatility Index ($VIX) theoretically rose from 36% to 150% in one day. In fact, call buyers of some $OEX options actually broke even or made a little money due to the explosion in implied volatility, despite the fact that the worst mar­ ket crash in history had occurred. If nothing else, these examples should impart to the reader how important it is to be aware of implied volatility at the time an option position is established. If you are buying options, and you buy them when implied volatility is "low," you stand to TABLE 37-5 Stock Price 100 95 90 85 80 75 70 Implied Volatility Necessary for Call to Maintain Value 20% (the initial parameters) 33% 44% 55% 67% 78% 89% ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:816 SCORE: 40.00 ================================================================================ 762 Part VI: Measuring and Trading Volatility benefit if implied volatility merely returns to "normal" levels while you hold the posi­ tion. Of course, having the underlying increase in price is also important. Conversely, an option seller should be keenly aware of implied volatility when the option is initially sold - perhaps even more so than the buyer of an option. This pertains equally well to naked option writers and to covered option writers. If implied volatility is "too low" when the option writing position is established, then an increase (or worse, an explosion) in implied volatility will be very detrimental to the position, completely overcoming the effects of time decay. Hence, an option writer should not just sell options because he thinks he is collecting time decay each day that passes. That may be true, but an increase in implied volatility can completely domin.ate what little time decay might exist, especially for a longer-term option. In a similar manner, a decrease in implied volatility can be just as important. Thus, if the call buyer purchases options that are "too costly," ones in which implied volatility is "too high," then he could lose money even if the underlying makes a mod­ est move in his favor. In the next chapters, the topic of just how an option buyer or seller should measure implied volatility to determine what is "too low" or "too high" will be dis­ cussed. For now, suffice it to grasp the general concept that a change in implied volatility can have substantial effects on an option's price far greater effects than the passage of time can have. In fact, all of this calls into question just exactly what time value premium is. That part of an option's value that is not intrinsic value is really affected much more by volatility than it is by time decay, yet it carries the term "time value premium." TIME VALUE PREMIUM IS A MISNOMER Many (perhaps novice) option traders seem to think of time as the main antagonist to an option buyer. However, when one really thinks about it, he should realize that the portion of an option that is not intrinsic value is really much more related to stock price movement and/or volatility than anything else, at least in the short term. For this reason, it might be beneficial to more closely analyze just what the "excess value" portion of an option represents and why a buyer should not primarily think of it as time value premium. An option's price is composed of two parts: (1) intrinsic value, which is the "real" part of the option's value - the distance by which the option is in-the-money, and (2) "excess value" - often called time value premium. There are actually five factors that affect the "excess value" portion of an option. Eventually, time will dominate them ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:817 SCORE: 12.00 ================================================================================ Chapter 37: How Volah'lity Affects Popular Strategies 763 all, but the longer the life of the option, the more the other factors influence the "excess value." The five factors influencing excess value are: 1. stock price movements, 2. changes in implied volatility, 3. the passage of time, 4. changes in the dividend (if any exist), and 5. changes in interest rates. Each is stated in terms of a movement or change; that is, these are not static things. In fact, to measure them one uses the "greeks": delta, vega, theta, (there is no "greek" for dividend change), and rho. Typically, the effect of a change in dividend or a change in interest rate is small (although a large dividend change or an interest rate change on a very long-term option can produce visible changes in the prices of options). If everything remains static, then time decay will eventually wipe out all of the excess value of an option. That's why it's called time value premium. But things don't ever remain static, and on a daily basis, time decay is small, so it is the remaining two factors that are most important. Example: XYZ is trading at 82 in late November. The January 80 call is trading at 8. Thus, the intrinsic value is 2 (82 minus 80) and the excess value is 6 (8 minus 2). If the stock is still at 82 at January expiration, the option will of course only be worth 2, and one will say that the 6 points of excess value that was lost was due to time decay. But on that day in late November, the other factors are much more dominant. On this particular day, the implied volatility of this option is just over 50%. One can determine that the call's greeks are: Delta: 0.60 Vega: 0.13 Theta: -0.06 This means, for example, that time decay is only 6 cents per day. It would increase as time went by, but even with a day or so to go, theta would not increase above about 20 cents unless volatility increased or the stock moved closer to the strike price. From the above figures, one can see - and this should be intuitively appealing that the biggest factor influencing the price of the option is stock price movement (delta). ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:818 SCORE: 4.00 ================================================================================ 764 Part VI: Measuring and Trading VolatiRty It's a little unfair to say that, because it's conceivable (although unlikely) that volatil­ ity could jump by a large enough margin to become a greater factor than delta for one day's move in the option. Furthermore, since this option is composed mostly of excess value, these more dominant forces influence the excess value more than time decay does. There is a direct relationship between vega and excess value. That is, if implied volatility increases, the excess value portion of the option will increase and, if implied volatility decreases, so will excess value. The relationship between delta and excess value is not so straightforward. The farther the stock moves away from the strike, the more this will have the effect of shrinking the excess value. If the call is in-the-money (as in the above example), then an increase in stock price will result in a decrease of excess value. That is, a deeply in­ the-money option is composed primarily of intrinsic value, while excess value is quite small. However, when the call is out-of-the-money, the effect is just the opposite: Then, an increase in call price will result in an increase in excess value, because the stock price increase is bringing the stock closer to the option's striking price. For some readers, the following may help to conceptualize this concept. The part of the delta that addresses excess value is this: Out-of-the-money call: 100% of the delta affects the excess value. In-the-money call: "1.00 minus delta" affects the excess value. (So, if a call is very deeply in-the-money and has a delta of 0.95, then the delta only has 1.00 - 0.95, or 0.05, room to increase. Hence it has little effect on what small amount of excess value remains in this deeply in-the-money call.) These relationships are not static, of course. Suppose, for example, that in the same situation of the stock trading at 82 and the January 80 call trading at 8, there is only week remaining until expiration! Then the implied volatility would be 155% (high, but not unheard of in volatile times). The greeks would bear a significantly dif­ ferent relationship to each other in this case, though: Delta: 0.59 Vega: 0.044 Theta: -0 .5 1 This very short-term option has about the same delta as its counterpart in the previ­ ous example (the delta of an at-the-money option is generally slightly above 0.50). Meanwhile, vega has shrunk. The effect of a change in volatility on such a short-term option is actually about a third of what it was in the previous example. However, time decay in this example is huge, amounting to half a point per day in this option. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:819 SCORE: 16.00 ================================================================================ Chapter 37: How Volatility Affects Popular Strategies 765 So now one has the idea of how the excess value is affected by the "big three" of stock price movement, change in implied volatility, and passage of time. How can one use this to his advantage? First of all, one can see that an option's excess value may be due much more to the potential volatility of the underlying stock, and there­ fore to the option's implied volatility, than to time. As a result of the above information regarding excess value, one shouldn't think that he can easily go around selling what appear to be options with a lot of excess value and then expect time to bring in the profits for him. In fact, there may be a lot of volatility both actual and implied - keeping that excess value nearly intact for a fairly long period of time. In fact, in the coming chapters on volatility estimation, it will be shown that option buyers have a much better chance of success than conven­ tional wisdom has maintained. VOLATILITY AND THE PUT OPTION While it is obvious that an increase in implied volatility ½ill increase the price of a put option, much as was shown for a call option in. the preceding discussion, there are certain differences between a put and a call, so a little review of the put option itself may be useful. A put option tends to lose its premium fairly quickly as it becomes an in-the-money option. This is due to the realities of conversion arbitrage. In a con­ version arbitrage, an arbitrageur or market-maker buys stock and buys the put, while selling the call. If he carries the position to expiration, he will have to pay carrying costs on the debit incurred to establish the position. Furthermore, he would earn any dividends that might be paid while he holds the position. This information was pre­ sented in a slightly different form in the chapter on arbitrage, but it is recounted here: In a perfect world, all option prices would be so accurate that there would be no profit available from a conversion. That is, the following equation (1) would apply: (1) Call price+ Strike price - Stock price - Put price+ Dividend- Carrying cost= 0 where carrying cost = strike price/ (1 + r)t t = time to expiration r = interest rate Now, it is also known that the time value premium of a put is the amount by which its value exceeds intrinsic value. The intrinsic value of an in-the-money put option is merely the difference between the strike price and the stock price. Hence, one can write the following equation (2) for the time value premium (TVP) of an in-the­ money put option: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:820 SCORE: 56.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:821 SCORE: 20.00 ================================================================================ Chapter 37: How Volatility Affects Popular Strategies 767 positively affect both the put and the call in a long straddle. Thus, if a straddle buyer is careful to buy straddles in situations in which implied volatility is "low," he can make money in one of two ways. Either (1) the underlying price makes a move great enough in magnitude to exceed the initial cost of the straddle, or (2) implied volatil­ ity increases quickly enough to overcome the deleterious effects of time decay. Conversely, a straddle seller risks just the opposite - potentially devastating loss­ es if implied volatility should increase dramatically. However, the straddle seller can register gains faster than just the rate of time decay would indicate if implied volatil­ ity decreases. Thus, it is very important when selling options - and this applies to cov­ ered options as well as to naked ones - to sell only when implied volatility is "high." A strangle is the same as a straddle, except that the call and put have different striking prices. Typically, the call strike price is higher than the put strike price. Naked option sellers often prefer selling strangles in which the options are well out­ of-the-money, so that there is less chance of them having any intrinsic value when they expire. Strangles behave much like straddles do with respect to changes in implied volatility. The concepts of straddle ownership will be discussed in much more detail in the following chapters. Moreover, the general concept of option buying versus option selling will receive a great deal of attention. CALL BULL SPREADS In this section, the bull spread strategy will be examined to see how it is affected by changes in implied volatility. Let's look at a call bull spread and see how implied volatility changes might affect the price of the spread if all else remains equal. Make the following assumptions: Assumption Set 1 : Stock Price: 1 00 Time to Expiration: 4 months Position: long Call Struck at 90 Short Call Struck at 110 Ask yourself this simple question: If the stock remains unchanged at 100, and implied volatility increases dramatically, will the price of the 90-110 call bull spread grow or shrink? Answer before reading on. The truth is that, if implied volatility increases, the price of the spread will shrink. I would suspect that this comes as something of a surprise to a good number of readers. Table 37-6 contains some examples, generated from a Black-Scholes ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:822 SCORE: 8.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:823 SCORE: 12.00 ================================================================================ Chapter 37: How VolatHity Afleds Popular Strategies 769 volatility decreases. Again, these statements may seem contrary to what one would expect from a bullish call position. Of course, it's highly unlikely that implied volatility would change much in the course of just one day while the stock price remained unchanged. So, to get a bet­ ter handle on what to expect, one really to needs to look at what might happen at some future time (say a couple of weeks hence) at various stock prices. The graph in Figure 37-3 begins the investigation of these more complex scenarios. The profit curve shown in Figure 37-3 makes certain assumptions: (1) The bull spread assumes the details in Assumption Set 1, above; (2) the spread was bought with an implied volatility of 20% and remained at that level when the profit picture above was drawn; and (3) 30 days have passed since the spread was bought. Under these assumptions, the profit graph shows that the bull spread conforms quite well to what one would expect; that is, the shape of this curve is pretty much like that of a bull spread at expiration, although if you look closely you'll see that it doesn't widen out to nearly its maximum gain or loss potential until the stock is well above llO or below 90 the strike prices used in the spread. Now observe what happens if one keeps all the other assumptions the same, except one. In this case, assume implied volatility was 80% at purchase and remains at 80% one month later. The comparison is shown in Figure 37-4. The 80% curve is overlaid on top of the 20% curve shown earlier. The contrast is quite startling. Instead of looking like a bull spread, the profit curve that uses 80% implied volatili- FIGURE 37-3. Bull spread profit picture in 30 days, at 20% IV. 1000 500 -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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:825 SCORE: 12.00 ================================================================================ Cbapter 37: How Volatility Affects Popular Strategies 771 high implied volatility situations, the bull spread won't expand out to its maximum price until expiration draws nigh. That can be frustrating and disappointing. Often, the bull spread is established because the option trader feels the options are "too expensive" and thus the spread strategy is a way to cut down on the total debit invested. However, the ultimate penalty paid is great. Consider the fact that, if the stock rose from 100 to 130 in 30 days, any reasonable four-month call pur­ chase (i.e., with a strike initially near the current stock price) would make a nice profit, while the bull spread barely ekes out a 5-point gain. To wit, the graph in Figure 37-5 compares the purchase of the at-the-money call with a striking price of 100 and the 90-110 call bull spread, both having implied volatility of 80%. Quite clearly, the call purchase dominates to a great extent on an upward move. Of course, the call purchase does worse on the downside, but since these are bullish strategies, one would have to assume that the trader had a positive outlook for the stock when the position was established. Hence, what happens on the downside is not primary in his thinking. The bull spread and the call purchase have opposite position vegas, too. That is, a rise in implied volatility will help the call purchase but will harm the bull spread ( and vice versa). Thus, the call purchase and the bull spread are not very similar posi­ tions at all. If one wants to use the bull spread to effectively reduce the cost of buying an expensive at-the-money option, then at least make sure the striking prices are quite FIGURE 37-5. Call buy versus bull spread in 30 days; IV = 80%. Cl) ~ 2500 2000 1500 1000 e 500 Cl. -500 -1000 Outright Call Buy Bull Spread --- 140 Stock ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:826 SCORE: 12.00 ================================================================================ 772 Part VI: Measuring and Trading Volatility wide apart. That will allow for a reasonable amount of price appreciation in the bull spread if the underlying rises in price. Also, one might want to consider establishing the bull spread with striking prices that are both out-of-the-money. Then, if the stock rallies strongly, a greater percentage gain can be had by the spreader. Still, though, the facts described above cannot be overcome; they can only possibly be mitigated by such actions. A FAMILIAR SCENARIO? Often, one may be deluded into thinking that the two positions are more similar than they are. For example, one does some sort of analysis - it does not matter if it's fun­ damental or technical - and comes to a conclusion that the stock ( or futures contract or index) is ready for a bullish move. Furthermore, he wants to use options to imple­ ment his strategy. But, upon inspecting the actual market prices, he finds that the options seem rather expensive. So, he thinks, "Why not use a bull spread instead? It costs less and it's bullish, too." Fairly quickly, the underlying moves higher - a good prediction by the trader, and a timely one as well. If the move is a violent one, especially in the futures mar­ ket, implied volatility might increase as well. If you had bought calls, you'd be a happy camper. But if you bought the bull spread, you are not only highly disappointed, but you are now facing the prospect of having to hold the spread for several more weeks (perhaps months) before your spread widens out to anything even approaching the maximum profit potential. Sound familiar? Every option trader has probably done himself in with this line of thinking at one time or another. At least, now you know the reason why: High or increasing implied volatility is not a friend of the bull spread, while it is a friendly ally of the outright call purchase. Somewhat surprisingly, many option traders don't real­ ize the difference between these two strategies, which they probably consider to be somewhat similar in nature. So, be careful when using bull spreads. If you really think a call option is too expensive and want to reduce its cost, ti:y this strategy: Buy the call and simultane­ ously sell a credit put spread (bull spread) using slightly out-of-the-money puts. This strategy reduces the call's net cost and maintains upside potential (although it increases downside risk, but at least it is still a fixed risk). Example: With XYZ at 100, a trader is bullish and wants to buy the July 100 calls, which expire in two months. However, upon inspection, he finds that they are trad­ ing at 10 - an implied volatility of 59%. He knows that, historically, the implied volatility of this stock's options range from approximately 40% to 60%, so these are ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:827 SCORE: 4.00 ================================================================================ Chapter 37: How Volatility Affects Popular Strategies 773 very expensive options. If he buys them now and implied volatility returns to its median range near 50%, he will suffer from the decrease in implied volatility. As a possible remedy, he considers selling an out-of-the-money put credit spread at the same time that he buys the calls. The credit from this spread will act as a means of reducing the net cost of the calls. If he's right and the stock goes up, all will be well. However, the introduction of the put spread into the mix has introduced some additional downside risk. Suppose the following prices exist: XYZ: 100 July 100 call: 10 (as stated above) July 90 put: 5 July 80 put: 2 The entire bullish position would now consist of the following: Buy 1 July 100 call at 1 0 Buy 1 July 80 put at 2 Sell 1 July 90 put at 5 Net expenditure: 7 point debit (plus commission) Figure 37-6 shows the profitability, at expiration, of both the outright call pur­ chase and the bullish position constructed above. FIGURE 37-6. Profitability at expiration. 2000 Bullish Spread // / 1000 "' "' 0 ...J 87 :!:: Outright Call Purchase e 0 C. 70 80 90 6cr 12 14 Total number of stocks moving >=3cr: 251 ( 10% of the stocks studied) Total 157 94 Finally, one more example was conducted, using the least volatile period that we had in our database - July of 1993. Those results are in Table 38-4. TABLE 38-4. Stock price movements during a nonvolatile period. Total Stocks: 588 Dates: 7 /1 /93-8/17 /93 3cr 4cr Scr >6cr Total Upside Moves: 14 5 1 1 21 Downside Moves: 28 5 3 4 40 Total number of stocks moving >=3cr: 61 ( 10% of the stocks studied) At first glance, it appears that the number of large stock moves diminished dra­ matically during this less volatile period in the market - until you realize that it still represents 10% of the stocks in the study. There were just a lot fewer stocks with list­ ed options in 1993 than there were in 1999, so the database is smaller (it tracks only stocks with listed options). Once again, this means that there is a far greater chance for large standard deviations moves - about one in ten - than the nearly zero percent chance that the lognormal distribution would indicate. VOLATILITY BUYER'S RULE! The point of the previous discussion is that stocks move a lot farther than you might expect. Moreover, when they make these moves, it tends to be with rapidity, gener- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:844 SCORE: 14.00 ================================================================================ 788 Part VI: Measuring and Trading VolatiDty ally including gap moves. There are not always gap moves, though, over a study of this length. Sometimes, there will be a more gradual transition. Consider the fact that one of the stocks in the study moved 5.8 sigma in the 30 days. There weren't any huge gaps during that time, but anyone who was short calls while the stock made its run surely didn't think it was a gradual advance. So, what does this information mean to the average option trader? For one, you should certainly think twice about selling stock options in a potentially volatile market ( or any market, for that matter, since these large moves are not by any means limited to the volatile market periods). This statement encompasses naked option selling, but also includes many forms of option selling, because of the possibilities of large moves by the underlying stocks. For example, covered call writing is considered to be "conservative." However, when the stock has the potential to make these big moves, it will either cause one to give up large upside profits or to suffer large downside losses. ( Covered call writing has limited profit potential and relatively large downside risk, as does its equivalent strategy, naked put selling.) When these large stock moves occur on the upside, a cov­ ered writer is often disappointed that he gave up too much of the upside profit poten­ tial. Conversely, if the stock drops quickly, and one is assigned on his naked put, he often no longer has much appetite for acquiring the stock ( even though he said he "wouldn't mind" doing so when he sold the puts to begin with). Even spreading has problems along these lines. For example, a vertical spread limits profits so that one can't participate in these relatively frequent large stock moves when they occur. What can an option seller do? First, he must carefully analyze his position and allow for much larger stock movements than one would expect under the lognormal distribution. Also, he must be careful to sell options only when they are expensive in terms of implied volatility, so that any decrease in implied will work in his favor. Probably most judicious, though, is that an option seller should really concentrate on indices (or perhaps certain futures contracts), because they are statistically much less volatile than stocks. Hard as it is to believe, futures are less volatile than stocks (although the leverage available in futures can make them a riskier investment overall). Two 30-day studies, similar to those conducted on stocks, were run on option­ able indices, covering the same time periods: 10/22/99 to 12/7/99 for one study and 7/1/93 to 8/17/93 for the other. The results are shown in Tables 38-5 and 38-6. This may be a somewhat distorted picture, though, because many of these indices overlap (there are four Internet indices, for example). The largest mover was the Morgan Stanley High-Tech Index (5 standard deviations), but it should also be noted that something that is considered fairly tame, such as the Russell 2000 ($RUT), also had a 3-standard deviation move in one study. The first study showed that 37% of the ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:845 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:850 SCORE: 0.00 ================================================================================ 794 Part VI: Measuring and Trading Volatility FIGURE 38-3. Stock price distribution, IBM, 7-year. 7 6 5 ~ 4 :;:, C: :::, 8 3 2 o----------------+---,.._,._""-¥-+- -4.o -3.o -2.0 -1.0 o.o +1.0 +2.0 +3.o +4.o Sigmas dangerous naked puts and long stock on margin can be on days like this. No proba­ bility calculator is going to give much likelihood to a day like this occurring, but it did occur and it benefited those holding long puts greatly, while it seriously hurt others. In addition to distributions for individual dates, distributions for individual stocks were created for the time period in question. The graph for IBM, using data from the same study as above (September 1993 to April 2000) is shown in Figure 38-3. In the next graph, Figure 38-4, a longer price history of IBM is used to draw the distribution: 1987 to 2000. Both graphs depict 30-day movements in IBM. FIGURE 38-4. Actual stock price distribution, IBM, 13-year. 13 12 11 10 9 o a ,- E 7 g 6 (.) 5 4 3 2 o -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 Sigmas ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:851 SCORE: 10.00 ================================================================================ Chapter 38: The Distribution of Stock Prices 795 Figure 38-3 perhaps shows even more starkly how the bull market has affected things over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily readings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar­ ently was able to move up quite easily throughout this time period. In fact, the worst move that occurred was one move of -2.5 standard deviations, while there were about ten moves of +4.0 standard deviations or more. For a longer-term look at how IBM behaves, consider the longer-term distribu­ tion of IBM prices, going back to March 1987, as shown in Figure 38-4. From Figure 38-4, it's clear that this longer-term distribution conforms more closely to the normal distribution in that it has a sort of symmetrical look, as opposed to Figure 38-3, which is clearly biased to the right (upside). These two graphs have implications for the big picture study shown in Figure 38-1. The database used for this study had data for most stocks only going back to 1993 (IBM is one of the exceptions); but if the broad study of all stocks were run using data all the way back to 1987, it is certain that the "actual" price distribution would be more evenly centered, as opposed to its justification to the right (upside). That's because there would be more bearish periods in the longer study (1987, 1989, and 1990 all had some rather nasty periods). Still, this doesn't detract from the basic premise that stocks can move farther than the normal distribution would indicate. WHAT THIS MEANS FOR OPTION TRADERS The most obvious thing that an option trader can learn from these distributions and studies is that buying options is probably a lot more feasible than conventional wisdom would have you believe. The old thinking that selling an option is "best" because it wastes away every day is false. In reality, when you have sold an option, you are exposed to adverse price movements and adverse movements in implied volatility all during the life of the option. The likelihood of those occurring is great, and they generally have more influence on the price of the aption in the short run than does time decay. You might ask, "But doesn't all the volatility in 1999 and 2000 just distort the figures, making the big moves more likely than they ever were, and possibly ever will be again?" The answer to that is a resounding, "Nol" The reason is that the current 20-day historical volatility was used on each day of the study in order to determine how many standard deviations each stock moved. So, in 1999 and 2000, that histori­ cal volatility was a high number and it therefore means that the stock would have had to move a very long way to move four standard deviations. In 1993, however, when the market was in the doldrums, historical volatility was low, and so a much smaller ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:852 SCORE: 0.00 ================================================================================ 794 Part VI: Measuring and Trading Volatility FIGURE 38-3. Stock price distribution, IBM, 7-year. 7 6 5 0 4 :g ::, 0 3 () 2 0f-<--,.Jil,,J:.~------+---+---+----+--____;_,=!!:¥+- -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 Sigmas dangerous naked puts and long stock on margin can be on days like this. No proba­ bility calculator is going to give much likelihood to a day like this occurring, but it did occur and it benefited those holding long puts greatly, while it seriously hurt others. In addition to distributions for individual dates, distributions for individual stocks were created for the time period in question. The graph for IBM, using data from the same study as above (September 1993 to April 2000) is shown in Figure 38-3. In the next graph, Figure 38-4, a longer price history of IBM is used to draw the distribution: 1987 to 2000. Both graphs depict 30-day movements in IBM. FIGURE 38-4. Actual stock price distribution, IBM, 13-year. 13 12 11 10 9 0 8 ,... E 7 5 6 () 5 4 3 2 1 o -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 Sigmas ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:853 SCORE: 10.00 ================================================================================ Chapter 38: The Distribution of Stock Prices 195 Figure 38-3 perhaps shows even more starkly how the bull market has affected things over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily readings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar­ ently was able to move up quite easily throughout this time period. In fact, the worst move that occurred was one move of -2.5 standard deviations, while there were about ten moves of +4.0 standard deviations or more. For a longer-term look at how IBM behaves, consider the longer-term distribu­ tion of IBM prices, going back to March 1987, as shown in Figure 38-4. From Figure 38-4, it's clear that this longer-term distribution conforms more closely to the normal distribution in that it has a sort of symmetrical look, as opposed to Figure 38-3, which is clearly biased to the right (upside). These two graphs have implications for the big picture study shown in Figure 38-1. The database used for this study had data for most stocks only going back to 1993 (IBM is one of the exceptions); but if the broad study of all stocks were run using data all the way back to 1987, it is certain that the "actual" price distribution would be more evenly centered, as opposed to its justification to the right (upside). That's because there would be more bearish periods in the longer study (1987, 1989, and 1990 all had some rather nasty periods). Still, this doesn't detract from the basic premise that stocks can move farther than the normal distribution would indicate. WHAT THIS MEANS FOR OPTION TRADERS The most obvious thing that an option trader can learn from these distributions and studies is that buying options is probably a lot more feasible than conventional wisdom would have you believe. The old thinking that selling an option is "best" because it wastes away every day is false. In reality, when you have sold an option, you are exposed to adverse price movements and adverse movements in implied volatility all during the life of the option. The likelihood of those occurring is great, and they generally have more influence on the price of the option in the short run than does time decay. You might ask, "But doesn't all the volatility in 1999 and 2000 just distort the figures, making the big moves more likely than they ever were, and possibly ever will be again?" The answer to that is a resounding, "Nol" The reason is that the current 20-day historical volatility was used on each day of the study in order to determine how many standard deviations each stock moved. So, in 1999 and 2000, that histori­ cal volatility was a high number and it therefore means that the stock would have had to move a very long way to move four standard deviations. In 1993, however, when the market was in the doldrums, historical volatility was low, and so a much smaller ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:854 SCORE: 3.00 ================================================================================ 796 Part VI: Measuring and Trading Volatility move was needed to register a 4-standard deviation move. To see a specific example of how this works in actual practice, look carefully at the chart of IBM in Figure 38- 4, the one that encompasses the crash of '87. Don't you think it's a little strange that the chart doesn't show any moves of greater than minus 4.0 standard deviations? The reason is that IBM's historical volatility had already increased so much in the days preceding the crash day itself, that when IBM fell on the day of the crash, its move was less than minus 4.0 standard deviations. (Actually, its one-day move was greater than -4 standard deviations, but the 30-day move - which is what the graphs in Figure 38-3 and 38-4 depict - was not.) STOCK PRICE DISTRIBUTION SUMMARY One can say with a great deal of certainty that stocks do not conform to the normal distribution. Actually, the normal distribution is a decent approximation of stock price movement rrwst of the time, but it's these "outlying" results that can hurt any­ one using it as a basis for a nonvolatility strategy. Scientists working on chaos theo:ry have been trying to get a better handle on this. An article in Scientific American magazine ("A Fractal Walk Down Wall Street," Februa:ry 1999 issue) met some criticism from followers of Elliot Wave theo:ry, in that they claim the article's author is purporting to have "invented" things that R. N. Elliott discovered years ago. I don't know about that, but I do know that the article addresses these same points in more detail. In the article, the author points out that chaos theo:ry was applied to the prediction of earthquakes. Essentially, it concluded that earthquakes can't be predicted. Is this therefore a useless analysis? No, says the author. It means that humans should concentrate on building stronger buildings that can withstand the earthquakes, for no one can predict when they may occur. Relating this to the option market, this means that one should concentrate on building strate­ gies that can withstand the chaotic movements that occasionally occur, since chaotic stock price behavior can't be predicted either. It is important that option traders, above all people, understand the risks of making too conservative an estimate of stock price movement. These risks are espe­ cially great for the writer of an option (and that includes covered writers and spread­ ers, who may be giving away too much upside by writing a call against long stock or long calls). By quantifying past stock price movements, as has been done in this chap­ ter, my aim is to convince you that "conventional" assumptions are not good enough for your analyses. This doesn't mean that it's okay to buy overpriced options just because stocks can make large moves with a greater frequency than most option ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:857 SCORE: 9.00 ================================================================================ Chapter 38: The Distribution of Stock Prices 799 thing that cannot be predicted with certainty. Nevertheless, any probability calcula­ tor requires this input. So, one must understand that the results one obtains from any of these probability calculators is an estimate of what might happen. It should not be relied on as "gospel." Additionally, probability calculators make a second assumption: that the volatil­ ity one inputs will remain constant over the entire length of the study. We know this is incorrect, for volatility can change daily. However, there really isn't a good way of estimating how volatility might change in the course of the study, so we are pretty much forced to live with this incorrect assumption as well. There is no certain way to mitigate these volatility "problems" as far as the prob­ ability calculator is concerned, but one helpful technique is to bias the volatility pro­ jection against your objectives. That is, be overly conservative in your volatility pro­ jections. If things tum out to be better than you estimated, fine. However, at least you won't be overstating things initially. An example may help to demonstrate this technique. Example: Suppose that a trader is considering buying a straddle on XYZ. The five­ month straddle is selling for a price of 8, with the stock currently trading near 40. A probability calculator will help him to determine the chances that XYZ can rise to 48 or fall to 32 (the break-even points) prior to the options' expiration. However, the probability calculator's answer will depend heavily on the volatility estimate that the trader plugs into the probability calculator. Suppose that the following information is know about the historical volatility of XYZ: l 0-day historical volatility: 20-day historical volatility: 50-day historical volatility: l 00-day historical volatility 22% 20% 28% 33% Which volatility should the trader use? Should he choose the 100-day historical volatility since this is a five-month straddle, which encompasses just about 100 trad­ ing days until expiration? Should he use the 20-day historical volatility, since that is the "generally accepted" measure that most traders refer to? Should he calculate a historical volatility based exactly on the number of days until expiration and use that? To be most conservative, none of those answers is right, at least not for the right reasons. Since one is buying options in this strategy, he should use the lowest of the above historical volatility measures as his volatility estimate. By doing so, he is taking a conservative approach. If the straddle buy looks good under this conservative assumption, then he can feel fairly certain that he has not overstated the possibilities ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:858 SCORE: 12.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:859 SCORE: 6.00 ================================================================================ Chapter 38: The Distribution of Stock Prices 801 back over the last 1,000 trading days for XYZ. A 100-day historical volatility can be computed, using 100 consecutive trading days of data, for 901 of those days (begin­ ning with the 100th day and continuing through the l,000th day, which is presumably the current trading day). Admittedly, these are not completely unique time periods; there would only be ten non-overlapping (independent) consecutive 100-day periods in 1,000 days of data. However, let's assume that the 901 periods are used. One can then arrive at a distribution of 100-day historical volatilities. Suppose it looks some­ thing like this: Percentile 100-Day Historical oth 34% 10th 37% 20th 43% 30th 45% 40th 46% 50th 48% 60th 51% 70th 58% aoth 67% 90th 75% 1 ooth 81% In other words, the 901 historical volatilities (100 days in each) are sorted and then the percentiles are determined. The above table is just a snapshot of where the per­ centiles lie. The range of those 901 volatilities is from 34% on the low side to 81 % on the high side. Notice also that there is a very flat grouping from about the 20th per­ centile to the 60th percentile: The 100-day historical volatility was between 43% and 51 % over that entire range. The median of the above figures is 48% - the 100-day volatility at the 50th percentile. Referring to the early part of this example, the current 100-day historical is 80%, a very high reading in comparison to what the measures were over the past 1,000 days, and certainly much higher than the median of 48%. One could perform similar analyses on the 1,000 days of historical data to deter­ mine where the 10-day, 20-day, and 50-day historical volatilities were over that time. Those, too, could be sorted and arranged in percentile format, using the 50% per­ centile (median) as a good estimate of volatility. After such computations, the trader might then have this information: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:869 SCORE: 0.00 ================================================================================ Chapter 38: The Distribution of Stock Prices 811 in the dark as to the likelihood of profitable outcomes for his strategy. Overall, in a diversified set of positions, the option strategist should use the fat tail distribution in a Monte Carlo simulation to estimate probabilities. However, if that is not available, he can use the normal or lognormal distribution with the proviso that he understands it is not "gospel." He should require ve:ry stringent criteria on any strategies that are antivolatility strategies, such as naked option writing of stock options, for there is a greater than normal chance of a large move by the underlying, especially if the underlying is stock. The sophisticated trader may want to view his probabilities in the light of more than one proposed distribution of prices. Of course, this type of analysis ( using sev­ eral distributions) puts the onus on the investor to choose the distribution that he wants to use in order to analyze his investment. However, such an approach should be extremely illustrative in that he can compare returns from different strategies and have a reasonable expectation as to which ones might perform the best under differ­ ent market conditions. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:870 SCORE: 18.00 ================================================================================ CHAPTER 39 Volatility Trading Techniques The previous three chapters laid the foundation for volatility trading. In this chapter, the actual application of the technique will be described. It should be understood that volatility trading is both an art and a science. It's a science to the extent that one must be rigorous about determining historical volatility or implied volatility, calculat­ ing probabilities, and so forth. However, given the vagaries of those measurements that were described in some detail in the previous chapters, volatility trading is also something of an art. Just as two fundamental analysts with the same information regarding earnings, sales projection, and so on might have two different opinions about a stock's fortunes, so also can two volatility traders disagree about the potential for movement in a stock. However, volatility traders do agree on the approach. It is based on comparing today's implied volatility with what one expects volatility to do in the future. As noted previously, one's expectations for volatility might be based on volatility charts, pat­ terns of historical volatility and implied volatility, or something as complicated as a GAR CH forecasting model. None of them guarantees success. However, we do know that volatility tends to trade in a range in the long run. Therefore, the approach that traders agree upon is this: If implied volatility is "low," buy it. If it's "high," sell it with caution. So simple: Buy low, sell high (not necessarily in that order). The theory behind volatility trading is that it's easier to buy low and sell high (or at least to deter­ mine what's "low" and "high") when one is speaking about volatility, than it is to do the same thing when one is talking about stock prices. Most of the time, implied volatility will not be significantly high or low on any particular stock, futures contract, or index. Therefore, the volatility trader will have little interest in most stocks on any given day. This is especially true of the big-cap stocks, the ones whose options are most heavily traded. There are so many traders 812 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:871 SCORE: 8.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:872 SCORE: 24.00 ================================================================================ 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. 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. 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- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:873 SCORE: 28.00 ================================================================================ Chapter 39: Volatility Trading Techniques 815 ing, he is generally talking about implied volatility. Thus, it makes sense to know where implied volatility is within the range of the past readings of implied volatility. If volatil­ ity is low with respect to where it usually trades, then we can say the options are cheap. Conversely, if it's high with respect to those past values, then we can say the options are expensive. These conclusions do not draw on historical volatility. The percentile of implied volatility is generally used to describe just where the current implied volatility reading lies with respect to its past values. The "implied volatility" reading that is being used in this case is the composite reading - the one that takes into account all the options on an underlying instrument, weighting them by their distance in- or out-of-the-money (at-the-money gets more weight) and also weighting them by their trading volume. This technique has been referred to many times and was first described in Chapter 28 on mathematical applications. That com­ posite implied volatility reading can be stored in a database for each underlying instrument every day. Such databases are available for purchase from firms that spe­ cialize in option data. Also, snapshots of such data are available to members of www.optionstrategist.com. In general, most underlying instruments would have a composite implied volatility reading somewhere near the 50th percentile on any given day. However, it is not uncommon to see some underlyings with percentile readings near zero or 100% on a given day. These are the ones that would interest a volatility trader. Those with readings in the 10th percentile or less, say, would be considered "cheap"; those in the 90th percentile or higher would be considered expensive. In reality, the percentile of implied volatility is going to be affected by what the broad market is doing. For example, during a severe market slide, implied volatilities will increase across the board. Then, one may find a large number of stocks whose options are in the 90th percentile or higher. Conversely, there have been other times when overall implied volatility has declined substantially: 1993, for example, and the summer of 2001, for another. At those times, we often find a great number of stocks whose options reside in the 10th percentile of implied volatility or lower. The point is that the distribution of percentile readings is a dynamic thing, not something stat­ ic like a lognormal distribution. Yes, perhaps over a long period of time and taking into account a great number of cases, we might find that the percentiles of implied volatility are normally distributed, but not on any given day. The trader has some discretion over this percentile calculation. Foremost, he must decide how many days of past history he wants to use in determining the per­ centiles. There are about 255 trading days in a year. So, if he wanted a two-year his­ tory, he would record the percentile of today's composite implied volatility with respect to the 510 daily readings over the past two years. This author typically uses ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:874 SCORE: 35.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:875 SCORE: 37.00 ================================================================================ Chapter 39: Volatility Trading Techniques 817 someone may have inside information that justifies expensive options. This is another reason why selling volatility can be difficult: You may be dealing with far less infor­ mation than those who are actually making the implied volatility high. COMPARING IMPLIED AND HISTORICAL VOLATILITY The most common way that traders determine which options are cheap or expensive is by comparing the current composite implied volatility with various historical volatility measures. However, just because this is the conventional wisdom does not necessarily mean that this method is the preferred one for determining which options are best for volatility trades. In this author's opinion, it is inferior to the percentile method (comparing implied to past measures of implied), but it does have its merits. The theory behind using this method is that it is a virtual certainty that implied and historical volatility will eventually converge with each other. So, if one establishes volatility trading positions when they are far apart, there is supposedly an advantage there. However, this argument has plenty of holes in it. First of all, there is no guar­ antee that the two will converge in a timely manner, for example, before the options in the trader's position can become profitable. Historical and implied volatility often remain fairly far apart for weeks at a time. Second, even if the convergence does occur, it doesn't necessarily mean one will make money. As an example, consider the case in which implied volatility is 40% and historical volatility is 60%. That's quite a difference, so you'd want to buy volatility. Furthermore, suppose the two do converge. Does that mean you'll make money? No, it does not. What if they converge and meet at 40%? Or, worse yet, at 30%? You'd most certainly lose in those cases as the stock slowed down while your options lost time value. Another problem with this method is that implied volatility is not necessarily low when it is bought, nor high when it is sold. Consider the example just cited. We merely knew that implied volatility was 40% and that historical volatility was 60%. We had no perspective on whether 40% was high, medium, or low. Thus, it is also nec­ essary to see what the percentile of implied volatility is. If it turns out that 40% is a relatively high reading for implied volatility, as determined by looking at where implied volatility has been over the past couple of years, then we would probably not want to buy volatility in this situation, even though implied and historical volatility have a large discrepancy between them. Many market-makers and floor traders use this approach. However, they are often looking for an option that is briefly mispriced, figuring that volatilities will ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:876 SCORE: 25.00 ================================================================================ 818 Part VI: Measuring and Trading Volatility quickly revert back to where they were. But for a position trader, the problems cited above can be troublesome. Having said that, if one looks to implement this method of trying to determine when options are out of line, something along the following lines should be imple­ mented. One should ensure that implied volatility is significantly different from all of the pertinent historical volatilities. For example, one might require that implied volatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili­ ty calculations. In addition, the current percentile of implied volatility should be noted so that one has some relative basis for determining if all of the volatilities, his­ torical and implied, are very high or very low. One would not want to buy options if they were all in a very high percentile, nor sell them if they were all in a very low per­ centile. Often, a volatility chart showing both the implied and certain historical volatili­ ties will be a useful aid in making these decisions. One can not only quickly tell if the options are in a high or low percentile, but he may also be able to see what happened at similar times in the past when implied and historical volatility deviated substan­ tially. Finally, one needs some measure to ensure that, if convergence between implied and historical volatility does occur, he will be able to make money. So, for example, if one is buying a straddle, he might require that if implied rises to meet his­ torical (say, the lowest of the historicals) in a month, he will actually make money. One could use a different time frame, but be careful not to make it something unrea­ sonable. For example, if implied volatility is currently 40% and historical is 60%, it is highly unlikely that implied would rise to 60% in a day or two. Using this criterion also ensures that the absolute difference between implied and historical volatility is wide enough to allow for profits to be made. That is, if implied is 10% and historical is 13%, that's a difference of 30% in the two - ostensibly a "wide" divergence between implied and historical. However, if implied rises to meet historical, it will mean only an absolute increase of 3 percentage points in implied volatility - proba­ bly not enough to produce a profit, after costs, if any length of time passes. If all of these criteria are satisfied, then one has successfully found "mispriced" options using the implied versus historical method, and he can proceed to the next step in the volatility analysis: using the probability calculator. READING THE VOLATILITY CHART Another technique that traders use in order to determine if options are mispriced is to actually try to analyze the chart of volatility - typically implied volatility, but it could be historical. This might seem to be a subjective approach, except that it is real- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:879 SCORE: 36.00 ================================================================================ Chapter 39: Volatility Trading Techniques 819 ly not much different from the GARCH approach, which is considered to be highly advanced. When one views the volatility chart, he is not looking for chart patterns like technical analysts might do with stock charts: support, resistance, head-and-shoul­ ders, flags, pennants, and so on. Rather, he is merely looking for the trend of volatil­ ity to change. This is a valid approach in the use of many indicators, particularly sentiment indicators, that can go to extreme levels. By waiting for the trend to change, the user is not subjecting himself to buying into the midst of a downtrend in volatility, nor sell­ ing into the midst of a steep uptrend in volatility. Example: Suppose a volatility trader has determined that the current level of implied volatility for XYZ stock is in the 1st percentile of all past readings. Thus, the options are as cheap as they've ever been. Perhaps, though, the overall market is experienc­ ing a very dull period, or XYZ itself has been in a prolonged, tight trading range - either of which might cause implied volatility to decline steadily and substantially. Having found these cheap options, he wants to buy volatility. However, he has no guarantee that implied volatility won't continue to decline, even though it is already as cheap as it's ever been. If he follows the technique of waiting for a reversal in the trend of implied volatility, then he would keep an eye on XYZ's implied volatility daily until it had at least a modest increase, something to indicate that option buyers have become more interested in XYZ's options. The chart in Figure 39-1 shows how this situation might look. There are a number of items marked on the chart, so it will be described in detail. There are two graphs in Figure 39-1: The top line is the implied volatility graph, while on the bottom is the stock price chart. The implied volatility chart shows that, near the first ofJune, it made new all-time lows near 28% (i.e., it was in the 0th percentile of implied volatility). Hence, one might have bought volatility at that point. However, it is obvious that implied volatility was in a steep downtrend at that time, so the volatility trader who reads the charts might have decided to wait for a pop in volatility before buying. This turned out to be a judicious decision, because the stock went nowhere for nearly another month and a half, all the while volatility was dropping. At the right of the chart, implied volatility has dropped to nearly 20%. The solid lines on the two graphs indicate the data that is known about the implied volatility and price history of XYZ. The dotted lines indicate a scenario that might unfold. If implied volatility were to jump ( and the stock price might jump, too), then one might think that the trend of implied volatility was no longer down, and he would then buy volatility. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:880 SCORE: 0.00 ================================================================================ 820 Part VI: Measuring and Trading VolatHity The reason that this approach has merit is that one never knows how low volatil­ ity can go, and more important, how high it can get. It was mentioned that the same sort of approach works well for other sentiment indicators, the put-call ratio, in par­ ticular. During the bull market of the 1990s, the equity-only put-call ratio generally ranged between about 30 and 55. Thus, some traders became accustomed to buying the market when the put-call ratio reached numbers exceeding 50 (high put-call ratio numbers are bullish predictors for the market in general). However, when the bull market ended, or at least faltered, the put-call ratios zoomed to heights near 70 or 75. Thus, those using a static approach (that is, "Buy at 50 or higher") were buried as they bought too early and had to suffer while the put-call ratios went to new all­ time highs. A trend reversal approach would have saved them. It is a more dynamic procedure, and thus one would have let the put-call ratio continue to rise until it peaked. Then the market could have been bought. This is exactly what reading the volatility chart is about. Rather than relying on past data to indicate where the absolute maxima and minima of movements might occur, one rather notes that the volatility data is at extreme levels ( 1st percentile or 100th percentile) and then watches it until it reverses direction. This is especially useful for options sellers, because it avoids stepping into the vortex of massive option FIGURE 39-1. Chart of the trend of implied volatility. XYZ ,J' ········································ · ························ ....................... ··················· 50. 0 ... · ····················· 40. 0 Implied Volatility I/vi A r ···-····························· .. •·•······•·········-·············································-··vw•···················)·•······ 30. 0 All-Time Volatility Low - , .... , ..... , .. ··················,·······~················ t :t·•····•····· ...•. ':·LJJSL5~?. --;---··········•·: o, b ::r F f1 h j ::r 34.000 32.000 30. 000 28. 000 26.000 24.000 22.000 20. 000 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:881 SCORE: 31.00 ================================================================================ Chapter 39: VolatiDty Trading Techniques 821 buying, where the buyers perhaps have inside information about some forthcominf corporate event such as a takeover. True, the options might be very expensive ( 10ot percentile), but there is a reason they are, and those with the inside information know the reason, whereas the typical volatility trader might not. However, if the volatility trader merely waits for a downturn in implied volatility readings before selling these options, he will most likely avoid the majority of trouble because the options will probably not lose implied volatility until news comes out or until the buyers give up (perhaps figuring that the takeover rumor has died). Volatility buyers don't face the same problems with early entry that volatility sellers do, but still it makes sense to wait for the trend of volatility to increase (as in Figure 39-1) before trying to guess the bottom in volatility. Just as it is usually fool­ hardy to buy a stock that is in a severe downtrend, so it may be, too, with buying volatility. A less useful approach would be to apply the same techniques to historical volatility charts, for such charts say nothing about option prices. See the next section for expansion on these thoughts. COMPARING HISTORICAL VERSUS HISTORICAL The above paragraphs summarize the three major ways that traders attempt to find options that are out of line. Sometimes, another method is mentioned: comparing current levels of historical volatility with past levels of the same measure, historical volatility. This method will be described, but it is generally an inferior method because such a comparison doesn't tell us anything about the option prices. It would do little good, for example, to find that current historical volatility is in a very low per­ centile of historical volatilities, only to learn later that the options are expensive and that perhaps implied volatility is even higher than historical volatility. One would nor­ mally not want to buy options in that case, so the initial analysis of comparing histor­ ical to historical is a wasted effort. Comparing current levels of historical volatility with past measures of historical volatility is sort of a backward-looking approach, since historical volatility involves strictly the use of past stock prices. There is no consideration of implied volatility in this approach. Moreover, this method makes the tacit assumption that a stock's volatility characteristics do not change, that it will revert to some sort of "normal" past price behavior in terms of volatility. In reality, this is not true at all. Nearly every stock can be shown to have considerable changes in its historical volatility patterns over time. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:882 SCORE: 12.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:883 SCORE: 0.00 ================================================================================ Chapter 39: Volatility Trading Techniques 823 FIGURE 39-3. Stock chart of RMBS. 19. 000 17. 250 18. 875 20010410 30.000 22. 000 14. 000 ' ' : : ! : : : ; 1 : : 1 r : ! : : : : ; : : : : : i l : l : 6. ooo 99 M il M :i J ii s b N b J F M il M :i J il s b N b J F h 1 What this method may be best used for is to complement the other methods described previously, in order to give the volatility trader some perspective on how volatile he can expect the underlying instrument to be; but it obviously has to be taken only as a general guideline. CHECK THE FUNDAMENTALS Once these mispriced options have been found, it is always imperative to check the news to see if there is some fundamental reason behind it. For example, if the options are extremely cheap and one then checks the news stories and finds that the under­ lying stock has been the beneficiary of an all-cash tender offer, he would not buy those options. The stock is not going to go anywhere, and in fact will disappear if the deal goes through as planned. Similarly, if the options appear to be very expensive, and one checks the news and finds that the underlying has a product up for review before a governmental agency (FDA, for example), then the options should not be sold because the stock may be about to undergo a large gap move based on the outcome of FDA hearings. There could be any number of similar corporate events that would make the options very expensive. The seller of volatility should not try to intercede when such events or rumors are occurring. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:886 SCORE: 4.00 ================================================================================ 826 Part VI: Measuring and Trading Volatility TABLE 39-1 January February April July October January LEAP Call price 1.25 2.25 3.50 5.00 6.00 7.15 Put price 1.50 2.35 3.35 4.35 5.00 5.55 Call delta 0.48 0.52 0.55 0.58 0.60 0.62 Put delta -0.52 -0.48 -0.45 -0.42 -0.40 -0.38 Neutral ~ 1-to-1 ~l-to-1 ~ 1-to-1 ~2-to-3 2-to-3 ~2-to-3 Debit 2.75 4.60 6.85 23.05 27.00 30.95 Upside break-even 42.75 44.60 46.85 51.57 53.50 55.47 Downside break-even 37.25 35.40 33.15 32.30 31.00 29.68 dar spread is too much of a burden"° either psychologically or in terms of commis­ sions, and so this strategy is only modestly used by volatility traders. Some traders will use the calendar spread if they don't see immediate prospects for an increase in implied volatility. They perhaps buy a call calendar slightly out-of-the-money and also buy a put calendar with slightly out-of-the-money puts. Then, if not much happens over the short term, the options that were sold expire worthless, and the remaining long straddle or strangle is even more attractive than ever. Of course, this strategy has its drawback in that a quick move by the underlying may result in a loss, something that would not have happened had a simple straddle or strangle been purchased. SELLING VOLATILITY If one were selling volatility (i.e., volatility is too high), his choices are more complex. Virtually anyone who has ever sold volatility has had a bad experience or two with either exploding stock prices or exploding volatility. Some of the concerns regarding the sale of volatility will be discussed at length later in this chapter. For now, the sim­ pler strategies will be considered, in keeping with the discussion involving the cre­ ation of a volatility trading position. Simplistically, a volatility seller would generally have a choice between one of two strategies (although there is a more complicated strategy that can be introduced as well). The simplest strategy is just to sell both an out-of-the-money put and an out­ of-the-money call. The striking prices chosen should be far enough away from the current underlying price so that the probabilities of the position getting in trouble (i.e., the probabilities that the underlying actually trades at the striking prices of the naked options during the life of the position) are quite small. Just as the option buyer ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:887 SCORE: 12.00 ================================================================================ Chapter 39: Volatility Trading Techniques 827 above outlined several expiration months, then computed the break-even prices, so should a volatility seller. Generally he will probably want to sell short-term options, but all expiration months should be considered, at least initially. Also, he may want to try different strike prices in order to get a balance between a low probability of the stock reaching the striking price of the naked options and taking in enough premium to make the trade worthwhile. To this author, the sale of naked options at small frac­ tional prices does not appear attractive. Of course, merely selling such a put and a call means the options are naked, and that strategy is not suitable for all traders. The next best choice then, I suppose, is a credit spread. The problem with a credit spread is that one is both selling expensive options and also buying expensive options as protection. The ramifications of volatil­ ity changes on the credit spread strategy were detailed two chapters previously, so they won't be recounted here, except to say that if volatility decreases, the profits to be realized by a credit spreader are quite small (perhaps not even enough to over­ come the commission expense of removing the position), whereas a naked option seller would benefit to a greater and more obvious extent. The choice between naked writing and credit spreading should be made based largely on the philosophy and psychological makeup of the trader himself. If one feels uncomfortable with naked options, or if he doesn't have the ability to watch the mar­ ket pretty much all the time (or have someone watch it for him), or ifhe doesn't have the financial wherewithal to margin the positions and carry them until the stock hits the break-even point, then naked writing is not for that trader. Another factor that might affect the choice of strategy for the option seller is what type of underlying instrument is being considered. Index options are by far the best choices for naked option selling. Futures are next, and stocks are last. This is because of the ways those various instruments behave; stocks have by far the great­ est capability of making huge gap moves that are the bane of naked option selling. So, if one has found expensive stock or futures options, that might lend more credence to the credit spread strategy. There is one other strategy that can be employed, upon occasion, when options are expensive. It is called the volatility backspread, but its discussion will be deferred until later in the chapter. USING A PROBABILITY CALCULATOR No matter which method is used to find options that are out of line, and no matter which strategy is preferred by the trader, it is still necessary to use a probability cal­ culator to get a meaningful idea of whether or not the underlying has the ability to ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:888 SCORE: 7.00 ================================================================================ 828 Part VI: Measuring and Trading Volatility make the move to profitability (or not make the move into loss territory, if you're sell­ ing options). This is where historical volatility plays a big part, for it is the input into the probability calculator. In fact, no probability calculator will give reasonable pre­ dictions without a good estimate of volatility. Please refer to the previous chapter for a more in-depth discussion of probability calculators and stock price distributions. The use of probability analysis also mitigates some of the problems inherent in the method of selection that compares implied and historical volatilities. If the prob­ abilities are good for success, then we might not care so much whether the options are currently in a low percentile of implied volatility or not (although we still would not want to buy volatility when the options were in a high percentile of implied volatility and we would not want to sell options that are in a low percentile). In using the probability calculator, one first selects a strategy (straddle buying, for example, if options are cheap) and then calculates the break-even points as demonstrated in the previous section. Then the probability calculator is used to determine what the chances are of the underlying instrument ever trading at one or the other of those break-even prices at any time during the life of the option position. It was shown in the previous chapter that a Monte Carlo simulation using the fat tail distribution is best used for this process. An attractive volatility buying situation should have probabilities in excess of 80% of the underlying ever exceeding the break-even point, while an attractive volatility selling situation should have probabilities of less than 25% of ever trading at prices that would cause losses. The volatility seller can, of course, heavily influence those probabilities by choosing options that are well out-of-the-money. As noted above, the volatility seller should, in fact, calculate the probabilities on several dif­ ferent striking prices, striving to find a balance between high probability of success and the ability to take in enough premium to make the risk worthwhile. Example: The OEX Index is trading at 650. Suppose that one has determined that volatilities are too high and wants to analyze the sale of some naked options. Furthermore, suppose that the choices have been narrowed down to selling the September options, which expire in about five weeks. The main choices under con­ sideration are those in Table 39-2. The option prices in this example, being index options, reflect a volatility skew (to be discussed later) to make the example realistic. The two right-hand columns should be rejected because the probabilities of the stock hitting one or the other of the striking prices prior to expiration are too high well in excess of the 25% guideline mentioned earlier. That leaves the September 500-800 strangle or the September 550-750 strangle to consider. The probabilities are best for the farthest out-of-the-money options (September 500- 800 strangle), but the options are selling at such small prices that they will not pro- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:892 SCORE: 7.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:893 SCORE: 28.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:894 SCORE: 28.00 ================================================================================ 834 Part VI: Measuring and Trading Volatility described in the chapter on reverse spreads. The reader might want to review that chapter, not only for the description of the strategy, but also for the description of the margin problems inherent in reverse spreads on stocks and indices. One of the problems that most traders have with the reverse calendar spread is that it doesn't produce very large profits. The spread can theoretically shrink to zero after it is sold, but in reality it will not do so, for the longer-term option will retain some amount of time value premium even if it is very deeply in- or out-of-the-money. Hence the spread ·will never really shrink to zero. Yet, there is another approach that can often provide larger profit potential and still retain the potential to make money if implied volatility decreases. In some sense it is a modification of the reverse calendar spread strategy that can create a poten­ tially even more desirable position. The strategy, known as a volatility backspread, involves selling a long-term at-the-money option (just as in the reverse calendar spread) and then buying a greater number of near-er term out-of-the-money options. The position is generally constructed to be delta-neutral and it has a negative vega, meaning that it will profit if implied volatility decreases. Example: XYZ is trading at 115 in early June. Its options are very expensive. A trad­ er would like to construct a volatility backspread using the following two options: Call Option July 130 call: October 120 call: Price 2.50 13 Delta 0.26 0.53 Vega 0.10 0.27 A delta-neutral position would be to buy 2 of the July 130 calls and sell one of the October 120 calls. This would bring in a credit of 8 points. Also, it would have a small negative position vega, since tvvo times the vega of the July calls minus one times the vega of the October call is -0.07. That is, for each one percentage point drop in implied volatility of XYZ options in general, this position would make $7 - not a large amount, but it is a small position. The profitability of the position is shown in Figure 39-6. This strategy has lim­ ited risk because it does not involve naked options. In fact, if XYZ were to rally by a good distance, one could make large profits because of the extra long call. Meanwhile, on the downside, if XYZ falls heavily, all the options would lose most of their value and one would have a profit approaching the amount of the initial credit received. Furthermore, a decrease in implied volatility produces a small profit as well, although time decay may not be in the trader's favor, depending on exactly which short-term options were bought. The biggest risk is that XYZ is exactly at 130 at July expiration, so any strategist employing this strategy should plan to close it out ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:895 SCORE: 8.00 ================================================================================ Chapter 39: Volatility Trading Techniques FIGURE 39-6. Volatility backspread neutral position. Underlying Price 835 in advance of the near-term expiration. It should not be allowed to deteriorate to the point of maximum loss. Modifications to the strategy can be considered. One is to sell even longer-term options and of course hedge them with the purchase of the near-term options. The longer-term the option is, the bigger its vega will be, so a decrease in implied volatil­ ity will cause the heftier-priced long-term option to decline more in price. This mod­ ification is somewhat tempered, though, by the fact that when options get really expensive, there is often a tendency for the near-term options to be skewed. That is, the near-term options will be trading with a much higher implied volatility than will the longer-term options. This is especially true for LEAPS options. For that reason, one should make sure that he is not entering into a situation in which the shorter­ term options could lose volatility while the longer-term ones more or less retain the same implied volatility, as LEAPS options often do. This concept of differing volatil­ ity between near- and long-term options was discussed in more detail in Chapter 36 on the basics of volatility trading. As a sort of general rule, if one finds that the longer­ term option has a much lower implied volatility than the one you were going to buy, this strategy is not recommended. As a corollary, then, it is unlikely that this strate­ gy will work well with LEAPS options. One other thing that you should analyze when looking for this type of trade is whether it might be better to use the puts than the calls. For one thing, you can estab­ lish a position in which the heavy profitability is on the downside (as opposed to the upside, as in the XYZ example above). Then, of course, having considered that, it might actually behoove one to establish both the call spread and the put spread. If ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:896 SCORE: 16.00 ================================================================================ 836 Part VI: Measuring and Trading Volatility you do both, though, you create a "good news, bad news" situation. The good news is that the maximum risk is reduced; for example, if XYZ goes exactly to 130 (the worst point for the call spread), the companion put spread's credit would reduce that risk a little. However, the bad news is that there is a much wider range over which there is not profit, since there are two spots where losses are more or less maximized (at the strike price of the long calls and again at the strike price of the long puts). Margin will be discussed only briefly, since it was addressed in the chapter on reverse spreads. For both index and stock options, this strategy is considered to have naked options - a preposterous assumption, since one can see from the profit graph that the position is fully hedged until the near-term options expire. This raises the capital requirement for nonmember traders. The margin anomaly is not a problem with futures options, however. For those options, one need only margin the differ­ ence in the strikes, less any credit received, because that is the true risk of the posi­ tion. In summary, the volatility trader who wants to sell volatility in equity and futures options markets needs to be hedged, because gaps are prevalent and potentially very costly. This strategy creates a more neutral, less price-dependent way to benefit if implied volatility decreases, especially when compared with simple credit spreads. SUMMARY: TRADING THE VOLATILITY PREDICTION Attempting to establish trades when implied volatility is out of line is a theoretically attractive strategy. The process outlined above consisted of a few steps, employing both statistical and theoretical analysis. In any case, though, probability calculators must "say" that a volatility trade has good probabilities of success. It's merely a mat­ ter of what criteria we apply to limit our choices before we run the probability analy­ sis. So, it might be more useful to view volatility trading analysis in this light: Step I: Use a selection criterion to limit the myriad of volatility trading choices. Any of these could be used as the first criterion, but not all of them at once: a. Require implied volatility to be at an extreme percentile. b. Require historical and implied volatility to have a large discrepancy between them. c. Interpret the chart of implied volatility to see if it has reversed trend. Step 2: Use a probability calculator to project whether the strategy can be expected to be a success. Step 3: Using past price histories, determine whether the underlying has been able to create profitable trades in the past. (For example, if one is considering ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:897 SCORE: 8.00 ================================================================================ Chapter 39: Volatility Trading Techniques 837 buying a straddle, ask the question, "Has this stock been able to move far enough, with great enough frequency, to make this straddle purchase prof­ itable?") Use histograms to ensure that the past distribution of stock prices is smooth, so that an aberrant, nonrepeatable move is not overly influenc­ ing the results. Each criterion from Step 1 would produce a different list of viable volatility trading candidates on any given day. If a particular candidate were to appear on more than one of the lists, it might be the best situation of all. TRADING THE VOLATILITY SKEW In the early part of this chapter, it was mentioned that there are two ways in which volatility predictions could be "wrong." The first was that implied volatility was out of line. The second is that individual options on the same underlying instrument have significantly different implied volatilities. This is called a volatility skew, and presents trading opportunities in its own right. DIFFERING IMPLIED VOLATILITIES ON THE SAME UNDERLYING SECURITY The implied volatility of an option is the volatility that one would have to use as input to the Black-Scholes model in order for the result of the model to be equal to the current market price of the option. Each option will thus have its own implied volatil­ ity. Generally, they will be fairly close to each other in value, although not exactly the same. However, in some cases, there will be large enough discrepancies between the individual implied volatilities to warrant the strategist's attention. It is this latter con­ dition of large discrepancies that will be addressed in this section. Example: XYZ is trading at 45. The following option prices exist, along with their implied volatilities: Actual Implied Option Price Volatility January 45 call 2.75 41% January 50 call 1.25 47% January 55 call 0.63 53% February 45 call 3.50 38% February 50 call 4.00 45% ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:900 SCORE: 4.00 ================================================================================ 840 Part VI: Measuring and Trading Volatility The causes of this effect stem from the stock market's penchant to crash occa­ sionally. Investors who want protection buy index puts; they don't sell index futures as much as they used to because of the failure of the portfolio insurance strategy dur­ ing the 1987 crash. In addition, margin requirements for selling naked index puts have increased, especially for market-makers, who are the main suppliers of naked puts. Consequently, demand for index puts is high and supply is low. Therefore, out­ of-the-money index puts are overly expensive. This does not entirely explain why index calls are so cheap. Part of the reason for that is that institutional traders can help finance the cost of those expensive index puts by selling some out-of-the-money index calls. Such sales would essentially be covered calls if the institution owned stocks, which it most certainly would. This strat­ egy is called a collar. This distortion in volatilities is not in accordance with the probability distribu­ tion of stock prices. These distorted implied volatilities define a different probability curve for stock movement. They seem to say that there is more chance of the market dropping than there is of it rising. This is not true; in fact, just the opposite is true. Refer to the reasons for using lognormal distribution to define stock price move­ ments. Consequently, there are opportunities to profit from volatility skewing, if one is able to hold the position until expiration. It was shown in previous examples that one would attempt to sell the options with higher implied volatilities and buy ones with lower implieds as a hedge. Hence, for OEX traders, three strategies seem relevant: 1. Buy a bear put spread in OEX. Example: Buy 10 OEX June 560 puts Sell IO OEX June 540 puts 2. Buy OEX puts and sell a larger number of out-of-the-money puts - a ratio write of put options. Example: Buy 10 OEX June 560 puts Sell 20 OEX June 550 puts 3. Sell OEX calls and buy a larger number of out-of-the-money calls - a backspread of call options. Example: Buy 20 OEX June 590 calls Sell IO OEX June 580 calls In all three cases, one is selling the higher implied volatility and buying options with lower implied volatilities. The first strategy is a simple bear spread. While it will ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:901 SCORE: 24.00 ================================================================================ Chapter 39: Volatility Trading Techniques 841 benefit from the fact that the options are skewed in terms of implied volatility, it is not a neutral strategy. It requires that the underlying drop in price in order to become profitable. There is nothing wrong with using a directional strategy like this, but the strategist must be aware that the skew is unlikely to disappear ( until expiration) and therefore the index price movement is going to be necessary for profitability. The second strategy would be best suited for moderately bearish investors, although a severe market decline might drive the index so low that the additional short puts could cause severe losses. However, statistically this is an attractive strat­ egy. At expiration, the volatility skewing must disappear; the markets will have moved in line with their real probability distribution, not the false one being implied by the skewed options. This makes for a potentially profitable situation for the strategist. The backspread strategy would work best for bullish investors, although some backspreads can be created for credits, so a little money could also be made if the index fell. In theory, a strategist could implement both strategies simultaneously, which would give him an edge over a wide range of index prices. Again, this does not mean that he cannot lose money; it merely means that his strategy is statistically superior because of the way the options are priced. That is, the odds are in his favor. In reality, though, a neutral trader would choose either the ratio spread or the backspread - not both. As a general rule of thumb, one would use the ratio spread strategy if the current level of implied volatility were in a high percentile. The back­ spread strategy would be used if implied volatility were in a low percentile current­ ly. In that way, a movement of implied volatility back toward the 50th percentile would also benefit the trade that is in place. Another interesting thing happens in these strategies that may be to their ben­ efit: The volatility skewing that is present propagates itself throughout the striking prices as OEX moves around. It was shown in the previous section's example that one should probably continue to project his profits using the distorted volatilities that were present when he establishes a position. This is a conservative approach, but a correct one. In the case of these OEX spreads, it may be a benefit. Assuming that the skewing is present wherever OEX is trading means that the at-the-money strike will have 16% as its implied volatility regardless of the absolute price level; the skewing will then extend out from that strike. So, if OEX rises to 600, then the 600 strike would have a volatility of 16%; or if it fell to 560, then the 560 puts and calls would have a volatility of 16%. Of course, 16% is just a representative figure; the "average" volatility of OEX can change as well. For illustrative purposes, it is convenient to assume that the at-the-money strike keeps a constant volatility. Example: Initially, a trader establishes a call backspread in OEX options in order to take advantage of the volatility skewing: ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:902 SCORE: 8.00 ================================================================================ 842 Initial situation: OEX: 580 Option June 590 call June 600 call A neutral spread would be: Buy 2 June 600 calls Sell I June 590 call Implied Volatility 15% 14% since the deltas are in the ratio of 2-to-l. Part VI: Measuring and Trading Volatility Delta 0.40 0.20 Now, suppose that OEX rises to 600 at a later date, but well before expiration. This is not a particularly attractive price for this position. Recall that, at expiration, a backspread has its worst result at the striking price of the purchased options. Even prior to expiration, one would not expect to have a profit with the index right at 600. However, the statistical advantage that the strategist had to begin with might be able to help him out. The present situation would probably look like this: Option June 590 call June 600 call Implied Volatility 17% 16% The June 600 call is now the at-the-money call, since OEX has risen to 600. As such, its implied volatility will be 16% ( or whatever the "average" volatility is for OEX at that time - the assumption is made that it is still 16% ). The June 590 call has a slightly higher volatility (17%) because volatility skewing is still present. Thus, the options that are long in this spread have had their implied volatility increase; that is a benefit. Of course, the options that are short had theirs increase as well, but the overall spread should benefit for two reasons: 1. Twice as many options are owned as were sold. 2. The effect of increased volatility is greatest on the at-the-money option; the in­ the-money will be affected to a lesser degree. All index options exhibit this volatility skewing. Volatility skewing exists in other markets as well. The other markets where volatility skewing is prevalent are usually ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:903 SCORE: 4.00 ================================================================================ Chapter 39: Volatility Trading Techniques 843 futures option markets. In particular, gold, silver, sugar, soybeans, and coffee options will from time to time display a form of volatility skewing that is the opposite of that displayed by index options. In these futures markets, the cheapest options are out-of­ the-money puts, while the most expensive options are out-of-the-money calls. Example: January soybeans are trading at 580 ($5.80 per bushel). The following table of implied volatilities shows how volatility skewing that is present in the soybean market is the opposite of that shown by the OEX market in the previous examples: January beans: 580 Strike Implied Volatility 525 12% 550 13% 575 15% 600 17% 625 19% 650 21% 675 23% Notice that the out-of-the-money calls are now the more expensive items, while out-of-the-money puts are the cheapest. This pattern of implied volatilities is called forward volatility skew or, alternatively, positive volatility skew. The distribution of soybean prices implied by these volatilities is just as incor­ rect as the OEX one was for the stock market. This soybean implied distribution is too bullish. It implies that there is a much larger probability of the soybean market rising 100 points than there is of it falling 50 points. That is incorrect, considering the historical price movement of soybeans. A strategist attempting to benefit from the forward ( or positive) volatility skew in this market has essentially three strategies available. They are the opposite of the three recommended for the $OEX, which had a reverse (or negative) volatility skew. First would be a call bull spread, second would be a put backspread, and third would be a call ratio spread. In all three cases, one would be buying options at the lower striking price and selling options at the higher striking price. This would give him the theoretical advantage. The same sorts of comments that were made about the OEX strategies can be applied here. The bull spread is a directional strategy and can probably only be expected to make money if the underlying rises in price, despite the statistical advan- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:904 SCORE: 16.00 ================================================================================ 844 Part VI: Measuring and Trading VolatiRty tage of the volatility skew. The put backspread is best established when the overall level of implied volatility is in a low percentile. Finally, the call ratio spread has a great deal of risk to the upside ( and futures prices can fly to the upside quickly, espe­ cially if bad fundamental conditions develop, such as weather in the grain markets). The call ratio spread would best be used when implied volatilities are already in a high percentile. As a general comment, it should be noted that if the volatility skew disappears while the trader has the position in place, a profit will generally result. It would nor­ mally behoove the strategist to take the profit at that time. Otherwise, follow-up action should adhere to the general kinds of action recommended for the strategies in question: protective action to prevent large losses in the case of the ratio spreads, or the taking of partial profits and possibly rolling the long options to a more at-the­ money strike in the case of the backspread strategies. SUMMARY OF VOLATILITY SKEWING Whenever volatility skewing exists - no matter what market - opportunities arise for the neutral strategist to establish a position that has advantages. These advantages arise out of the fact that normal market movements are different from what the options are implying. Moreover, the options are wrong when there is skewing at all strikes, from the lowest to the highest. The strategist should be careful to project his profits prior to expiration using the same skewing, for it may persist for some time to come. However, at expiration, it must of course disappear. Therefore, the strategist who is planning to hold the position to expiration will find that volatility skewing has presented him with an opportunity for a positive expected return. SUMMARY OF VOLATILITY TRADING The theoretical trading of options, mostly in a neutral manner, has evolved into one large branch - volatility trading. This part of the book has attempted to lay out the foundations, structures, and practices prevalent in this branch of trading. As the read­ er can see, there are some sophisticated techniques being applied - not so much in terms of strategy, but in terms of the ways that one looks at volatility and in the ways that stocks can move. Statistical methods are used liberally in trying to determine the ways that either volatility can move or stocks can move. The probability calculators, stock price dis­ tributions, and related topics are all statistical in nature. The volatility trader is intent on finding situations in which current market implied volatility is incorrect, either in its absolute value or in the skew that is prevalent in the options on a particular under- ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:905 SCORE: 7.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:908 SCORE: 0.00 ================================================================================ 848 Part VI: Measuring and Trading Volatmty THE "GREEKS" Risk measurements have generally been given the names of actual or contrived Greek letters. For example, "delta" was discussed in previous chapters. It has become common practice to refer to the exposure of an option position merely by describing it in terms of this "Greek" nomenclature. For example, "delta long 200 shares" means that the entire option position behaves as if the strategist were merely long 200 shares of the underlying stock. In all, there are six components, but only four are heavily used. DELTA The first risk measurement that concerns the option strategist is how much current exposure his option position has as the underlying security moves. This is called the "delta." In fact, the term delta is commonly used in at least two different contexts: to express the amount by which an option changes for a I-point move in the underlying security, or to describe the equivalent stock position of an entire option portfolio. Reviewing the definition of the delta of an individual option (first described in Chapter 3), recall that the delta is a number that ranges between 0.0 and 1.0 for calls, and between -1.0 and 0.0 for puts. It is the amount by which the option will move if the underlying stock moves 1 point; stated another way, it is the percentage of any stock price change that will be reflected in the change of price of the option. Example: Assume an XYZ January 50 call has a delta of 0.50 with XYZ at a price of 49. This means that the call will move 50% as fast as the stock will move. So, if XYZ jumps to 51, a gain of 2 points, then the January 50 call can be expected to increase in price by 1 point (50% of the stock increase). In another context, the delta of a call is often thought of as the probability of the call being in-the-money at expiration. That is, ifXYZ is 50 and the January 55 call has a delta of 0.40, then there is a 40% probability that XYZ will be over 55 at January expiration. Put deltas are expressed as negative numbers to indicate that put prices move in the opposite direction from the underlying security. Recall that deltas of out-of­ the-money options are smaller numbers, tending toward 0 as the option becomes very far out-of-the-money. Conversely, deeply in-the-money calls have deltas approaching 1.0, while deeply in-the-money puts have deltas approaching -1.0. Note: Mathematically, the delta of an option is the partial derivative of the Black-Scholes equation ( or whatever formula one is using) with respect to stock price. Graphically, it is the slope of a line that is tangent to the option pricing curve. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:909 SCORE: 24.00 ================================================================================ Chapter 40: Advanced Concepts 849 Let us now take a look at how both volatility and time affect the delta of a call option. Much of the data to be presented in this chapter will be in both tabular and graphical form, since some readers prefer one style or the other. The volatility of the underlying stock has an effect on delta. If the stock is not volatile, then in-the-money options have a higher delta, and out-of-the-money options have a lower delta. Figure 40-1 and Table 40-1 depict the deltas of various calls on two stocks with differing volatilities. The deltas are shown for various strike prices, with the time remaining to expiration equal to 3 months and the underlying stock at a price of 50 in all cases. Note that the graph confirms the fact that a low­ volatility stock's in-the-money options have the higher delta. The opposite holds true for out-of-the-money options: The high-volatility stock's options have the higher delta in that case. Another way to view this data is that a higher-volatility stock's options will always have more time value premium than the low-volatility stock's. In-the-money, these options with more time value will not track the underlying stock price move­ ment as closely as ones with little or no time value. Thus, in-the-money, the low­ volatility stock's options have the higher delta, since they track the underlying stock price movements more closely. Out-of-the-money, the entire price of the option is composed of time value premium. The ones with higher time value (the ones on the high-volatility stock) will move more since they have a higher price. Thus, out-of-the­ money, the higher-volatility stock's options have the greater delta. Time also affects delta. Figures 40-2 (see Table 40-2) and 40-4 show the rela­ tionships between time and delta. Figure 40-2's scales are similar to those in Figure 40-2, delta vs. volatility: The deltas are shown for various striking prices, with XYZ assumed to be equal to 50 in all cases. Notice that in-the-money, the shorter-term options have the higher delta. Again, this is because they have the least time value premium. Out-of-the-money, the opposite is true: The longer-term options have the higher deltas, since these options have the most time value premium. Figure 40-3 (see Table 40-3) depicts the delta for an XYZ January 50 call with XYZ equal to 50. The horizontal axis in this graph is "weeks until expiration." Note that the delta of a longer-term at-the-money option is larger than that of a shorter­ term option. In fact, the delta shrinks more rapidly as expiration draws nearer. Thus, even if a stock remains unchanged and its volatility is constant, the delta of its options will be altered as time passes. This is an important point to note for the strategist, since he is constantly monitoring the risk characteristics of his position. He cannot assume that his position is the same just because the stock has remained at the same price for a period of time. Position Delta. Another usage of the term delta is what has previously been referred to as the equivalent stock position (ESP); for futures options, it would be ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:910 SCORE: 0.00 ================================================================================ 850 FIGURE 40-1. Delta comparison, with XYZ = 50. 100 75 $ 4 i 111181 251 1 1 8 115122 ■ 29 I 6 1 13 1 20 1 27 1 3 110117 >241 1 * 8 1 1^ 22 • 29 • Figure 18.1 It is possible to lose money owning stocks in a Bull Market. Notice this Major Top Formation did not occur in 1929, but in the summer of 1928. For more than a year after this, a majority of stocks and the Averages continued the Bull Market Advance. But Cudahy declined steadily, reaching a price below 50 well before the 1929 Panic, and continued in its Bearish course for more than four years, ultimately selling at 20. Except for the somewhat unusual volume on the head on August 21, this is a typical Head-and-Shoulders Pattern with a perfect Pullback Rally in mid-November. It underscores what we have mentioned before—a Head-and-Shoulders Top in a stock, even when other stocks look strong, cannot safely be disregarded. The Head-and-Shoulders Pattern, either in its simple form or with multiple heads or shoulders, is likely to occur at Major and Intermediate Tops, and in reverse position at Major and Intermediate Bottoms. It has the same general characteristics as volume, duration, and breakout as the Rectangles and the Ascending and Descending Triangles. In conservative stocks, it tends to resemble the Rounding Turns. of a strong company are often weak, and sometimes the securities of a very weak concern are exceedingly strong. It is important to realize the company and the stock are not precisely identical. The technical method is concerned only with the value of the stock as perceived by those who buy, sell, or own it. A second difference is in the matter of dividends. The “pure investor,” who, by the way, is a very rare person, is supposed to consider only the “income” or potential income from stocks—the return on his investment in cash dividends. (EN: This rara avis is largely extinct now.) Nevertheless, there are many cases of stocks that have maintained a steady dividend while losing as much as 75% or more of their capital value. There are other cases in which stocks have made huge capital gains while paying only nominal dividends or none at all. If the dividend rate were as important as some investors consider it, the only research tool one would need would be a calculator to determine the percentage yields of the various issues; hence, their “value,” which, on this basis, stocks paying no dividends would have no value at all. From the technical standpoint, “income,” as separate from capital gains and losses, ceases to have any meaning. The amount realized in the sale of a stock, less the price paid and plus total dividends received, is the total gain. Whether the gain is made entirely in capital increase, entirely in dividends, or in some combination of these, makes no difference. In the case of short sales, the short seller must pay the dividends. Although, here again, this is simply one factor to be lumped with the capital gain or loss in determining the net result of the transaction. Figure 18.2 What would you have done with Hudson Motors? The great Panic Move of October-November 1929 carried the Dow-Jones Industrial Average down from its September all-time high of 386.10 to a November low of 198.69. A rally, bringing the Average back to 294.07 in April 1930, recovered 95 points, or 51% of the ground lost, a perfectly normal correction. Suppose you had bought HT after the decline from its 1929 high of 93 1/2, say at 56, in the belief that the 37-point drop had brought it into a “bargain” range. On your daily chart, you would have seen the pattern shown above (which you will now recognize as a Descending Triangle) taking shape in the early months of 1930. Would you have had a protective stop at 51? Would you have sold at the market the day after HT broke and closed below 54? Or would you have hoped for a rally, perhaps even bought more “bargains” at 50, at 48, at 40? Would you still have been holding onto your “good long-term investment” when HT reached 25 1/2 in June? Would you still have been holding HT when it reached its ultimate 1932 bottom at less than 3 (see Figure 8.22) ? (EN: See Figure 18.4 for a recapitulation of the lesson from the 2000s.) There is a third source of confusion; very often, the “pure investor” will insist he has no loss in the stock he paid $30.00 for, which is now selling at $22.00, because he has not sold it. Usually he will tell you he has confidence in the company and he will hold the stock until it recovers. Sometimes he will state emphatically that he never takes losses. How such an investor would justify his position if he had bought Studebaker at more than $40.00 in 1953 and still held Studebaker Packard at around $5.00 in 1956 (EN: Or Osborne at $25.00 and $0.00 in the 1980s or Visacalc at similar prices in the same decade. EN9: Or Enron and WorldCom in the 2000s. Or Bear Stearns, or Lehman, or ... ) is hard to say; however, for him, the loss does not exist until it becomes a “realized” loss. Actually, his faith the stock will eventually be worth what he paid for it may be no more than a speculative hope—and a forlorn one at that. Furthermore, one may question whether his reasoning is always consistent. For example, suppose another stock this investor had bought at $30.00 was now selling at $45.00. Would he tell you he did not consider a profit or loss until the stock was sold? Or would he be tempted to speak of the “profit” he had in this purchase? It is all right to consider gains or losses either on the basis of “realized” or completed transactions, or on the basis of the market values “accrued” at a particular time? Yet, it is not being honest with yourself to use one method to conceal your mistakes and the other method to accentuate your successes. The confusion of these concepts is responsible for many financial tragedies. (EN: One might almost say, in the modern context, such confusion amounts to willful or neurotic behavior. Given the easy availability of portfolio software that marks-to-market positions, avoidance of this knowledge can only be regarded as self-defeating.) As a trader using technical methods, you will probably find the most realistic view is to consider your gains and losses “as accrued.” In other words, your gain or loss at a given time will be measured with reference to the closing pricing of the stock on that day. Recapitulating, it is important (1) to avoid regarding a stock and the company it represents as identical or equivalent; (2) to avoid the conscious or unconscious attribution of “value” to a stock on the basis of dividend yield, without regard to market prices; and (3) to avoid confusing “realized” and “accrued” gains or losses. The technical trader is not committed to a buy-and-hold policy. There are times when it is clearly advantageous to retain a position for many months or for years, but there are also times when it will pay to get out of a stock, either with a profit or with a loss. The successful technician will never, for emotional causes, remain in a situation that, on the evidence at hand, is no longer tenable. An experienced trader using technical methods can take advantage of the shorter Intermediate Trends, and it can be shown that the possible net gains are larger than the entire net gains on the Major Trend, even after allowing for the greater costs in commissions and allowing for the greater income tax liability on short-term operations. It should be understood that any such additional profits are not easily won. They can be obtained only by continual alertness and adherence to systematic tactical methods. For the market, regarded as a gambling machine, compares very poorly with stud poker or roulette, and it is not possible to “beat the market” by the application of any simple mathematical system. If you doubt this, it would be best to stop at this point and make a careful study of any such “system” that may appeal to you, checking it against a long record of actual market moves. Ask yourself whether you have ever known anyone who followed such a system alone, as a guide to market operations, and was successful. (EN: After Magee wrote this, many successful traders, aided by computer technology and advances in finance theory, have created algorithmic systems that have been successful in the financial markets. However, the markets usually become aware of the success of these systems and develop counterstrategies to defeat them. So there is a tendency for the performance of mechanical systems to degenerate or totally fail over time. It is the happy combination of the system with markets hospitable to it that makes mechanical systems successful over defined periods of time.) The practice of technical analysis, on the other hand, is not a mathematical process, although it does involve mathematics. It is intended to search out the significance of market moves in the light of past experience in similar cases, by means of charts, with a full recognition of the fact that the market is a sensitive mechanism by which all of the opinions of all interested persons are reduced by a competitive democratic auction to a single figure, representing the price of the security at any particular moment. The various formations and patterns we have studied are not meaningless or arbitrary. They signify changes in real values, the expectations, hopes, fears, developments in the industry, and all other factors that are known to anyone. It is not necessary to know, in each case, what particular hopes, fears, or developments are represented by a certain pattern. It is important to recognize the pattern and understand what results may be expected to emerge from it. The short-term profits are, you might say, payment for service in the “smoothing out” of inequalities of trends, and for providing liquidity in the market. As compared with the long-term investor, you will be quicker to make commitments and quicker to take either profits or (if necessary) losses. You will not concern yourself with maintaining “position” in a market on any particular stocks (although, as you will see, we will try to maintain a certain “total Composite Leverage” [or risk and profit exposure] according to the state of the market, which accomplishes the same result). You will have smaller gains on each transaction than the long-term investor, but you will have the advantage of being able to frequently step aside and review the entire situation before making a new commitment. Most particularly, you will be protected against Panic Markets. There are times (and 1929 was by no means the only time) (EN: 1987 and 1989 also come to mind. EN9: Add 20012002, if you please: May 2, 2001, Dow 11,350; September 17, 2001, 8,062; March 18, 2002, 10,673; and July 22, 2002, 7,532) , when the long-term investor stands to see a large part of his slowly accumulated gains wiped out in a few days. The short-term trader, in such catastrophes, will be taken out by his stop-loss orders, or his market orders, with only moderate losses, and will still have his capital largely intact to use in the new trend as it develops. (EN: The best technical analysts' opinion in “modern times” is that even long-term investors should not grin and bear a Bear Market. This is a necessity only for bank trust departments and believers in Burton Malkiel.) Finally, before we get on with the subject of tactics, the operations we are speaking of are those of the small and midsize trader. The methods suggested here, either for getting into a market or getting out of it, will apply to the purchase or sale of odd lots, 100 shares, 200 shares, and sometimes up to lots of thousands of shares or more of a stock, depending on the activity and the market for the particular issue. The same methods would not work for the trader who was dealing in 10,000-share blocks (except in the largest issues) because, in such cases, his own purchases or sales would seriously affect the price of the stock. Such large-scale operations are in a special field governed by the same basic trends and strategy, but that requires a different type of market tactics (see Figure 18.3 ). (EN: Or, put another way, as Magee said to me one time, a mouse can go where an elephant cannot . ) Strategy and tactics for the long-term investor— What's a speculator? What's an investor? In the years since Magee wrote the original Chapter 18 , some different connotations have attached themselves to the terms “speculator” and “investor.” A great cultural shift has also occurred. The days when the New Haven (New York, New Haven, and Hartford Railroad) was a beacon of respectability (and lent luster to its investor) and paid “good dividends” are gone forever; as is the New Haven. In fact, after the turn of the century, corporations saw a change in investor sentiment about dividends. Investors wanted capital appreciation Figure 18.3 If an investor only learned one thing from this book, it would be that one thing might be the salvation of his portfolio or his retirement plan (if all his assets in the investment plan were shares of Enron). Instead, the employees of Enron made a major mistake in not having a diversified retirement portfolio—they had all their eggs in one basket, their income and savings came from one source. But diversification is not even the crucial lesson here; the lesson is get out of the stock when it reverses. The corollary of that lesson is never buy a stock in a downtrend. However, the more important lesson is never buy a stock when it is in a swan dive. So obvious you say, but not so obvious at the time for portfolio managers for the University of Miami who continued to accumulate Enron stock even as it neared earth at 100 miles an hour. Of course, they had a sophisticated (?) company; the Motley Fools had a death grip on the stock all the way to the bottom. and cared less for dividends. In fact, it has lately been considered the mark of a “growth stock” not to pay dividends. Evidently, the days of the New Haven are gone forever, when an “investor” was one who bought, held, and collected dividends, and “speculators” were slightly suspect men like Magee who played the medium-term trends and bought “unchic, speculative” stocks. It all has a sepia tone to it. Yesterday's Magee speculator might be called a medium-term investor today. Although the term “speculator” could still be applied to anyone who “trades” the market, today that old-time speculator and his kind would more likely be called traders than speculators. Commodity traders who have no business interest in the contracts they exchange are always referred to as speculators , as opposed to commercials , who are hedgers and users of the commodities they trade. Now “day traders” might be considered the equivalent of the old-time speculators—except that day trading veers dangerously close to gambling. And only the passive, in the opinion of this editor, never trade at all and sit on their holdings during Bear Markets. On the spectrum of investors, from investor to gambler, the old “New Haven Investor” who “wants his dividends” is pretty rare these days, and, again, may be one of those trust departments that does not want to get sued and so stays out of stocks that go up. After all, prudent men do not “trade in volatile stocks” but “invest in safe issues, like bonds,” which only lose about 1.5%-2.0% of their purchasing value per year but preserve the illusion of having “preserved principal.” One definition of the long-term investor Let us take as a long-term investor now one who expects to at least track market returns, for it has been demonstrated over a relatively long period of time that this can be done by passive indexing. At the turn of the century, as this is written, it would seem neither longterm, medium-term, nor short-term investors think about the risks involved in matching the market because, entering the third millennium, it has been so many years since we have had a really vicious Bear Market. Dow 36,000? This is a passing phase. As each Bull Market reaches higher and higher, the odds are lower and lower that it will continue— historic Bull Markets of the 1990s notwithstanding. What then are the strategy and tactics for the long-term investor to achieve a goal of matching the market? (EN9: Is it necessary to remind the reader of Chapter 4 and the Dow Theory?) Let us remark immediately that the tactics Magee described for the speculator—or trader if you will—are not at all in conflict with the short-term tactics used occasionally by the long-term investor. As buying or selling time approaches the stops of the long-term investor, that investor becomes a trader who can and should adopt the trader's tactics. Sooner or later, the focus even narrows to real time at the moment of trade execution. Interestingly, the charting techniques we have described here work on tick-by-tick data in real time also. Hence, if the trader wants to enter into the real-time environment, he can attempt to time his trade right down to the real-time chart formations. Only the really active and skilled long-term investor will be concerned with squeezing the last half point or points out of his position. This illustration of the time focus is addressed to any investor or trader or speculator to demonstrate the fractal nature of both price data and the applicability of Magee-type technical analysis to it. The strategy of the long-term investor The strategy of the long-term investor is to catch the long trends—to participate in trades that lasts months and years. However, this strategy does not intend to be sucked into long Bear Markets. Rather, portfolios are liquidated or hedged when Bear Market signals are received. As has been previously seen in examples of the performance of (more or less) mechanical Dow Theory (see Chapter 4 ), this kind of performance can be quite satisfactory—better indeed than buy-and-hold strategies that have come much into vogue because of the Clinton-Gore Bull Markets of the 1990s. If the goal is to beat not only the markets but also the mutual funds (only 20% of which outperform the market over the long term anyway—and sometimes none of them make money), then passive indexing is the most likely strategy. This may be done in a number of ways—index funds, buying the basket, buying the futures, and so on. Nevertheless, the most attractive method might be the use of the Standard & Poor's Depositary Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and the like. The tactics may be calibrated to the risk tolerance and character of the investor. He might hedge or sell on Dow Theory signals, or on breaks of the 200-day moving average, or on breaks of the long-term or intermediate trendlines with a filter (Magee recommended 2%, and this might be calibrated to the character of the markets and increased to 3% or a factor relevant to actual market volatility). Basing Points (see Chapter 28 ) is also a powerful method. Instruments we have previously discussed— SPDRs, DIAMONDS, index futures, and options—can be used to execute these tactics. Suffice it to say that every strategy must provide for the plan gone wrong, in other words, the dreaded Bear Market. Bear Markets would not be so fearsome if the average investor did not insist on seeing only the long side of the market. Long-term strategies go out the window quickly when blood runs on the floor of the New York Stock Exchange. The well-prepared technical investor has a plan that provides for the liquidation of positions gone bad and presumably the discipline to execute it. This involves the regular recomputation of stops as markets go in the planned direction, and ruthless liquidation of losers that do not perform. One may think of a portfolio as a fruit tree. Weak branches must be pruned to improve the yield. Stop computation is treated in a number of places in this book (see Chapters 27 and 28 ). For the investor trading long term, this may be, as an example only and not as a recommendation, the breaking of the 200-day moving average or the breaking of a long-term trendline. The 200-day moving average is widely believed to be the long-term trend indicator, for which believing will sometimes make it come true. (EN9: Let me emphasize here that “200” is a parameter and an example. Personal research may fit a better parameter to the actual market.) In reality, more than just the 200-day moving average or a manually drawn trendline should be looked at. The chart patterns comprising the portfolio should be considered also, as well as charts of major indexes and averages. Also, consider the condition of the averages and their components—their technical state—whether they are topping, consolidating, or trending as indicated by their charts. Moreover, it would be impossible not to mention Magee's Basing Points Procedure (see Chapter 28 ). Possibly the most powerful trailing stop method in existence. Rhythmic investing In addition, if Chapter 31 on “Not All in One Basket” is weighed seriously, one might be rolling a portfolio from long to short gradually in natural rhythm with the markets and in harmony with the Magee Evaluative Index described there. That is the preferred strategy of the authors and editor of this book. These things all depend on the goals, temperament, and character of the investor. If he is going to spend full time on the markets, he is probably not a long-term investor. Such men eat well and sleep soundly at night. The trader is lean and hungry—not necessarily for money, but for activity. It behooves one to know his type as a trader or investor. Knowing one's type or character is best established before finding it out in the markets, as the markets can be an expensive place to search for self-knowledge. There is no inherent conflict in holding long-term positions and also attempting to profit from intermediate trends, depending on the amount of capital in hand and how much time, energy, and capital the investor wants to put into trading. A long-term strategy can be implemented with a modicum of time and energy, as follows: pay attention to the major indexes and averages and buy on breakouts, at the bottoms of consolidations and on pullbacks; sell or hedge on the breaking of trendlines, calculated on Basing Points (see Chapter 28 ) and the penetration of support zones. The long-term investor will accept greater swings against his position than the intermediate-term trader or speculator. As an example with the method of using Basing Points in Chapter 28 , the speculator is using a three-days-away rule, whereas a long-term investor might be using a three-week Basing Point or some such analogy. Plus, if interested, when he suspects or analyzes a long Bull Market is approaching a climax, he might adopt the three-days rule also, or even begin following his stock with a daily stop just under the market. Beware though, as professionals look for stops just under the close of the previous day in situations such as these. It would be wise not to confuse long-term investing with “buy and hold,” or as it was expressed in one investment fad in the 1970s, “one-decision investing.” As an example of this misguided thinking, in 1972, the “best and brightest” investment analysts (fundamental) on the Street picked a portfolio of stocks for the generation, or 20 years. The companies would be difficult to argue with as the creme de la creme of American business. After all, who could kvetch at Avon, Eastman Kodak, IBM, Polaroid (unless he happened to look at Figure 37.27 ), Sears Roebuck, and Xerox? Even today, if you did not have a close eye on the market, you would immediately respond, “blue chips.” Consider the following table showing the stocks and the results achieved over the long term. Price Price Percent Stock 4/14/72 12/31/92 Change Avon Products 61.00 27.69 (54.6)% Eastman Kodak 42.47 32.26 (24.0)% IBM 39.50 25.19 (36.2)% Polaroid 65.75 31.13 (52.7)% Sears Roebuck 21.67 17.13 (21.0)% Xerox 47.37 26.42 (44.2)% In 2017, the vagaries of unsupervised portfolios is again seen: Avon 2.50; Kodak 7.75; IBM 141; Polaroid unlisted; Sears 7.21; Xerox 32.64. Beware of pundits and mindless investing. Charts ( Figures 18.4 and 18.5 ) showing activity for IBM and Xerox appear on the following pages. Figure 18.4 The questionable—even bizarre—results of “one-decision investing” (i.e., buy and hold) are amply illustrated by this chart. First of all, the “best and brightest” recommended IBM at a decade high to see it decline by more than 50%. It subsequently recovered to double from their original recommendation. Ah, sweet justification! Only, unfortunately, at the end of 20 years to see it rest approximately 40% beneath the recommendation. The analytical lines give some hint of how a technician might have traded the issue. I like to say that there are bulls, bears, and ostriches, and anyone who followed this one-decision investment proves my case. Figure 18.5 Like IBM in the previous figure, Xerox was recommended at a place at which it should have been sold instead of bought. The comments there might apply to the chart here. The foolishness of “buy and hold” or “one-decision investing” is amply illustrated by observing the long-term swings of the stock and thus of the investor's equity. Technical analysis is intended to be an antidote to such foolishness. Summary The long-term investor attempts to catch major market moves—those lasting hundreds, if not thousands, of Dow points and stay in trades for many months if not years. Within this time frame, he expects to take secondary trends against his position. Depending on his temperament and inclination, he may attempt to hedge his portfolio upon recognizing secondary market moves against his primary direction. His preference for stocks and portfolio will be for market leaders, for baskets that reproduce the major indexes (or Index Shares) as the ballast for his portfolio, and he may choose some speculative stocks to add spice to his portfolio. In spite of his penchant for long-lasting trades he will not tolerate weak, losing, or underperforming stocks. They are the shortest of his trades. He will cut losses and let profits run, the truest of the market maxims and the least understood by unsuccessful investors. The other maxim least understood by investors is “buy strength, sell weakness.” Truly sophisticated investors attempt to participate in Bear Market trends also. This is the greatest difference between professional and general investors—professionals have no bias against the short side. For the convenience of day traders, the URL of Gamblers Anonymous is noted: http:// www.gamblersanonymous.org . chapter nineteen ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends 11thed\Converted\Technical Analysis of Stock Trends, Eleventh Edition.epub#section:main-25.xhtml SCORE: 0.00 ================================================================================ The all-important details In this chapter and the one following, we take up a number of elementary suggestions intended largely for the benefit of those who have never kept charts before. Much of this will seem obvious and repetitive to the advanced student, although even he may find some thoughts that will simplify his work. The beginner should read these chapters carefully and use them for later reference. The details of how and when you keep the charts will not guarantee you profits, but if you fail to work out these details in such a way as to make your work easy, as part of a regular systematic routine, you cannot expect to keep up your charts properly or make any profits. Charting and analyzing your charts is not a difficult process, nor will it take too much of your time if you have determined a reasonable number of charts and have arranged for doing the work regularly, meaning every day without fail. You will need a source of data—the day's market prices and volume. If you live in a big city, your evening paper will carry the complete list, and you can plan to set aside a certain period before dinner, or after dinner, or during the evening. If you cannot allot such a period and keep it sacred against all other social or business obligations, then plan to do the charting in the morning. The key is to set a definite time and let nothing interfere, ever, or you are lost. (EN: This process is radically simplified by automated computer downloading procedures and access to data sources and internet sites, but the principle is the same.) You should have a suitable place to work and keep your charts. If it is at home, in the dining room or living room, other members of the family should understand that what you are doing is important. You should be able to shut the door and work without interruption. The light should be bright and as free from shadows as possible. (It makes a big difference, especially if you are keeping a large number of charts.) The ordinary desk lamp throws a reflected glare directly across the paper and into the eyes. It can be a strain if you are doing much of this close work. Better to have an overhead light, placed just a few inches in front of your head and a convenient distance above; and if this light can be a fluorescent fixture using two 40-watt lamps, you will get almost perfect shadowless lighting. These suggestions apply in case you are not working by daylight. Additionally, have plenty of room. A big desk top or a dining room table with a large clear space for chart books, extra sheets, pencils, scratch paper, ruler, calculator, computer equipment, and anything else you need. If your working surface is fairly low, say 28 or 29 inches from the floor, it will be less tiring than the usual 30-inch desk height. Whether you are working in ink or in pencil, pick out the writing tool that is easiest for you to use. If you are using pencils, try several different makes and degrees of hardness. Find one that is hard enough not to smudge too easily, and yet is not so hard you have to bear down to make a clean black mark. The wrong kind of pencil can tire you and irritate you more than you realize. Also, have plenty of pencils, a dozen at least, well-sharpened, so as soon as one becomes a trifle dull and you are not getting a clean, fine line, you can simply lay it aside and continue at once with another freshly-sharpened pencil. Keep your charts in loose leaf books with big enough rings to make turning the pages easy. Do not overcrowd the books; get new books if a volume is too crowded. Finished charts may be kept in file folders. The only ones that need to be in the books are the current sheets and the sheets for the immediately preceding period. If possible, use a seven-ring binder. Pages are easily torn loose from two- and three-ring binders, but seven rings will hold the pages safely and you will seldom have one tear out. The charts you keep will become increasingly valuable to you as the chart history builds up. The old chart sheets will be very helpful to you for reference. Provide a file or space where they can be indexed and kept in chronological order, and also have file folders for brokers' slips, dividend notices, corporate reports, clippings and articles, notes on your own methods, and analyses and special studies of the work you are doing. In this connection you will, of course, keep a simple but complete record of each purchase, sale, dividend, and so on, on stocks you have bought or sold. This record will make your work much easier when the time comes to figure out income taxes. It will also give you all the statistical information you need to judge the results of your trading operations. (EN: At the beginning of my investment career, and often in the middle of it, I thought the above was cracker-barrel wisdom. The longer I last the more I think that homespun wisdom might be the best kind to have in investing—somewhat like Mark Twain, who was astounded at how much his father increased in wisdom the older Twain himself got. We may restate the modest homilies above: Be serious. Be methodical. Be disciplined. Be businesslike. Anyone who succeeds in investing without these qualities is the recipient of blind luck and will be fortunate not to fall into a hole before his career is over. These thoughts occur when one is wondering how Magee would have viewed the advent of the microcomputer and its impact on technical analysis and investing. Might he have said, “What hath this tool wrought?! Wonders and abominations!!” Given the possibilities for complicating analysis and operations when confronted with all the bells and whistles of the average computer software package, the investor must maintain perspective. What, then, are the all-important details in practicing technical analysis with the aid of a computer?) The simplest and most direct way to use a computer for charting analysis In reality, the computer can be used as a simple tool to do a simple job. There is nothing inherently complicated about keeping a chart on a computer. All computer software packages enable bar charting and many, if not most, enable many other kinds of charting, from candlesticks to oscillator charting. The process, in almost all commercially available packages, is so simple that explaining it here would be superfluous (see Appendix B, Resources, for demonstrations), except to generally say it consists of retrieving data, updating the program's price database, and clicking an icon to run a chart. The software packages themselves explain their features better than can be done here. What is important here is to give perspective. Even simpler when the whole process takes place on the internet, as at http://www.stockcharts.com or http://www.bigcharts.com , or http://www. tradestation.com . In this respect, charting can be done with quite expensive programs and also on publicly available free programs or freeware. Charting can also be done with interactive charting programs on many internet sites. The basic bar chart can be enhanced with an unending number of technical studies— moving averages, oscillators, and so on. Therein lies the danger. Chart analysis in itself is a qualitative process. Decorating graphic charts with number-driven information and studies can lead the general investor astray—and into confusion and indecision. Thus, the first preference of this analyst is to keep the process as simple as possible. Get the data, draw a chart, analyze the patterns, consider the volume, and draw the appropriate analytical lines—this can usually be done by the program on the screen. Often a better graphic picture may be obtained by printing the chart and hand-drawing the analytical lines. This brings to the fore one of the main problems of almost all the software packages—screen graphics are poor and, at least to old chartists, disorienting. They are especially befuddling to analysts who are accustomed to working on TEKNIPLAT™ chart paper. With passing editions of Resources, this problem will be dealt with. (EN9: In the intervening years since the eighth edition, two things have occurred: the editor adjusted to modern technology and the technology achieved a level of excellence acceptable to a carping analyst. Internet technical analysis sites such as http://www.stockcharts.com and http://www.thinkorswim.com improved to be surprisingly valuable resources at unbelievably low prices—even free.) The question of graphic representation of the facts is worth noting as a persistent one. To a certain extent, the individual analyst will solve this conundrum by adapting his eye and mind to a graphic environment, using one graphic method consistently and seeing how it relates to the facts in the market. John Magee-oriented solutions to this problem will be available on the website http:// www.edwards-magee.com . In Appendix B, Resources, the reader may see some examples of simple and inexpensive software packages and internet sites that are quite adequate to the required tasks of charting technical analysis, as well as more complex number-driven analysis. Summary The computer is an invaluable tool for analysis. Use of it will enable the following: • Data may be acquired automatically via internet or dial-up sites at little or no cost. Some of these even offer real-time data, which is a way for the unsophisticated trader to go broke in real time, but which the general investor may desire on the day of executing a trade. Many of these sites offer every kind of analysis from respectable technical analysis (usually too complicated) to extraterrestrial channeling. • A computer package and internet portfolio sites will give the analyst virtually effortless portfolio accounting and mark-to-market prices—a valuable device to have to keep the investor from mixing his cash and accrual accounting, as Magee says. • The computer will 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 Chapters 20 and 21 . • Appendix B, Resources, contains information on software packages that the reader may try and purchase at quite reasonable prices. In all likelihood, the least expensive of these will be adequate to the needs of most general investors. In addition, I present a brief discussion of internet sites and resources. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter twenty The kind of stocks we want: the speculator's viewpoint The specifications of the kind of stock we want to chart are fairly simple and few. We want a stock that will enable us to make a profit through trading operations, meaning a stock whose price will move over a wide enough range to make trading worthwhile. There are those who are concerned mainly with safety of principal and the assurance of income from a stock. For them, there are (EN9: or were) stocks that afford a considerable degree of stability. You may (and probably will) want to keep a substantial part of your total capital in stocks of this type. They move in a narrow price range; are extremely resistant to downside breaks in the market; are also (and necessarily) unresponsive to fast upside moves in the market as a whole, and are highly desirable for the conservative investor. They are not, however, the most suitable issues for trading operations, because their swings are small, and commissions would tend to diminish the narrow trading profits that could be taken. Also, they do not make the sharp, clear chart patterns of the more speculative issues, but move in rounding, sluggish undulations. (EN9: These remarks reflect a bygone time. The described stocks by and large went the way of the Dodo. When T can disappear from the market as a factor, there is no place to hide, except in bonds, which, when stagnant, only lose real value at the rate of inflation and loss of purchasing power of the dollar. Even bonds should be subject to frequent reevaluation using the tools described in this book.) (For illustrations in this chapter, see Figures 20.1 through 20.4 .) To amplify this comment and explain a bit about what underlies what we are doing, let us assume a certain company has two issues of stock, a preferred and a common. We will assume the concern has a certain steady minimum profit it has earned for years, sufficient to pay the preferred dividend, the continuance of these dividends seems practically assured. The dividends on the preferred are fixed at, let us say, 6%. Now the common stock gets all that is left. In one year, there may be $0.50 a share for the common stockholders. The next year, there may be $2.00 a share or four times as much. In a case like this, if there are no other factors, you would expect the preferred stock to sell at a fairly steady price without much change, whereas the common stock is subject to a “leverage” and might shoot up to four times its former value. The more speculative issues represent either a business that is, by its nature, uncertain as to net profit from year to year, where the volume of business or the profit margin fluctuates widely, or one in which the majority of the “sure” net profit has been sheared off for the benefit of senior obligations. There are also other factors that affect the speculative swing of a stock, and, as a result, one issue may be very sensitive and another extremely conservative, and between them there would be all shades and degrees of sensitivity or risk. It is enough here to note briefly the nature of the business itself does not always account for the habits of the stock because the other factors may be very important. Most stocks have a fairly well-defined “swing” power, which can usually be determined by past performance of 76 72 68 64 60 56 52 48 44 40 36 32 28 --------------------------------1-------------------------------- _ GOODYEAR TIJ COMMON RE ”ti J1L J Ji 1 1 I pnpr 1 ir I 1943 1944 1945 1946 1947 120 112 104 96 88 80 ---------------------------------1--------------------------------- “GOODYEAR T 1st PREFERR] IRE RD II      ill l.lll, ■■•I,,..." 1 ........... nil.I .Hl 1 ' r 1943 1944 1945 1946 1947 Figure 20.1 Opportunity vs. Security. Here (at left) is Goodyear Common, representing the residual interest in all profits after senior obligations have been met, compared (at right) with the Goodyear $5.00 Preferred, which carries a high degree of assurance that the $5.00 dividend will be met, but no promise of further participation in profits. Monthly range of each stock for the same 54-month period is shown on a ratio scale. As the Common makes an advance of more than 300%, the Preferred advances about 25%, leveling off at a point that represents the maximum price investors are willing to pay for the sure $5.00 dividend. 88 89 90 99 00 92 93 97 500 400 300 1500 1400 1300 1200 1100 1000 900 800 700 600 SPX LAST-Monthly-— 94 Figure 20.2 S&P. Here the benefits of relaxed long-term investing may be seen, buttressed, of course, by the longest and handsomest Bull Market in American history in the Clinton-Gore years. At the end of this record, the effects of public enthusiasm (or as Chairman Greenspan of the Fed said, “irrational exuberance” vide tulipomania ) can be seen in the wide undisciplined swings (best seen in Figure 20.3 ). The dotted line represents 150-day (approximately) Moving Average. Just using the Moving Average as a signal (or the Basing Points Procedure) would have beaten the market and 99% (the 99%) of other investors. II'. Zj I I’ 2000000 1600000 1200000 8000000 4000000 '5/19986/19 r 987/i99887i998 , 9/1998’' 2/19993/199 >4/1999 5/1999 6/1999 7/1999 8/1999 9/1999 10/1999 11/1999 12/199 '10/1998'11/1998 12/1998 99 129.999 ).999 114.999 • 104.999 .. 9 4.999 ■ •    • 109.999 SPY LAST-Daily J ;     ; Created with TiadeStation www.Tai i +-■ T i i..... Figure 20.3 SPY. For illustration, here is a chart of the AMEX Index Share, the SPY, or ETF based on the S&P 500. After the crash of 1998 (the Asian Economic Flu crash), the fan lines tell a story, as does the last phase of the chart where the market whips in what appears a Broadening Top. (EN9: Note this Broadening Top was identified in 1999-2000 before the crash as documented in the http://www. edwards-magee.com archives. See Figure 20.4 .) Figure 20.4 The S&P 500 in all its glory and tragedy. An especially good portrait by Holbein, the younger. The Broadening Top pointed out in Figure 20.3 in 2000 foretold the decline of the S&P to below 790—not quite 50% but close enough to catch the eye. Particularly fine lessons here, besides the Broadening Top lesson. All of them screaming for action. The broken trendline at A, the broken trendline at B, the broken “neckline” or horizontal line at C. Notice the close correspondence of the break at B and C. The next lesson is not to buy downtrends until a clear bottom is made in a major bear market. Clearly no bottom is made until the Kilroy Bottom at 1-2-3. Even then, the least risky trade for the long-term investor is when the Kilroy Fenceline (Neckline) is broken at D. All of this was knowable at the time. how a stock will behave in the future as to the extent of its swing. (EN9: Or we might say, short-term volatility and long-term range.) Incidentally, for short-term trading (EN9: amusing in the modern context; by short-term trading Magee means trading of trends of shorter length than Dow Waves) , we are thinking about the habits of the stock that are only partly determined by the business it represents. Purchase of stock in one company that has a somewhat uncertain or fluctuating profit record may be more conservative than purchase of a highly leveraged stock of another company whose basic business is steadier and more conservative. We will take up the matter of determining these risk constants a little later. One should also understand the short sale of a stock does not imply any feeling that the country is going to the dogs or even that the concern represented is going to the dogs. Such a sale merely indicates your belief the stock may be temporarily overpriced; that earnings or dividends may have been abnormal in recent years and are likely to be reduced; or that for one reason or another, the stock of the company may be worth a bit less than it has been worth. For technical trading, we want a fairly speculative stock, one that will make sizable swings up in a Bullish Trend and down in a Bearish Trend. The very factors that tend to make a stock safe and desirable to the investor may make it entirely unsuitable for trading. Also, with certain reservations that will be taken up later on, the more speculative the stock the better it is for our purposes. (EN: Entering the third millennium (since we Anglo-Saxons started counting—the fourth or fifth by other measures), the distinctions between “speculative” stocks and every other kind of stock has grown increasingly blurry. Rather than apply a perhaps pejorative (in the minds of some readers) term like “speculative” to otherwise-innocent stocks, we would do better to describe stocks as wide ranging or narrow ranging, as volatile or nonvolatile. Stocks may then be evaluated one against another by their betas and historical volatilities, statistical data easy to obtain. “Betas” and “volatilities” are dealt with in Chapters 24 and 42 .) In line with this more current thinking, there is another question for readers of this book—the choice of trading (or investment) instruments for the long-term investor. The kind of stocks we want: the long-term investor's viewpoint Changing opinions about conservative investing Virtually no one invests like the conservative investor described above in Chapter 20 — except perhaps trust departments of antediluvian banks. There may be some investors still out there who are so risk averse they still follow the method described. Bank trust departments may be still doing it; they used to do it so the trust beneficiaries could not sue them. This is the reason trust departments exist, to give legal cover (the so-called prudent man rule) to trustees in case of suit by beneficiaries. Most enlightened trust departments and trustees now probably follow indexing or other more productive strategies to cater to new understandings of the prudent man rule. “Indexing” refers to the practice of constructing a portfolio to replicate or closely reproduce the behavior of a widely followed index such as the Standard & Poor's (S&P) 500 or the Dow-Jones Industrials. These portfolios never track the Indexes exactly because the advisors and funds who manage them take management fees and expenses. These fees are generally less than fees and expenses on actively managed funds, but in fact are not necessary for the private investor to pay because even the tyro investor can now use “Index Shares” (e.g., DIAMONDS™ [DIA], S&P Depositary Receipts [SPDR; SPY, QQQ,] and so on) or other proxy instruments to do what the funds and professionals do. Essentially what indexing does is track the Averages, a strategy that was impossible or difficult (expensive) when Magee examined it, as in Chapter 15 . (EN9: In the opinion of this editor, hiring a management company to run an indexing strategy is a waste of capital. Much better for the investor to invest directly in ETFs and to exit the market when uptrends end and reverse. This is a much better strategy than “passive indexing,” which cleverly manages to capture both losses and profits in the Averages.) The kinds of stocks long-term investors want: the long-term investor's viewpoint Perhaps one of the most important actualizations of recent editions is to bring current this book's treatment of the Averages, noting that it is now possible to trade the Averages in stock-like instruments. This fact deserves to be marked as a vitally important development in modern markets. This chapter will confine itself to describing facilities for trading and investing in the Averages and Indexes. In 1993, the American Stock Exchange (AMEX) introduced trading in SPDRs™, an Exchange-traded unit investment trust based on the S&P 500 Composite Stock Price Index. The AMEX calls these securities Index Shares™, a name they also use for other similar instruments. As noted above, large investors and funds have long traded “baskets” of stocks representing the S&P 500, obviously an activity requiring large capital. In fact, a certain class of investment managers and funds have practiced “passive investing” meaning indexing, primarily for large clients. The purchase and liquidation of these and other “baskets” is one form of “program trading.” Recognizing the utility of this investment practice, the AMEX created the SPDR as a proxy instrument to allow the smaller investor to practice the same strategy. The effectiveness of this product introduction may be measured by public participation in the trading of the SPDR (SPY). By 2000, almost $15 billion was invested in SPDRs with more than 100,000,000 shares outstanding. These units allow the investor to buy or sell the entire portfolio or basket of the S&P 500 stocks just as he would an individual stock, but the capital required to do so is radically reduced. In 1998, the AMEX introduced DIA, Index Shares on the Dow-Jones Industrial Average™ (DJIA), which is analogous in every way to the SPDRs. Thus, an investor may “buy the DJIA.” So in current financial markets, it is possible to “buy the market,” unlike those conditions under which Edwards and Magee operated. Construction of the Index Shares and similar instruments The AMEX unit investment trusts are constructed to replicate the composition of their base instrument. The SPDR, for example, is an instrument that represents one-tenth of the full value of a basket of the S&P stocks and trades on the AMEX, just like a stock (SPY). Other characteristics of stocks are also reproduced such as long life (the SPDR Trust lasts into the twenty-second century) and quarterly dividends (cash paid on the SPDRs reproducing dividends accumulated on the stocks of the S&P 500). Even dividend reinvestment is possible, and the units may be traded on the AMEX during regular trading hours. Under normal conditions, there should be little variance in the price of the SPY relative to the S&P 500. (In 2008, the AMEX merged with the New York Stock Exchange. Trading and instruments remain as described.) These elements, as discussed for SPDRs, are common to all the Index Shares— DIAMONDS, World Equity Benchmarks (WEBs), and others. There are, of course, some expenses and costs to using the Index Shares—a small price to pay for the use of the instrument and generally less than the costs of a fund. Index Shares are also much more flexible for the independent investor. Among other advantages, the private investor can control the tax consequences of his investment, which is not possible in funds. Other Exchanges have created similar security instruments or derivatives or futures to replicate or track the well-known averages and indexes. Among these are tracking shares or index shares or futures (let us call them “instruments”) on other indexes (Russell, Nikkei, and so on) or options on the futures or indexes until there is a bewildering array of instruments available for trading, investing, and hedging. Among the more important exchanges and instruments traded are the Chicago Board of Trade (futures and options on futures on the Dow); the Chicago Mercantile Exchange (futures on the S&P, Nikkei 225, Mini S&P 500, S&P Midcap 400, Russell 2000, and NASDAQ 100); and the Chicago Board Options Exchange (S&P 100 and 500 options). This, by no means, is an exhaustive list. All the futures and options that matter will be found listed in the Wall Street Journal under Futures Prices or Futures Options Prices. This book does not deal in comprehensive detail with futures and options, but it is worth mentioning these exchanges and their futures and options products because of the facility they offer the investor and trader for hedging portfolios in Index Shares and Average trading, not to mention opportunities for speculating. Briefly, hedging is the practice of being neutral in the market. That is, one might be long the DIAMONDS and buy a put option on the DJIA at the Chicago Board of Trade, meaning that advances in the DJIA would result in profits in the DIAMONDS, and a loss of premium in the put. Conversely, a decline in the Dow would result in profits in the put and losses in the DIAMONDS. As this area is not the province of this book, this is a highly simplified description of a hedge. Nevertheless, the reader should see and understand that hedging can be an important strategy. Hedging can take the place of liquidation of a portfolio when the analyst recognizes a change of trend or unstable conditions but does not wish to incur taxes or wishes to defer them. An outline of instruments available for trading and investing It would be herculean to attempt to list the entire panoply of averages, indexes, futures, and options available for trading—herculean due to the fact new trading instruments are constantly in creation and due to the fact, now operating at internet speed, we may expect the rate of change to accelerate. In addition to those listed above, there are WEBS (meaning that exposure to world markets may be arranged). In all, approximately 30 or more Index Share units or instruments were available for trading on the AMEX at the turn of the century, in addition to DIAMONDS and SPDRs. Similar instruments exist on the Philadelphia and in Chicago, and others are being created daily. To reduce the confusion, the general investor will probably find the major indices of the most importance. The more instruments one deals with the more complicated the strategy and tactics become. Therefore, the Dow, the S&P 500, and the NASDAQ composite (DIA, SPY, QQQ) are probably sufficient for the purposes of the gentleman (or lady) investor. The Mid-Caps, the Nikkei, and others begin to come into play when the trader begins to try to catch sector rotation, fads, short-term cycles, and so on. The importance of these instruments: diversification, dampened risks, tax, and technical regularity It would be difficult to underestimate the importance of these new trading instruments. First of all, they afford the private investor what was previously reserved for the large capital trader—the ultimate in market diversification. The S&P 500 represents stocks comprising 69% of the value of stocks on the New York Stock Exchange. Buying it is buying the American economy. The 30 Dow Industrial stocks represent the most important symbol in the American economy—and perhaps in the world. Investors are well advised to pay attention to both Averages if they would fare well in the markets (Note the plural: markets ). These two Averages now have the influence or clout that once the Dow alone had to express the state of the markets and stocks in general. Buying the SPY or DIA then represents the immediate acquisition of a diversified portfolio. And buying the NASDAQ or QQQ gives one immediate exposure to the more speculative and volatile sector of the American economy. Given the long-term bullish bias of the averages and the American economy, it is difficult to argue with this as both strategy and tactics for the long-term investor. This does not mean positions should be taken blindly without thought or not monitored. On the contrary, recall if you will the record of the Dow Theory; even for the long-term investor, bear markets should not be allowed to destroy liquidity and equity value. These questions are discussed at greater length in Chapter 18 . Although we believe these instruments are good vehicles, it is wise to remember Magee's frequent admonition (less important now than when spoken) that it is a market of stocks, not a stock market. Meaning when the tide is flowing down with the Dow and S&P, prudence and care must be used in taking long positions in stocks that are in doubt as to direction. Additionally, it is worth noting investments in these instruments will be less profitable than an astutely chosen individual stock. For example, Qualcomm appreciated approximately 240% (temporarily) in 1999-2000 compared with about 24% in the S&P over the same period. Those who bought Qualcomm at its top and sold it at the bottom of its reaction lost about 75% or about $148 a share. Traders in Qualcomm tended to obsess and pay hyper attention to the stock, whereas investors in the SPY reviewed it once a week or less or told their computers or their brokers to give them a call if it broke the trendline or entered stops. Then they slept at night and had eupeptic digestion. Other advantages accrue to the trading of the SPDRs. Ownership of a fund can result in tax liabilities as managers adjust portfolios to reflect changing membership in the fund or withdrawals in capital by irate stockholders. Since Index Shares last into the twenty-second century, the long-term investor has no need to realize gains and pay taxes. Bear markets may be dealt with by hedging with other instruments—futures, options, or proxy baskets of stock, or individual stocks, and accepting the tax consequences of these trades. John Magee aptly observed before the direct trading of the Averages was possible that the Dow-Jones Industrials were very regular and dependable from the technical point of view. This observation is annotated at some length in comments on Dow Theory in Chapter 36 . Therefore, the investor in the Index Shares may have a smoother time technically than a trader of an individual stock. Summary The long-term investor and mid-term speculator attempt to capture long secular (as well as cyclical) trends in the markets. They shun frequent trading and capital-eroding transactions. They recognize that risk fluctuates with time and trend, and they know that frequent turnover benefits mainly the broker. The strategy of the long-term investor may be to match the market by using funds or SPDRs or baskets, but he does not like to participate in Bear trends. He hedges or liquidates his positions on major trend shifts. In fact, he may even short the indexes if his analysis indicates major bear markets. If he desires to outperform the market (which will happen automatically if he follows the methods of this work), he finds some individual speculative stocks to trade in addition to his foundation portfolio. Depending on his risk tolerance, he may always be somewhat hedged. When long the indexes, he finds some stocks in downtrends to short. When he is short the indexes, he finds some strong stocks to hold long. There is no excuse for a moderately skilled and reasonably capitalized investor to lose money over the long term in the market. As a reminder, Chapters 5 and 28 describe powerful methods for the long-term investor using Magee's Basing Points Procedure. chapter twenty-one ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf#page:320 SCORE: 0.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf#page:321 SCORE: 10.00 ================================================================================ 272 Technical Analysis of Stock Trends 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 options in their heads and make money on price anomalies of 1/16, or, as they call it, a “teenie.” For perspective, the reader may contemplate a conversation the editor had with one of the most important options traders in the world who remarked casually that his fortune was built on teenies. The reader may imagine at some length what would be necessary for the general investor to make a profit on anomalies of 1/16. (EN10: The advent of digital pricing has given market makers and specialists even more flexibility to beat the investor by shaving spreads, theoretically, to $0.01.) This does not mean the general investor should never touch options; it just means he should be thoroughly prepared before he goes down to play that game. In options trading, traders speak of bull spreads, bear spreads, and alligator spreads. The alligator spread is an options strategy that eats the customer’s capital in toto. Among these strategies is covered call writing. This strategy is touted as being an income producer on a stock portfolio. There is no purpose in writing a call on a stock in which the investor is long—unless that stock is stuck in a clear congestion phase that is not due to expire before the option expires. Besides, if the stock is in a downtrend, it should be liquidated, but to write a call on a stock in a clear uptrend is to make oneself beloved of the broker, whose good humor improves markedly with account activity and commission income. The outcome of a covered call on an ascending stock is that the writer (you, dear reader) has the stock called at the exercise price, losing his position and future appreciation, not to mention costs. The income is actually small consolation, a sort of booby prize—a way of cutting your profits while increasing your costs. Nevertheless, covered writes are justified and profitable in some cases. Quantitative analysis The investor should be aware of another area of computer and investment technology that has yielded much more dramatic and profitable results, but that is in a model-driven market—namely, the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf#page:322 SCORE: 0.00 ================================================================================ 273Chapter seventeen: A summary a nd concluding comments irony, behavioral markets, the stock markets, are used as the basis for derivatives, or options whose price is determined largely by the operation of algorithms called “models.” The original model that created the modern world of options trading was the Black– Scholes options analysis model, which assumed the “fair value” of an option could be determined by entering five parameters into the formula: the strike price of the option, the price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility of the stock. The eventual universal acceptance of this model resulted in the derivatives industry we have today. To list all the forms of derivatives available for trading today would be to expand this book by many pages, and it is not the purpose of this book anyway. The purpose of this paragraph is to sternly warn general investors who are thinking of “beating the derivatives markets” to undergo rigorous training first. The alternative could be extremely expensive. At first, the traders who saw the importance of this model and used it to price options virtually skinned older options traders and the public, who traded pretty much by the seat of the pants or the strength of their convictions, meaning human emotion. But professional losers learn fast and now all competent options traders use some sort of model or anti-model, or anti-antimodel to trade. True to form, options sellers, who are largely professionals, take most of the public’s (the buyers) money. This is the way of the world. Options pricing models and their importance After the introduction of the Black–Scholes model, numerous other models followed, among them the Cox–Ross–Rubinstein, the Black Futures, and others. For the general investor, the message is this: he must be acquainted with these models and what their functions are if he intends to use options. Recall, the model computes the “fair value” of the option. One way professionals make money off amateurs is by selling overpriced options and buying underpriced options to create a relatively lower risk spread (for themselves). Not knowing what these values are for the private investor is like not knowing where the present price is for a stock; it is a piece of ignorance for which the professional will charge him a premium to be educated about. Unfortunately, many private options traders never get educated, in spite of paying tuition over and over again. But ignorance is not bliss—it is expensive. Technology and knowledge works its way from innovators and creative geniuses through the ranks of professionals and sooner or later is disseminated to the general public. By that time, the innovators have developed new technology. Nonetheless, even assuming that professionals have superior tools and technology, the general investor must thoroughly educate himself before using options. As it is not the province of this book to dissect options trading, though the reader may find references in Appendix B, Resources. Here it would not be untoward to mention one of the better books on options as a starting point for the moderately advanced and motivated trader. Lawrence McMillan’s Options as a Strategic Investment is necessary reading. In addition, the newcomer may contact the Chicago Board Options Exchange (the CBOE) at http:/ /www.cboe.com , which has tutorial software. Futures on indexes Futures, like options, offer the speculator intense leverage—the ability to control a comparatively large position with much less capital than the purchase of the underlying commodity or index. Futures salesmen are fond of pointing out the fact that, if you are margined at 5% or 10% of the contract value, a similar move in the price of the index will ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf#page:331 SCORE: 0.00 ================================================================================ 282 Technical Analysis of Stock Trends Having correctly analyzed market trends, your action results in an increase in portfolio value from $418,000 to $429,375. You could have accomplished the same result by buying and selling bonds and stocks, but not without tax consequences and the attendant transaction headaches. The use of futures to accomplish your goals allowed you to implement your trading plan without disturbing your existing portfolio. Perspective Although there can be no argument about the importance of CBOT® DJIASM Index futures— they are markets of enormous usefulness and importance—there can also be no doubt the futures novice should thoroughly prepare himself before venturing into these pits. In such a highly leveraged environment, mistakes will be punished much more severely than an error in the stock market. By the same token, ignorance of this vital tool is the mark of an investor who is not serious about his portfolio, or who is less intense in his investment goals. “They” (the infamous “they”) use all the weapons at their disposal; so should “we.” Options on Dow Index futures The buyer of this instrument has the choice, or the right, to assume a position. It is his option to do so—unlike a futures contract in which he has an obligation once entered. There are two kinds of options: calls (the right to buy the underlying instrument) and puts (the right to sell). Also, options can be bought (long) or sold (short) like futures contracts. A long call option on Dow Index futures gives the buyer the right to buy one futures contract at a specified price which is called the “exercise” or “strike” price. A long put option 12000 11800 11600 11400 11200 11000 10800 10600 10400 10200 1600 1200 800 400 11/1999 12/1999 00 2/2000 /DI200006 LAST-Daily 02/24/2000 Created with TradeStation www.TradeStation.com Figure 17.4 Dow–Jones Futures and Options. A put purchased at the arrow on the break would have protected patiently won gains over the previous 11 months. The increase in the value of the put can be seen as futures track declining Dow cash. A theoretical drill, but theoretical drills precede actual tactics in the market. ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf#page:332 SCORE: 24.00 ================================================================================ 283Chapter seventeen: A summary a nd concluding comments on Dow Index futures gives the buyer the right to sell one futures contract at the strike price. For example, a call at a strike price of 10,000 entitles the buyer to be long one futures contract at a price of 10,000 when he exercises the option. A put at the same strike price entitles the buyer to be short one futures contract at 10,000. The strike prices of Dow Index futures options are listed in increments of 100 index points, giving the trader the flexibility to express his opinions about upward or downward movement of the market. The seller, or writer, of a call or put is short the option. Effectively selling a call makes the writer short the market, just as selling a put makes the writer long the market. As in a futures contract, the seller is obligated to fulfill the terms of the option if the buyer exercises. If you are short a call, and the long exercises, you become short one futures contract at 10,000. If you are short one put and the long exercises, you become long one futures contract at 10,000. Buyers of options enjoy fixed risk. They can lose no more than the premium they pay to go long an option. On the other hand, sellers of options have potentially unlimited risk. Catastrophic moves in the markets often bankrupt imprudent option sellers. Option premiums The purchase price of the option is called the option premium. The option premium is quoted in points, each point being worth $100. The premium for a Dow Index option is paid by the buyer at initiation of the transaction. The underlying instrument for one CBOT ® futures option is one CBOT® DJIASM futures contract; so the option contract and the futures contract are essentially different expressions of the same instrument, and both are based on the Dow–Jones Index. Options premiums consist of two elements: intrinsic value and time value. The difference between the futures price and strike price is the intrinsic value of the option. If the futures price is greater than the strike price of a call, the call is said to be “in-the-money.” In fact, you can be long the futures contract at less than its current price. For example, if the futures price is 10,020 and the strike price is 10,000, the call is in-the-money and immediate exercise of the call pays $10.00 times the difference between the futures and strike price, or $10 × 20 = $200. If the futures price is less than the strike price, the call is “out-of-the- money.” If the two are equal, the call is “at-the-money.” A put is in-the-money if the futures price is less than the strike price and out-of-the-money if the futures price is greater than the strike price. It is at-the-money when these two prices are equal. Since a Dow Index futures option can be exercised at any date until expiration, and exercise results in a cash payment equal to the intrinsic value, the value of the option must be at least as great as its intrinsic value. The difference between the option price and the intrinsic value represents 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 ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf#page:333 SCORE: 0.00 ================================================================================ 284 Technical Analysis of Stock Trends 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 unexercised put is $0.00. If the price of the expiring futures contract is 7 ,500, a 7 ,600 put should be exercised but not a call at 7 ,600 or a higher strike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00. The profit on long options is the difference between the expiration value and the option premium. The profit on short options is the expiration value plus the option premium. The expiration values and profits on call and put options can often be an important tool in an investment strategy. Their payoff patterns and risk parameters make options quite different from futures. Their versatility makes them good instruments to adjust a portfolio to changing expectations about stock market conditions. Moreover, these expectations can range from general to specific predictions about the future direction and volatility of stock prices. Effectively, there is an option strategy suited to virtually every set of market conditions. Using futures options to participate in market movements Traders must often react to rapid and surprising events in the market. The transaction costs and price impact of buying or selling a portfolio’s stocks on short notice inhibit many investors from reacting to short-term market developments. Shorting stocks is an even less palatable option for average investors because of the margin and risks involved and semantical prejudices. The flexibility that options provide can allow one to take advantage of the profits from market cycles quickly and conveniently. A long call option on Dow Index futures profits at all levels above its strike price. A long put option similarly profits at all levels below its strike price. Let us examine both strategies. Profits in rising markets In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You expect the current Bull Market to continue, and you would like to take advantage of the trend without tying up too much capital and also undertake only limited risk. ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf#page:506 SCORE: 0.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf#page:507 SCORE: 10.00 ================================================================================ options in their heads and make money on price anomalies of 1/16, or, as they call it, a “teenie.” For perspective, the reader may contemplate a conversation the editor had with one of the most important options traders in the world who remarked casually that his fortune was built on teenies. The reader may imagine at some length what would be necessary for the general investor to make a profit on anomalies of 1/16. (EN10: The advent of digital pricing has given market makers and specialists even more flexibility to beat the investor by shaving spreads, theoretically, to $0.01.) This does not mean the general investor should never touch options; it just means he should be thoroughly prepared before he goes down to play that game. In options trading, traders speak of bull spreads, bear spreads, and alligator spreads. The alligator spread is an options strategy that eats the customer's capital in toto. Among these strategies is covered call writing. This strategy is touted as being an income producer on a stock portfolio. There is no purpose in writing a call on a stock in which the investor is long—unless that stock is stuck in a clear congestion phase that is not due to expire before the option expires. Besides, if the stock is in a downtrend, it should be liquidated, but to write a call on a stock in a clear uptrend is to make oneself beloved of the broker, whose good humor improves markedly with account activity and commission income. The outcome of a covered call on an ascending stock is that the writer (you, dear reader) has the stock called at the exercise price, losing his position and future appreciation, not to mention costs. The income is actually small consolation, a sort of booby prize—a way of cutting your profits while increasing your costs. Nevertheless, covered writes are justified and profitable in some cases. Quantitative analysis The investor should be aware of another area of computer and investment technology that has yielded much more dramatic and profitable results, but that is in a model-driven market—namely, the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting irony, behavioral markets, the stock markets, are used as the basis for derivatives, or options whose ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf#page:508 SCORE: 0.00 ================================================================================ price is determined largely by the operation of algorithms called “models.” The original model that created the modern world of options trading was the Black-Scholes options analysis model, which assumed the “fair value” of an option could be determined by entering five parameters into the formula: the strike price of the option, the price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility of the stock. The eventual universal acceptance of this model resulted in the derivatives industry we have today. To list all the forms of derivatives available for trading today would be to expand this book by many pages, and it is not the purpose of this book anyway. The purpose of this paragraph is to sternly warn general investors who are thinking of “beating the derivatives markets” to undergo rigorous training first. The alternative could be extremely expensive. At first, the traders who saw the importance of this model and used it to price options virtually skinned older options traders and the public, who traded pretty much by the seat of the pants or the strength of their convictions, meaning human emotion. But professional losers learn fast and now all competent options traders use some sort of model or anti-model, or anti-antimodel to trade. True to form, options sellers, who are largely professionals, take most of the public's (the buyers) money. This is the way of the world. Options pricing models and their importance After the introduction of the Black-Scholes model, numerous other models followed, among them the Cox-Ross-Rubinstein, the Black Futures, and others. For the general investor, the message is this: he must be acquainted with these models and what their functions are if he intends to use options. Recall, the model computes the “fair value” of the option. One way professionals make money off amateurs is by selling overpriced options and buying underpriced options to create a relatively lower risk spread (for themselves). Not knowing what these values are for the private investor is like not knowing where the present price is for a stock; it is a piece of ignorance for which the professional will charge him a premium to be educated about. Unfortunately, many private options traders never get ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf#page:527 SCORE: 8.00 ================================================================================ long exercises, you become short one futures contract at 10,000. If you are short one put and the long exercises, you become long one futures contract at 10,000. Buyers of options enjoy fixed risk. They can lose no more than the premium they pay to go long an option. On the other hand, sellers of options have potentially unlimited risk. Catastrophic moves in the markets often bankrupt imprudent option sellers. Option premiums The purchase price of the option is called the option premium. The option premium is quoted in points, each point being worth $100. The premium for a Dow Index option is paid by the buyer at initiation of the transaction. The underlying instrument for one CBOT® futures option is one CBOT® DJIASM futures contract; so the option contract and the futures contract are essentially different expressions of the same instrument, and both are based on the Dow-Jones Index. Options premiums consist of two elements: intrinsic value and time value. The difference between the futures price and strike price is the intrinsic value of the option. If the futures price is greater than the strike price of a call, the call is said to be “in-the-money.” In fact, you can be long the futures contract at less than its current price. For example, if the futures price is 10,020 and the strike price is 10,000, the call is in-the-money and immediate exercise of the call pays $10.00 times the difference between the futures and strike price, or $10 x 20 = $200. If the futures price is less than the strike price, the call is “out-of-the-money.” If the two are equal, the call is “at-the-money.” A put is in-the-money if the futures price is less than the strike price and out-of-the-money if the futures price is greater than the strike price. It is at-the-money when these two prices are equal. Since a Dow Index futures option can be exercised at any date until expiration, and exercise results in a cash payment equal to the intrinsic value, the value of the option must be at least as great as its intrinsic value. The difference between the option price and the intrinsic value represents ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf#page:528 SCORE: 20.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf#page:529 SCORE: 0.00 ================================================================================ unexercised put is $0.00. If the price of the expiring futures contract is 7,500, a 7,600 put should be exercised but not a call at 7,600 or a higher strike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00. The profit on long options is the difference between the expiration value and the option premium. The profit on short options is the expiration value plus the option premium. The expiration values and profits on call and put options can often be an important tool in an investment strategy. Their payoff patterns and risk parameters make options quite different from futures. Their versatility makes them good instruments to adjust a portfolio to changing expectations about stock market conditions. Moreover, these expectations can range from general to specific predictions about the future direction and volatility of stock prices. Effectively, there is an option strategy suited to virtually every set of market conditions. Using futures options to participate in market movements Traders must often react to rapid and surprising events in the market. The transaction costs and price impact of buying or selling a portfolio's stocks on short notice inhibit many investors from reacting to short-term market developments. Shorting stocks is an even less palatable option for average investors because of the margin and risks involved and semantical prejudices. The flexibility that options provide can allow one to take advantage of the profits from market cycles quickly and conveniently. A long call option on Dow Index futures profits at all levels above its strike price. A long put option similarly profits at all levels below its strike price. Let us examine both strategies. Profits in rising markets In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You expect the current Bull Market to continue, and you would like to take advantage of the trend without tying up too much capital and also undertake only limited risk. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:f09.xhtml SCORE: 4.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml SCORE: 107.00 ================================================================================ Chapter 1 Math and Finance Preliminaries The purpose of this book is to provide a qualitative framework for options investing based on a quantitative analysis of financial data and theory. Mathematics plays a crucial role when developing this framework, but it is predominantly a means to an end. This chapter therefore includes a brief overview of the prerequisite math and financial concepts required to understand this book. Because this isn't in‐depth coverage of the following topics, we encourage you to explore the supplemental texts listed in the references section for those mathematically inclined. Formulae and their descriptions are included in several sections for reference, but they are not necessary to follow the remainder of the book. Stocks, Exchange‐Traded Funds, and Options From swaptions to non‐fungible tokens (NFTs), new instruments and opportunities frequently emerge as markets evolve. By the time this book reaches the shelf, the financial landscape and the instruments occupying it may be very different from when it was written. Rather than focus on a wide range of instruments, this book discusses fundamental trading concepts using a small selection of asset classes (stocks, exchange‐traded funds, and options) to formulate examples. A share of stock is a security that represents a fraction of ownership of a corporation. Stock shares are normally issued by the corporation as a source of funding, and these instruments are usually publicly traded on stock exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq. Shareholders are entitled to a fraction of the company's assets and profits based on the proportion of shares they own relative to the number of outstanding shares. An exchange‐traded fund (ETF) is a basket of securities, such as stocks, bonds, or commodities. Like stocks, shares of ETFs are traded publicly on stock exchanges. Similar to mutual funds, these instruments represent a fraction of ownership of a diversified portfolio that is usually managed professionally. These assets track aspects of the market such as an index, sector, industry, or commodity. For example, SPDR S&P 500 (SPY) is a market index ETF tracking the S&P 500, Energy Select Sector SPDR Fund (XLE) is a sector ETF tracking the energy sector, and SPDR Gold Trust (GLD) is a commodity ETF tracking gold. ETFs are typically much cheaper to trade than the individual assets in an ETF portfolio and are inherently diversified. For instance, a share of stock for an energy company is subject to company‐specific risk factors, while a share of an energy ETF is diversified over several energy companies. When assessing the price dynamics of a stock or ETF and comparing the dynamics of different assets, it is common to convert price information into returns. The return of a stock is the amount the stock price increased or decreased as a proportion of its value rather than a dollar amount. Returns can be scaled over any time frame (daily, monthly, annual), with calculations typically calling for daily returns. The two most common types of returns are simple returns, represented as a percentage and calculated using Equation (1.1) , and log returns, calculated using Equation (1.2) . The logarithm's mathematical definition and properties are covered in the appendix for those interested, but that information is not necessary to know to follow the remainder of the book. (1.1) (1.2) where is the price of the asset on day and is the price of the asset the prior day. For example, an asset priced at $100 on day 1 and $101 on day 2 has a simple daily return of 0.01 (1%) and a log return of 0.00995. Simple and log returns have different mathematical characteristics (e.g., log returns are time‐additive), which impact more advanced quantitative analysis. However, these factors are not relevant for the purposes of this book because the difference between log returns and simple returns is fairly negligible when working on daily timescales. Simple daily returns are used for all returns calculations shown. An option is a type of financial derivative, meaning its price is based on the value of an underlying asset. Options contracts are either traded on public exchanges (exchange‐traded options) or traded privately with little regulatory oversight (over‐the‐counter [OTC] options). As OTC options are nonstandardized and usually inaccessible for retail investors, only exchange‐traded options will be discussed in this book. An option gives the holder the right (but not the obligation) to buy or sell some amount of an underlying asset, such as a stock or ETF, at a predetermined price on or before a future date. The two most common styles of options are American and European options. American options can be exercised at any point prior to expiration, and European options can only be exercised on the expiration date. 1 Because American options are generally more popular than European options and offer more flexibility, this book focuses on American options. The most basic types of options are calls and puts. American calls give the holder the right to buy the underlying asset at a certain price within a given time frame, and American puts give the holder the right to sell the underlying asset. The contract parameters must be specified prior to opening the trade and are listed below: The underlying asset trading at the spot price, or the current per share price . The number of underlying shares. One option usually covers 100 shares of the underlying, known as a one lot. The price at which the underlying shares can be bought or sold prior to expiration. This price is called the strike price . The expiration date, after which the contract is worthless. The time between the present day and the expiration date is the contract's duration or days to expiration (DTE). Note that the price of the option is commonly denoted as C for calls, P for puts, and V if the type of contract is not specified. Options traders may buy or sell these contracts, and the conditions for profitability differ depending on the choice of position. The purchaser of the contract pays the option premium (current market price of the option) to adopt the long side of the position. This is also known as a long premium trade. The seller of the contract receives the option premium to adopt the short side of the position, thus placing a short premium trade. The choice of strategy corresponds to the directional assumption of the trader. For calls and puts, the directional assumption is either bullish, assuming the underlying price will increase, or bearish, assuming the underlying price will decrease. The directional assumptions and scenarios for profitability for these contracts are summarized in the following table. Table 1.1 The definitions, conditions for profitability, and directional assumptions for long/short calls/puts. Call Put Long Purchase the right to buy an underlying asset at the strike price prior to the expiration date. Profits increase as the price of the underlying increases above the strike price . Directional assumption: Bullish Purchase the right to sell an underlying asset at the strike price prior to the expiration date. Profits increase as the price of the underlying decreases below the strike price . Directional assumption: Bearish Short Sell the right to buy an underlying asset at the strike price prior to the expiration date. Profits increase as the price of the underlying decreases below the strike price . Directional assumption: Bearish Sell the right to sell an underlying asset at the strike price prior to the expiration date. Profits increase as the price of the underlying increases above the strike price . Directional assumption: Bullish The relationship between the strike price and the current price of the underlying determines the moneyness of the position. This is equivalently the intrinsic value of a position, or the value of the contract if it were exercised immediately. Contracts can be described as one of the following, noting that options cannot have negative intrinsic value: In‐the‐money (ITM): The contract would be profitable if it was exercised immediately and thus has intrinsic value. Out‐of‐the‐money (OTM): The contract would result in a loss if it was exercised immediately and thus has no intrinsic value. At‐the‐money (ATM): The contract has a strike price equal to the price of the underlying and thus has no intrinsic value. The intrinsic value of a position is based entirely on the type of position and the choice of strike price relative to the price of the underlying: Call options Intrinsic Value = Either (stock price – strike price) or 0 ITM: OTM: ATM: Put options Intrinsic Value = Either or 0 ITM: OTM: ATM: For example, consider a 45 DTE put contract with a strike price of $100: Scenario 1 (ITM): The underlying price is $95. In this case, the intrinsic value of the put contract is $5 per share. Scenario 2 (OTM): The underlying price is $105. In this case, the put contract has no intrinsic value. Scenario 3 (ATM): The underlying price is $100. In this case, the put is also considered to have no intrinsic value. The value of an option also depends on speculative factors, driven by supply and demand. The extrinsic value of the option is the difference between the current market price for the option and the intrinsic value of the option. Again, consider a 45 DTE put contract with a strike price of $100 on an underlying with a current price per share of $105. Suppose that, due to a period of recent market turbulence, investors are fearful the underlying price will crash within the next 45 days and create a demand for these OTM put contracts. The surge in demand inflates the price of the put contract to $10 per share. Therefore, because the put contract has no intrinsic value but has a market price of $10, the extrinsic value of the contract is $10 per share. If, instead, the price of the underlying is $95 and the price of the ITM put is still $10 per share, then the contract will have $5 in intrinsic value and $5 in extrinsic value. The profitability of an option ultimately depends on both intrinsic and extrinsic factors, and it is calculated as the difference between the intrinsic value of an option and the cost of the contract. Mathematically, profit and loss (P/L) approximations for long calls and puts at exercise are given by the following equations: 2 (1.3) (1.4) where the max function simply outputs the larger of the two values. For instance, equals 1 while equals 0. The P/Ls for the corresponding short sides are merely Equations (1.3) and (1.4) multiplied by –1. Following is a sample trade that applies the long call profit formula. Example trade: A call with 45 DTE duration is traded on an underlying that is currently priced at $100 . The strike price is $105 and the long call is currently valued at $100 per one lot ($1 per share). Scenario 1: The underlying increases to $105 by the expiration date. Long call P/L: Short call P/L: +$100. Scenario 2: The underlying increases to $110 by the expiration date. Long call P/L: Short call P/L: –$400. Scenario 3: The underlying decreases to $95 by the expiration date. Long call P/L: Short call P/L: +$100. The trader adopting the long position pays the seller the option premium upfront and profits when the intrinsic value exceeds the price of the contract. The short trader profits when the intrinsic value remains below the price of the contract, especially when the position expires worthless (no intrinsic value). The extrinsic value of an option generally decreases over the duration of the contract, as uncertainty around the underlying price and uncertainty around the profit potential of the option decrease. As a position nears expiration, the price of an option converges toward its intrinsic value. Options pricing clearly plays a large role in options trading. To develop an intuitive understanding around how options are priced, understanding the mathematical assumptions around market efficiency and price dynamics is critical. The Efficient Market Hypothesis Traders must make a number of assumptions prior to placing a trade. Options traders must make directional assumptions about the price of the underlying over a given time frame: bearish (expecting price to decrease), bullish (expecting price to increase), or neutral (expecting price to remain relatively unchanged). Options traders also must make assumptions about the current value of an option. If options contracts are perceived as overvalued, long positions are less likely to profit. If options contracts are perceived as undervalued, short positions are less likely to profit. These assumptions about underlying and option price dynamics are a personal choice, but traders can formulate consistent assumptions by referring to the efficient market hypothesis (EMH). The EMH states that instruments are traded at a fair price, and the current price of an asset reflects some amount of available information. The hypothesis comes in three forms: Weak EMH: Current prices reflect all past price information. Semi‐strong EMH: Current prices reflect all publicly available information. Strong EMH: Current prices reflect all possible information. No variant of the EMH is universally accepted or rejected. The form that a trader assumes is subjective, and methods of market analysis available are limited depending on that choice. Proponents of the strong EMH posit that investors benefit from investing in low‐cost passive index funds because the market is unbeatable. Opponents believe the market is beatable by exploiting inefficiencies in the market. Traders who accept the weak EMH believe technical analysis (using past price trends to predict future price trends) is invalidated, but fundamental analysis (using related economic data to predict future price trends) is still viable. Traders who accept the semi‐strong EMH assume fundamental analysis would not yield systematic success but trading according to private information would. Traders who accept the strong EMH maintain that even insider trading will not result in consistent success and no exploitable market inefficiencies are available to anyone. This book focuses on highly liquid markets, and inefficiencies are assumed to be minimal. More specifically, this book assumes a semi‐strong form of the EMH. Rather than constructing portfolios according to forecasts of future price trends, the purpose of this text is to demonstrate how trading options according to current market conditions and directional volatility assumptions (rather than price assumptions) has allowed options sellers to consistently outperform the market. This “edge” is not the result of some inherent market inefficiency but rather a trade‐off of risk. Recall the example long call trade from the previous section. Notice that there are more scenarios in which the short trader profits compared to the long trader. Generally, short premium positions are more likely to yield a profit compared to long premium positions. This is because options are assumed to be priced efficiently and scaled according to the perceived risk in the market, meaning that long positions only profit when the underlying has large directional moves outside of expectations. As these types of events are uncommon, options contracts go unused the majority of the time and short premium positions profit more often than long positions. However, when those large, unexpected moves do occur, the short premium positions are subject to potentially massive losses. The risk profiles for options are complex, but they can be intuitively represented with probability distributions. Probability Distributions To better understand the risk profiles of short options, this book utilizes basic concepts from probability theory, specifically random variables and probability distributions. Random variables are formal stand‐ins for uncertain quantities. The probability distribution of a random variable describes possible values of that quantity and the likelihood of each value occurring. Generally, probability distributions are represented by the symbol , which can be read as “the probability that.” For example, . Random variables and probability distributions are tools for working with probabilistic systems (i.e., systems with many unpredictable outcomes), such as stock prices. Although future outcomes cannot be precisely predicted, understanding the distribution of a probabilistic system makes it possible to form expectations about the future, including the uncertainty associated with those expectations. Let's begin with an example of a simple probabilistic system: rolling a pair of fair, six‐sided dice. In this case, if represents the sum of the dice, then is a random variable with 11 possible values ranging from 2 to 12. Some of these outcomes are more likely than others. Since, for instance, there are more ways to roll a sum of 7 ([1,6], [2,5], [3,4], [4,3], [5,2], [6,1]) than a sum of 10 ([4,6], [5,5], [6,4]), there is a higher probability of rolling a 7 than a 10. Observing that there are 36 possible rolls ([1,1], [1,2], [2,1], etc.) and that each is equally likely, one can use symbols to be more precise about this: The distribution of can be represented elegantly using a histogram. These types of graphs display the frequency of different outcomes, grouped according to defined ranges. When working with measured data, histograms are used to estimate the true underlying probability distribution of a probabilistic system. For this fair dice example, there will be 11 bins, corresponding to the 11 possible outcomes. This histogram is shown below in Figure 1.1 , populated with data from 100,000 simulated dice rolls. Figure 1.1 A histogram for 100,000 simulated rolls for a pair of fair dice. This diagram shows the likelihood of each outcome occurring according to this simulation (e.g., the height of the bin ranging from 6.5 to 7.5 is near 17%, indicating that 7 occurred nearly 17% of the time in the 100,000 trials). Distributions like the ones shown here can be summarized using quantitative measures called moments . 3 The first two moments are mean and variance. Mean (first moment): Also known as the average and represented by the Greek letter (mu), this value describes the central tendency of a distribution. This is calculated by summing all the observed outcomes together and dividing by the number of observations : (1.5) For distributions based on statistical observations with a sufficiently large number of occurrences , the mean corresponds to the expected value of that distribution. The expected value of a random variable is the weighted average of outcomes and the anticipated average outcome over future trials. The expected value of a random variable , denoted , can be estimated using statistical data and Equation (1.5) , or if the unique outcomes ( ) and their respective probabilities are known, then the expected value can also be calculated using the following formula: (1.6) In the dice sum example, represented with random variable , the possible outcomes (2, 3, 4, …, 12) and the probability of each occurring (2.78%, 5.56%, 8.33%, …, 2.78%) are known, so the expected value can be determined as follows: The theoretical long‐term average sum is seven. Therefore, if this experiment is repeated many times, the mean of the observations calculated using Equation (1.5) should yield an output close to seven. Variance (second moment): This is the measure of the spread, or variation, of the data points from the mean of the distribution. Standard deviation, represented with by the Greek letter (sigma), is the square root of variance and is commonly used as a measure of uncertainty (equivalently, risk or volatility). Distributions with more variance are wider and have more uncertainty around future outcomes. Variance is calculated according to the following: 4 (1.7) When a large portion of data points are dispersed far from the mean, the variance of the entire set is large, and uncertainty on measurements from that system is significant. The variance of a random variable X , denoted ( X ), can also be calculated in terms of the expected value, [ X ]: (1.8) For the dice sum random variable, D , the possible outcomes (2, 3, 4, …, 12) and the probability of each occurring (2.78%, 5.56%, 8.33%, …, 2.78%) are known, so the variance of this experiment is as follows: This equation indicates that the spread of the distribution for this random variable is around 5.84 and the uncertainty (standard deviation) is approximately 2.4 (shown in Figure 1.2 ). One can compare these theoretical estimates for the mean and standard deviation of the dice sum experiment to the values measured from statistical data. The calculated first and second moments from the simulated dice roll experiment are plotted in Figure 1.2 for comparison. Obtaining a distribution average near 7.0 makes intuitive sense because 7 is the most likely sum to roll out of the possible outcomes. The standard deviation indicates that the uncertainty associated with that expected value is near 2.4. Inferring from the shape of the distribution, which has most of the probability mass concentrated near the center, one can conclude that on any given roll the outcome will most likely fall between five and nine. The distribution just shown is symmetric about the mean, but probability distributions are often asymmetric. To quantify the degree of asymmetry for a distribution, the third moment is used. Skew (third moment): This is a measure of the asymmetry of a distribution. A distribution's skew can be positive, negative, or zero and depends on whether the tail to the right of the mean is larger (positive skew), to the left is larger (negative skew), or equal on both sides (zero skew). Unlike mean and standard deviation, which have units defined by the random variable, skew is a pure number that quantifies the degree of asymmetry according to the following formula: (1.9) Figure 1.2 A histogram for 100,000 simulated dice rolls with fair dice. Included is the mean of the distribution (solid line) and the standard deviation of the distribution on either side of the mean (dotted line), both calculated using the observations from the simulated experiment. The average of this distribution was 7.0 and the standard deviation was 2.4, consistent with the theoretical estimates. The concept of skew and its applications can be best understood with a modification to the dice rolling example. Suppose that the dice are biased rather than fair. Let's consider two scenarios: a pair of unfair dice with a small number bias (two and three more likely) and a pair of unfair dice with a large number bias (four and five more likely). The probabilities of each number appearing on each die for the different cases are shown in Table 1.2 . Table 1.2 The probability of each number appearing on each die in the three different scenarios, one fair and two unfair. Probability of Number Appearing on Each Die Die Number Fair Unfair (Small Number Bias) Unfair (Large Number Bias) 1 16.67% 10% 10% 2 16.67% 30% 10% 3 16.67% 30% 10% 4 16.67% 10% 30% 5 16.67% 10% 30% 6 16.67% 10% 10% When rolling the fair pair and plotting the histogram of the possible sums, the distribution is symmetric about the mean and has a skew of zero. However, the distributions when rolling the unfair dice are skewed, as shown in Figures 1.3 (a) and (b). The skew of a distribution is classified according to where the majority of the distribution mass is concentrated. Remember that the positive side is to the right of the mean and the negative side is to the left. The histogram in Figure 1.3 (a) has a longer tail on the positive side and has the most mass concentrated on the negative side of the mean: This is an example of positive skew (skew = 0.45). The histogram in Figure 1.3 (b) has a longer tail on the negative side and has the majority of the mass concentrated on the positive side of the mean: This is an example of negative skew (skew = –0.45). When a distribution has skew, the interpretation of standard deviation changes. In the example with fair dice, the expected value of the experiment is 2.4, suggesting that any given trial will most likely have an outcome between five and nine. This is a valid interpretation because the distribution is symmetric about the mean and most of the distribution mass is concentrated around it. However, consider the distribution in the unfair example with the large number bias. This distribution has a mean of 7.8 and a standard deviation of 2.0, naively suggesting that the outcome will most likely be between six and nine with the outcomes on either side being equally probable. However, because the majority of the occurrences are concentrated on the positive side of the mean (roughly 60% of occurrences), the uncertainty is not symmetric. This concept will be discussed in more detail in a later chapter, as distributions of financial instruments are commonly skewed, and there is ambiguity in defining risk under those circumstances. Figure 1.3 (a) A histogram for 100,000 simulated dice rolls with unfair dice, biased such that smaller numbers (2 and 3) are more likely to appear on each die. (b) A histogram for 100,000 simulated dice rolls with unfair dice, biased such that larger numbers (4 and 5) are more likely to appear on each die. Mathematicians and scientists have encountered some probability distributions repeatedly in theory and applications. These distributions have, in turn, received a great deal of study. Assuming the underlying distribution of an experiment resembles a well known form can often greatly simplify statistical analysis. The normal distribution (also known as the Gaussian distribution or the bell curve) is arguably one of the most well‐known probability distributions and foundational in quantitative finance. It describes countless different real‐world systems because of a result known as the central limit theorem. This theorem says, roughly, that if a random variable is made by adding together many independently random pieces, then, regardless of what those pieces are, the result will be normally distributed. For example, the distribution in the two‐dice example is fairly non‐normal, being relatively triangular and lacking tails. If one considered the sum of more and more dice, each of which is an independent random variable, the distribution would gradually take on a bell shape. This is shown in Figure 1.4 . The normal distribution is a symmetric, bell‐shaped distribution, meaning that equidistant events on either side of the center are equally likely and the skew is zero. The distribution is centered around the mean, and outcomes further away from the mean are less likely. The normal distribution has the intriguing property that 68% of occurrences fall within of the mean, 95% of occurrences are within of the mean, and 99.7% of occurrences are within of the mean. Figure 1.5 plots a normal distribution. These probabilities can be used to roughly contextualize distributions with similar geometry. For example, in the fair dice pair model, the expected value of the fair dice experiment was 7.0, and the standard deviation was 2.4. With the assumption of normality, one would infer there is roughly a 68% chance that future outcomes will fall between five and nine. The true probability is 66.67% for this random variable, indicating that the normality assumption is not exactly correct but can be used for the purposes of approximation. As more dice are added to the example, this approximation becomes increasingly accurate. Figure 1.4 A histogram for 100,000 simulated rolls with a group of fair, six‐sided dice numbering (a) 2, (b) 4, or (c) 6. Understanding distribution statistics and the properties of the normal distribution is incredibly useful in quantitative finance. The expected return of a stock is usually estimated by the mean return, and the historic risk is estimated with the standard deviation of returns (historical volatility). Stock log returns are also widely assumed to be normally distributed. Although, this is only approximately true because the overwhelming majority of stocks and ETFs have skewed returns distributions. 5 Regardless, this normality estimation provides a quantitative framework for expectations around future price moments. This approximation also simplifies mathematical models of price dynamics and options pricing, the most notable of which is the Black‐Scholes model. Figure 1.5 A detailed plot of the normal distribution and the corresponding probabilities at each standard deviation mark. The Black‐Scholes Model The Black‐Scholes options pricing formalism revolutionized options markets when it was published in 1973. It provided the first popular quantitative framework for estimating the fair price of an option according to the contract parameters and the characteristics of the underlying. The Black‐Scholes equation models the price evolution of a European‐style option (an option that can only be exercised at expiration) within the context of the broader financial market. The corresponding Black‐Scholes formula uses this equation to estimate the theoretical price of that option according to its parameters. It's important to note that the purpose of this Black‐Scholes section is not to elucidate the underlying mathematics of the model, which can be quite complicated. The output of the model is merely a theoretical value for the fair price of an option. In practice, an option's price typically deviates from this value because of market speculation and supply and demand, which this model does not take into account. Rather, it is essential to have at least a superficial grasp of the Black‐Scholes model to understand (1) the foundational assumptions of financial markets and (2) where implied volatility (a gauge for the market's perception of risk) comes from. The Black‐Scholes model is based on a set of assumptions related to the dynamics of financial assets and the market as a whole. The assumptions are as follows: The market is frictionless (i.e., there are no transaction fees). Cash can be borrowed and lent in any amount, even fractional, at the risk‐free rate (the theoretical rate of return of an investment with no risk, a macroeconomic variable assumed to be constant). There is no arbitrage opportunity (i.e., profits in excess of the risk‐free rate cannot be made without risk). Stocks can be bought and sold in any amount, even fractional amounts. Stocks do not pay dividends. 6 Stock log returns follow Brownian motion with constant drift and volatility (the theoretical mean and standard deviation of annual log returns). A Brownian motion, or a Wiener process, is a type of stochastic process or a system that experiences random fluctuations as it evolves with time. Traditionally used to describe the positional fluctuations of a particle suspended in fluid at thermal equilibrium, 7 a standard Wiener process (denoted W ( t )) is mathematically defined by the conditions in the grey box. The mathematical definition can be overlooked if preferred, as the intuition behind the mathematics is more crucial for understanding the theoretical foundation of options pricing and follows after. (i.e., the process initially begins at location 0). is almost surely continuous. The increments of , defined as where , are normally distributed with mean 0 and variance (i.e., the steps of the Wiener process are normally distributed with constant mean of 0 and variance of ). Disjoint increments of are independent of one another (i.e., the current step of the process is not influenced by the previous steps, nor does it influence the subsequent steps). Simplified, a Wiener process is a process that follows a random path. Each step in this path is probabilistic and independent of one another. When disjoint steps of equal duration are plotted in a histogram, that distribution is normal with a constant mean and variance. Brownian motion dynamics are driven by this underlying process. These conditions can be best understood visually, which will also demonstrate why this assumption appears in the development of the Black‐Scholes model as an approximation for price dynamics. Figures 1.6 and 1.7 illustrate the characteristics of Brownian motion, and Figure 1.8 illustrates the dynamics of SPY from 2010–2015 8 for the purposes of comparison. The price trends of SPY in Figure 1.8 (b) appear fairly similar to the Brownian motion cumulative horizontal displacements shown in Figure 1.6 (c). The daily returns for SPY are more prone to outlier moves compared to the horizontal displacements of Brownian motion but share some characteristics. The symmetric geometry of the SPY returns histogram bears resemblance to the fairly normal distribution of horizontal displacements, with the tails of the distribution being more prominent as a result of the history of large price moves. Figure 1.6 (a) The 2D position of a particle in a fluid, moving with Brownian motion. The particle begins at a coordinate of and drifts to a new location over 1,000 steps. (b) The horizontal displacements 9 of the particle (i.e., the movements of the particle along the X‐axis over 1,000 steps). (c) The cumulative horizontal displacement of the particle over 1,000 steps. Similarities are clear between price dynamics and Brownian motion, but this remains a highly simplified model of price dynamics. In reality, stock log returns are not normal and are typically skewed to the upside or downside, depending on the specific underlying. Additionally, the drift and volatility of a stock are not directly observable, and it cannot be experimentally confirmed whether or not these variables are constant. Stock volatility approximated with historical return data is rarely constant with time (a phenomenon known as heteroscedasticity). Stock returns are also not typically independent of one another across time (a phenomenon known as autocorrelation), which is a requirement for this model. Figure 1.7 The distribution of the horizontal displacements of the particle over 1,000 steps. As characteristic of a Wiener process, the increments are normally distributed, have a mean of zero and variance (which equals 1 in this case). This figure indicates that horizontal step sizes between –1 and 1 are most common, and step sizes with a larger magnitude than 1 are less common. Figure 1.8 The (a) daily returns, (b) price, and (c) daily returns histogram for SPY from 2010–2015. Although the normality assumption is not entirely accurate, making this simplification allows the development of the rest of this theoretical framework shown in the gray box. The formalism in the gray box is supplemental material for the mathematically inclined. The interpretation of the math, which is more significant, follows after. It should be noted that the Black‐Scholes model technically assumes that stock prices follow geometric Brownian motion , which is more accurate because price movements cannot be negative. Geometric Brownian motion is a slight modification of Brownian motion and requires that the logarithm of the signal follow Brownian motion rather than the signal itself. As it relates to price dynamics, this suggests that the log returns are normally distributed with constant drift (return rate) and volatility. 10 For the price of a stock that follows a geometric Brownian motion, the dynamics of the asset price can be represented with the following stochastic differential equation: 11 (1.10) where is the price of the stock at time t , is the Wiener process at time , is a drift rate, and is the volatility of the stock. The drift rate and volatility of the stock are assumed to be constant, and it's important to reiterate that neither of these variables are directly observable. These constants can be approximated using the average return of a stock and the standard deviation of historical returns, but they can never be precisely known. The equation states that each stock price increment is driven by a predictable amount of drift (with expected return ) and some amount of random noise . In other words, this equation has two components: one that models deterministic price trends and one that models probabilistic price fluctuations . The important takeaway from this observation is that inherent uncertainty is in the price of stock, represented with the contributions from the Wiener process. Because the increments of a Wiener process are independent of one another, it also is common to assume that the weak EMH holds at minimum, in addition to the normality of log returns. Using this equation as a basis for the derivation, assuming a riskless options portfolio must earn the risk‐free rate, and rearranging terms, the Black‐Scholes equation follows: (1.11) where is the price of a European call (with a dependence on and ), is the price of the stock (with a dependence on ), is the risk‐free rate, and is the volatility of the stock. The Black‐Scholes formula can be calculated by solving the Black‐Scholes equation according to boundary conditions given by the payoff at expiration of European options. The formula, which provides the value of a European call option for a non‐dividend‐paying stock, is given by the following equation: (1.12) where is the value of the standard normal cumulative distribution function at and similarly for , T is the time that the option will expire ( is the duration of the contract), is the price of the stock at time t , K is the strike price of the option, and and are given by the following: (1.13) (1.14) where is the volatility of the stock. If the equations seem gross, it's because they are. Again, the purpose of this section is not to describe the underlying mechanics of the Black‐Scholes model in detail. Rather, Equations (1.10) through (1.14) are included to emphasize three important points. There is inherent uncertainty in the price of stock. Stock price movements are also assumed to be independent of one another and log‐normally distributed. 12 An estimate for the fair price of an option can be calculated according to the price of the stock, the volatility of the stock, the risk‐free rate, the duration of the contract, and the strike price. The volatility of a stock, which plays an important role in estimating the risk of an asset and the valuation of an option, cannot be directly observed. This suggests that the “true risk” of an instrument can never be exactly known. Risk can only be approximated using a metric, such as historical volatility or the standard deviation of the historical returns over some timescale, typically matching the duration of the contract. Other than using a past‐looking metric, such as historical volatility to estimate the risk of an asset, one can also infer the risk of an asset from the price of its options. As stated previously, the Black‐Scholes model only gives a theoretical estimate for the fair price of an option. Once the contract is traded on the options market, the price of the contract is often driven up or down depending on speculation and perceived risk. The deviation of an option's price from its theoretical value as a result of these external factors is indicative of implied volatility . When initially valuing an option, the historical volatility of the stock has been priced into the model. However, when the price of the option trades higher or lower than its theoretical value, this indicates that the perceived volatility of the underlying deviates from what is estimated by historical returns. Implied volatility may be the most important metric in options trading. It is effectively a measure of the sentiment of risk for a given underlying according to the supply and demand for options contracts. For an example, suppose a non‐dividend‐paying stock currently trading at $100 per share has a historical 45‐day returns volatility of 20%. Suppose its call option with a 45‐day duration and a strike price of $105 is trading at $2 per share. Plugging these parameters into the Black‐Scholes model, this call option should theoretically be trading at $1 per share. However, demand for this position has increased the contract price significantly. For the model to return a call price of $2 per share, the volatility of this underlying would have to be 28% (assuming all else is constant). Therefore, although the historical volatility of the underlying is only 20%, the perceived risk of that underlying (i.e., the implied volatility) is actually 28%. To conclude, the primary purpose of this section was not to dive into the math of the Black‐Scholes. These concepts were, instead, introduced to justify the following axioms that are foundational to this book: Profits cannot be made without risk. Stock log returns have inherent uncertainty and are assumed to follow a normal distribution. Stock price movements are independent across time (i.e., future price changes are independent of past price changes, requiring a minimum of the weak EMH). Options can theoretically be priced fairly based on the price of the stock, the volatility of the stock, the risk‐free rate, the duration of the contract, and the strike price. The volatility of an asset cannot be directly observed, only estimated using metrics like historical volatility or implied volatility. The Greeks Other than implied volatility, the Greeks are the most relevant metrics derived from the Black‐Scholes model. The Greeks are a set of risk measures, and each describes the sensitivity of an option's price with respect to changes in some variable. The most essential Greeks for options traders are delta , gamma , and theta . Delta is one of the most important and widely used Greeks. It is a first‐order 13 Greek that measures the expected change in the option price given a $1 increase in the price of the underlying (assuming all other variables stay constant). The equation is as follows: (1.15) where V is the price of the option (a call or a put) and S is the price of the underlying stock, noting that ∂ is the partial derivative. The value of delta ranges from –1 to 1, and the sign of delta depends on the type of position: Long stock: is 1. Long call and short put: is between 0 and 1. Long put and short call: is between –1 and 0. For example, the price of a long call option with a delta of 0.50 (denoted 50 because that is the total for a one lot, or 100 shares of underlying) will increase by approximately $0.50 per share when the price of the underlying increases by $1. This makes intuitive sense because a long stock, a long call, and a short put are all bullish strategies, meaning they will profit when the underlying price increases. Similarly, because long puts and short calls are bearish, they will take a loss when the underlying price increases. Delta has a sign and magnitude, so it is a measure of the degree of directional risk of a position. The sign of delta indicates the direction of the risk, and the magnitude of delta indicates the severity of exposure. The larger the magnitude of delta, the larger the profit and loss potential of the contract. This is because positions with larger deltas are closer to/deeper ITM and more sensitive to changes in the underlying price. A contract with a delta of 1.0 (100 ) has maximal directional exposure and is maximally ITM. 100 options behave like the stock price, as a $1 increase in the underlying creates a $1 increase in the option's price per share. A contract with a delta of 0.0 has no directional exposure and is maximally OTM. A 50 contract is defined as having the ATM strike. 14 Because delta is a measure of directional exposure, it plays a large role when hedging directional risks. For instance, if a trader currently has a 50 position on and wants the position to be relatively insensitive to directional moves in the underlying, the trader could offset that exposure with the addition of 50 negative deltas (e.g., two 25 long puts). The composite position is called delta neutral. Gamma is a second‐order Greek and a measure of the expected change in the option delta given a $1 change in the underlying price. Gamma is mathematically represented as follows: (1.16) As with delta, the sign of gamma depends on the type of position: Long call and long put: . Short call and short put: . In other words, if there is a $1 increase in the underlying price, then the delta for all long positions will become more positive, and the delta for all short positions will become more negative. This makes intuitive sense because a $1 increase in the underlying pushes long calls further ITM, increasing the directional exposure of the contract, and it pushes long puts further OTM, decreasing the inverse directional exposure of the contract and bringing the negative delta closer to zero. The magnitude of gamma is highest for ATM positions and lower for ITM and OTM positions, meaning that delta is most sensitive to underlying price movements at –50 and 50 . Awareness of gamma is critical when trading options, particularly when aiming for specific directional exposure. The delta of a contract is typically transient, so the gamma of a position gives a better indication of the long‐term directional exposure. Suppose traders wanted to construct a delta neutral position by pairing a short call (negative delta) with a short put (positive delta), and they are considering using 20 or 40 contracts (all other parameters identical). The 40 contracts are much closer to ATM (50 ) and have more profit potential than the 20 positions, but they also have significantly more gamma risk and are less likely to remain delta neutral in the long term. The optimal choice would then depend on how much risk traders are willing to accept and their profit goals. For traders with high profit goals and a large enough account to handle the large P/L swings and loss potential of the trade, the 40 contracts are more suitable. Theta is a first‐order Greek that measures the expected P/L changes resulting from the decay of the option's extrinsic value (the difference between the current market price for the option and the intrinsic value of the option) per day. It is also commonly referred to as the time decay of the option. Theta is mathematically represented as follows: (1.17) where V is the price of the option (a call or a put) and t is time. The sign of theta depends on the type of position and is opposite gamma: Long call and long put: . Short call and short put: . In other words, the time decay of the extrinsic value decreases the value of the long position and increases the value of the short position. For instance, a long call with a theta of –5 per one lot is expected to decline in value by $5 per day. This makes intuitive sense because the holders of the contract take gradual losses as their asset depreciates with time, a result of the value of the option converging to its intrinsic value as uncertainty dissipates. Because the extrinsic value of a contract decreases with time, the short side of the position profits with time and experiences positive time decay. The magnitude of theta is highest for ATM options and lower for ITM and OTM positions, all else constant. There is a trade‐off between the gamma and theta of a position. For instance, a long call with the benefit of a large, positive gamma will also be subjected to a large amount of negative time decay. Consider these examples: Position 1: A 45 DTE, 16 call with a strike price of $50 is trading on a $45 underlying. The long position has a gamma of 5.4 and a theta of –1.3. Position 2: A 45 DTE, 44 call with a strike price of $50 is trading on a $49 underlying. The long position has a gamma of 7.9 and a theta of –2.2. Compared to the first position, the second position has more gamma exposure, meaning that the contract delta (and the contract price) is more sensitive to changes in the underlying price and is more likely to move ITM. However, this position also comes with more theta decay, meaning that the extrinsic value also decreases more rapidly with time. To conclude this discussion of the Black‐Scholes model and its risk measures, note that the outputs of all options pricing models should be taken with a grain of salt. Pricing models are founded on simplified assumptions of real financial markets. Those assumptions tend to become less representative in highly volatile market conditions when potential profits and losses become much larger. The assumptions and Greeks of the Black‐Scholes model can be used to form reasonable expectations around risk and return in most market conditions , but it's also important to supplement that framework with model‐free statistics. Covariance and Correlation Up until now we have discussed trading with respect to a single position, but quantifying the relationships between multiple positions is equally important. Covariance quantifies how two signals move relative to their means with respect to one another. It is an effective way to measure the variability between two variables. For one signal, X , with observations and mean , and another, Y , with observations and mean the covariance between the two signals is given by the following: (1.18) Represented in terms of random variables X and Y, this is equivalent to the following: 15 (1.19) Simplified, covariance quantifies the tendency of the linear relationship between two variables: A positive covariance indicates that the high values of one signal coincide with the high values of the other and likewise for the low values of each signal. A negative covariance indicates that the high values of one signal coincide with the low values of the other and vice versa. A covariance of zero indicates that no linear trend was observed between the two variables. Covariance can be best understood with a graphical example. Consider the following ETFs with daily returns shown in the following figures: SPY (S&P 500), QQQ (Nasdaq 100), and GLD (Gold), TLT (20+ Year Treasury Bonds). Figure 1.9 (a) QQQ returns versus SPY returns. The covariance between these assets is 1.25, indicating that these instruments tend to move similarly. (b) TLT returns versus SPY returns. The covariance between these assets is –0.48, indicating that they tend to move inversely of one another. (c) GLD returns versus SPY returns. The covariance between these assets is 0.02, indicating that there is not a strong linear relationship between these variables. Covariance measures the direction of the linear relationship between two variables, but it does not give a clear notion of the strength of that relationship. Because the covariance between two variables is specific to the scale of those variables, the covariances between two sets of pairs are not comparable. Correlation, however, is a normalized covariance that indicates the direction and strength of the linear relationship, and it is also invariant to scale. For signals with standard deviations and covariance , the correlation coefficient (rho) is given by the following: (1.20) The correlation coefficient ranges from –1 to 1, with 1 corresponding to a perfect positive linear relationship, –1 corresponding to a perfect negative linear relationship, and 0 corresponding to no measured linear relationship. Revisiting the example pairs shown in Figure 1.9 , the strength of the linear relationship in each case can now be evaluated and compared. For Figure 1.9 (a), QQQ returns versus SPY returns, the correlation between these assets is 0.88, indicating a strong, positive linear relationship. For Figure 1.9 (b), TLT returns versus SPY returns, the correlation between these assets is –0.43, indicating a moderate, negative linear relationship. And for Figure 1.9 (c), GLD returns versus SPY returns, the correlation between these assets is 0.00, indicating no measurable linear relationship between these variables. According to the correlation values for the pairs shown, the strongest linear relationship is between SPY and QQQ because the magnitude of the correlation coefficient is largest. The correlation coefficient plays a huge role in portfolio construction, particularly from a risk management perspective. Correlation quantifies the relationship between the directional tendencies of two assets. If portfolio assets have highly correlated returns (either positively or negatively), the portfolio is highly exposed to directional risk. To understand how correlation impacts risk, consider the additive property of variance. For two random variables with individual variances and covariance , the combined variance is given by the following: (1.21) When combining two assets, the overall impact on the uncertainty of the portfolio depends on the uncertainties of the individual assets as well as the covariance between them. Therefore, for every new position that occupies additional portfolio capital, the covariance will increase portfolio uncertainty (high correlation), have little effect on portfolio uncertainty (correlation near zero), or reduce portfolio uncertainty (negative correlation). Additional Measures of Risk This chapter has introduced several measures for risk including historical volatility, implied volatility, and the option Greeks. Two additional metrics are worth noting and will appear throughout this text: beta and conditional value at risk (CVaR). Beta is a measure of systematic risk and specifically quantifies the volatility of the stock relative to that of the overall market, which is typically estimated with a reference asset, such as SPY. Given the market's returns, , a stock with returns has the following beta: (1.22) The volatility of a stock relative to the market can then be evaluated according to the following: : The asset tends to move more than the market. (For example, if the beta of a stock is 1.5, then the asset will tend to move $1.50 for every $1 the market moves.) : The asset movements tend to match those of the market. : The asset is less volatile than the market. (For example, if the beta of a stock is 0.5, then the asset will be 50% less volatile than the market.) : The asset has no systematic risk (market risk). : The asset tends to move inversely to the market as a whole. This metric is essential for portfolio management, where it is used in the formulation of beta‐weighted delta. This will be covered in more detail in Chapter 7 . Value at risk (VaR) is another distribution statistic that is especially useful when dealing with heavily skewed distributions. VaR is an estimate of the potential losses for a portfolio or position over a given time frame at a specific likelihood level based on historical behavior. For example, a position with a daily VaR of –$100 at the 5% likelihood level can expect to lose $100 (or more) in a single day at most 5% of the time. This means that the bottom 5% of occurrences on the historical daily P/L distribution are –$100 or worse. For a visualization, see the historical daily returns distribution for SPY in Figure 1.10 . Figure 1.10 SPY daily returns distribution from 2010–2021. Included is the VaR at the 5% likelihood level, indicating that SPY lost at most 1.65% of its value on 95% of all days. For strategies with significant negative tail skew, VaR gives a numerical estimate for the extreme loss potential according to past tendencies. To place more emphasis on the negative tail of a distribution and determine a more extreme loss estimate, traders may use CVaR, otherwise known as expected shortfall. CVaR is an estimate for the expected loss of portfolio or position if the extreme loss threshold (VaR) is crossed. This is calculated by taking the average of the distribution losses past the VaR benchmark. To see how VaR and CVaR compare for SPY returns, refer to Figure 1.11 . Figure 1.11 SPY daily returns distribution from 2010–2021. Included are VaR and CVaR at the 5% likelihood level. A CVaR of 2.7% indicates that SPY can expect an average daily loss of roughly 2.7% on the worst 5% of days. The choice between using VaR and CVaR depends on the risk profile of the portfolio or position considered. CVaR is more sensitive to tail losses and provides a metric that is more conservative from the perspective of risk, which is more suitable for the kind of instruments focused on in this book. Notes 1 In liquid markets, which will be discussed in Chapter 5 , American and European options are mathematically very similar. 2 The future value of the option should be used, but for simplicity, this approximates the future value as the current price of the option. The future value of the option premium is the current value of the option multiplied by the time‐adjusted interest rate factor. 3 Population calculations are used for all the moments introduced throughout this chapter. 4 This is the sum of the squared differences between each data point and the distribution mean, normalized by the number of data points in the set. 5 The skew of the returns distribution is also used to estimate the directional risk of an asset. The fourth moment (kurtosis) quantifies how heavy the tails of a returns distribution are and is commonly used to estimate the outlier risk of an asset. 6 Dividends can be accounted for in variants of the original model. 7 This application of Wiener processes as well as their use in financial mathematics are due to them arising as the scaling limit of simple random walk. A simple random walk is a discrete process that takes independent steps with probability . The scaling limit is reached by shrinking the size of the steps while speeding up their rate in such a way that the process neither sits at its initial location nor runs off to infinity immediately. 8 Note that, unless stated or shown otherwise, the date ranges throughout this book generally end on the first of the final year. For the range shown here, the data begins on January 1, 2010 and ends on January 1, 2015. 9 Displacement along the X‐axis is the difference between the current horizontal location of the particle and the previous horizontal location of the particle for each step. 10 Simple returns will also be approximated as normally distributed throughout this book. Although this is not explicitly implied by the Black‐Scholes model, it is a fair and intuitive approximation in most cases because the difference between log returns and simple returns is typically negligible on daily timescales. 11 d is a symbol used in calculus to represent a mathematical derivative. It equivalently represents an infinitesimal change in the variable it's applied to. dS ( t ) is merely a very small, incremental movement of the stock price at time t . ∂ is the partial derivative, which also represents a very small change in one variable with respect to variations in another. 12 The log function and log‐normal distribution are both covered in the appendix. 13 Order refers to the number of mathematical derivatives taken on the price of the option. Delta has a single derivative of V and is first‐order. Greeks of second‐order are reached by taking a derivative of first‐order Greeks. 14 In practice, the strike and underlying prices for 50Δ contracts tend to differ slightly due to strike skew. 15 The covariance of a variable with itself (e.g., Cov(X, X)) is merely the variance of the signal itself. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c02.xhtml SCORE: 23.00 ================================================================================ Chapter 2 The Nature of Volatility Trading and Implied Volatility Traders often hedge against periods of extreme market volatility (either to the upside or the downside) using options. Options are effectively financial insurance, and they are priced according to similar principles as other forms of insurance. Premiums increase or decrease according to the perceived risk of a given underlying (a result of supply and demand for those contracts), just as the cost of hurricane insurance increases or decreases depending on the perceived risk of hurricanes in a given area. To quantify the perceived risk in the market, traders use implied volatility (IV). Implied volatility is the value of volatility that would make the current market price for an option be the fair price for that option in a given model, such as Black‐Scholes. 1 When options prices increase (i.e., there is more demand for insurance), IV increases accordingly, and when options prices decrease, IV decreases. IV is, thus, a proxy for the sentiment of market risk as it relates to supply and demand for financial insurance. IV gives the perceived magnitude of expected price movements; it is not directional. 2 Table 2.1 gives a numerical example. Table 2.1 Two underlyings with the same price and put contracts on each underlying with identical parameters (number of shares, put strike, contract duration). The contract prices differ, indicating that these two instruments have different implied volatilities. 45‐day Put Contract Underlying A Underlying B Underlying Price $101 $101 Strike Price $100 $100 Contract Price $10 $5 The price of the put is around 10% of the stock price for underlying A and 5% of the stock price for underlying B. This suggests that there is more perceived uncertainty associated with the price of underlying A compared to underlying B. Equivalently, this indicates that the anticipated magnitude of future moves in the underlying price is larger for underlying A compared to underlying B. Demand for options tends to increase when the historical volatility of an underlying increases unexpectedly, particularly with large moves to the downside. This means that IV tends to be positively correlated with historical volatility and negatively correlated with price. However, there are exceptions to this rule, as IV is based on the perceived risk and not on historical risk directly. IV may increase due to factors that are not directly related to price movements, such as company‐specific uncertainty (earnings reports, silly tweets from the CEO) or larger‐scale macroeconomic uncertainty (political conflict, proposed legislative measures). This also means that volatility profiles vary significantly from instrument to instrument, which will be discussed more later in the chapter. Similar to historical volatility, IV gives a one standard deviation range of annual returns for an instrument. Though historical volatility represents the realized past volatility of returns , IV is the approximation for future volatility of returns because it is based on how the market is using options to hedge against future price changes. While each option for an underlying has its own implied volatility, the “overall” IV of an asset is normally calculated from 30‐day options and is a rough annualized volatility forecast. 3 Example: An asset has a price of $100 and an IV of 0.10 (10%). Therefore, the asset is expected to move about 10% to the upside or the downside by the end of the following year. This means the ending price will most likely be between $90 and $110. The volatility forecast can also be scaled to approximate the expected price across days, weeks, months, or longer. The equations used to calculate the expected price ranges of an asset over some forecasting period are given below. 4 (2.1) (2.2) These estimates of expected range will be used to formulate options strategies in future chapters. The time frame for the expected range is often scaled to match the contract duration. Most examples in this book will have a duration of 45 days to expiration (DTE) (or 33 trading days), so implied volatilities are typically multiplied by 0.35 to ensure forecasts match the duration of the contract. The expected move cone is helpful to visualize this likely price range for an instrument according to market speculation. The width of the cone is calculated using Equation (2.2) and scales with the IV of the underlying. More specifically, the cones are wider in higher volatility environments and narrower when volatility is low and the expected range is tighter. Consider the expected move cones shown in Figure 2.1 , corresponding to the expected price ranges for SPY. Figure 2.1 (c) shows the realized price trajectory for SPY in December 2019, which stayed within its expected price range for the majority of the 45‐day duration. Prices tend to stay within their expected range more often than not, and the assumptions of the Black‐Scholes model can be used to develop a theoretical estimate for how often that should be. Trading Volatility An inconceivable number of factors affect prices in financial markets, which makes precisely forecasting price movements extremely difficult. Arguably, the most reliable way to form expectations around future price trends is using statistics from past price data and financial models. IV is derived from current options prices and the Black‐Scholes options pricing model, meaning that the Black‐Scholes assumptions can be used to add statistical context to the expected price range. More specifically, one can infer the likelihood of a stock price remaining within its IV‐derived price range because stock returns are assumed to be normally distributed. The one standard deviation range of the normal distribution encompasses 68.2% of event outcomes, so there is theoretically a 68.2% chance the price of an equity lands within its expected range. This probability can also be generalized over any timescale using Equation (2.1) . Figure 2.1 (a) The 45‐day expected move cone for SPY in early 2019. The price of SPY was roughly $275, and the IV was around 19%, corresponding to a 45‐day expected price range of ±6.7% ( Equation (2.1) ) or ±$18 ( Equation (2.2) ). (b) The 45‐day expected move cone for SPY when IV was 12%. (c) The same expected move cone as (b) with the realized price over 45 days. Example: An asset has a price of $100 and an IV of 0.10 (10%). The asset price is expected to remain between $90 and $110 by the end of the following year with 68% certainty. Equivalently, the asset price is expected to remain between $96 and $104 58 days from today with 68% certainty (calculated using Equation (2.2) ). However, historical data show that perceived uncertainty in the market (IV) tends to overstate the realized underlying price move more often than theory suggests. Though theory predicts that IV should overstate the realized move roughly only 68% of the time, market IV (estimated using the IV for SPY) overstated the realized move 87% of the time between 2016 and 2021. This means the price for SPY stayed within its expected price range more often than estimated. Realized moves were larger just 13% of the time, indicating that IV rarely understates the realized risk in the market. The exact degree to which IV tends to overstate realized volatility depends on the instrument. For example, consider the IV overstatement rates of the stocks and exchange‐traded funds (ETFs) in Table 2.2 . Table 2.2 IV overstatement of realized moves for six assets from 2016–2021. Assets include SPY (S&P 500 ETF), GLD (gold commodity ETF), SLV (silver commodity ETF), AAPL (Apple stock), GOOGL (Google stock), AMZN (Amazon stock). Volatility Data (2016–2021) Asset IV Overstatement Rate SPY 87% GLD 79% SLV 89% AAPL 70% GOOGL 79% AMZN 77% Different assets are more or less prone to stay within their expected move range depending on their unique risk profile. Stocks are subject to single‐company risk factors and tend to be more volatile. ETFs, which contain a variety of assets, are inherently diversified and tend to be less prone to dramatic price swings. For example, the S&P 500 includes Apple, but it also includes around 499 other companies. This means that a tech‐sector specific event will have a bigger impact on APPL compared to SPY. Commodities like gold and silver also tend to be less volatile than individual stocks, meaning they are less prone to spikes in IV and have more predictable returns. Although the IV overstatement rates differ between instruments, one can conclude that fear of large price moves is usually greater than realized price moves in the market. So, how exactly can options traders capitalize on this knowledge of IV and IV overstatement? Let's revisit the example of hurricane insurance. The price for hurricane insurance is proportional to the expected cost of potential hurricane damage in the area. These prices are based on historical hurricane activity and forecasts of future events, which may underestimate, overestimate, or match the realized outcomes. People who sell hurricane insurance initially collect premiums, with the value depending on the perceived risk of home damage. During uneventful hurricane seasons, most policies go unused, and insurers keep the majority of premiums initially collected. In the unlikely event that hurricane damage is significantly worse than expected in an area dense with policyholders, insurers take very large losses. Insurance companies essentially make small, consistent profits the majority of the time while being exposed to large, infrequent losses. Financial insurance carries a similar risk‐reward trade‐off as sellers make small, consistent profits most of the time but run the risk of large losses in extreme circumstances. IV yields an approximate price range forecast for a given underlying with 68% certainty. This means there is a 68% chance that the calls with strikes at the upper end of the expected range and puts with strikes at the lower end will both expire with no intrinsic value. For example, if traders sold one call and one put with strikes along the expected move cone, they would theoretically profit with 68% certainty. If the underlying price were to move unexpectedly to the upside or the downside, however, the traders may take substantial losses. Unlike sellers of hurricane insurance, options sellers have more room to strategize and more control over their risk‐reward profile. Premium sellers can choose when to sell insurance and how to construct contracts most likely to be profitable. Because IV is a proxy for the demand for options and the inflation of premium, it can be used to identify opportune times to sell insurance. Additionally, because IV can be used to estimate the most likely price range for a specific asset, premium sellers can use IV to structure those positions so they likely expire worthless, like in the previous example. Options sellers (or short premium traders) have the long‐term statistical advantage over options buyers, with the trade‐off of exposure to unlikely, potentially significant losses. Because of that long‐term statistical advantage, short premium trading is the focus of this book, with the next chapter detailing the mechanics of trading based on implied volatility. The States of VIX SPY is frequently used as a proxy for the broader market. It is also a baseline underlying for the short options strategies in this book because it is highly diversified across market sectors and has minimal idiosyncratic risk factors. The CBOE Volatility Index (VIX) is meant to track the annualized IV for SPY and is derived from 30‐day index options. As SPY is a proxy for the broader market, the VIX, therefore, gauges the perceived risk of the broader market. For context, from 1990 to 2021, the VIX ranged from roughly 10 to a peak of just over 80 in March 2020 during the COVID‐19 pandemic. 5 Unlike equities, whose prices typically drift from their starting values over time, IV tends to revert back to a long‐term value following a cyclic trend. This is because equities are used to estimate the perceived value of a company, sector, or commodity, but IV tracks the uncertainty sentiment of the market, which can only stay elevated for so long. During typical bull market conditions, the VIX hovers at a relatively low value at or below its average of 18.5. This is known as a lull state. When market uncertainty rapidly increases for whatever reason, often in response to large sudden price changes, the VIX expands and spikes far above its steady‐state value. Once the market adjusts to the new volatility conditions or the volatile conditions dissipate, the VIX gradually contracts back to a lull state. To see an example of this cycle, refer to Figure 2.2 . Figure 2.2 The three phases of the VIX, using data from early 2017 to late 2018. When comparing how often the VIX is in each state, one finds the following approximate rates: Lull (70%): IV consistently remains below or near its long‐term average. This state occurs when market prices trend upward gradually and market uncertainty is consistently low. Expansion (10%): IV expansion usually follows a prolonged lull period and is marked by expanding market uncertainty and typically large price moves in the underlying equity. Contraction (20%): IV contraction follows an expansion and is marked by a continued decline in IV. A contraction turns into a lull when IV reverts back to its long‐term average. Lull periods are most common and tend to be much longer than the average expansion or contraction period. Since 2000, the average lull period was more than three times the length of the average expansion or contraction. When expansions do happen, the higher the IV peak, the faster the VIX contracts. For example, according to data from 2005 to 2020, when the VIX contracted from 20 to 16 points (20% decrease), it took an average of 75.3 trading days to do so. However, when the VIX contracted from 70 to 56 points (also a 20% decrease), it only took an average of four trading days. Spikes in the VIX are generally caused by unprecedented market or worldwide events. For example, the VIX reached over 80 in November 2008 during the peak of the worldwide financial crisis and hit its all‐time high of 82.69 in March 2020 during the COVID‐19 pandemic. The VIX peak of 2020 was especially unprecedented as the first major spike due to COVID‐19 happened on February 28, 2020 when the VIX hit 40.11. This VIX high in 2020 had not been reached since February 2018, and it followed a 96‐day lull. On March 16, 2020, the VIX hit 82.69, making the 2020 VIX expansion one of the most rapid ever recorded. Though contraction periods tend to be longer than expansions but much shorter than lulls, fairly long contractions tend to follow major sell‐offs or corrections. For example, the VIX contraction following the 2008 sell‐off lasted well over a year, and the contraction following the 2020 sell‐off lasted more than 10 months. This is normally because it takes time for the market (and specific subsectors) to revert to regular conditions following such broad macroeconomic shocks. Premium sellers can potentially profit in any type of market, whether it be during volatility expansions (bearish), contractions (bullish/neutral), or lulls (neutral) if adopting an appropriate strategy for the volatility conditions. Generally, the most favorable trading state for selling premium is when IV contracts. This is because IV contracts when premium prices deflate, meaning that options traders who sold positions in high IV 6 are able to buy identical positions back in low IV at a lower price, thus profiting from the difference. Volatility expansions, on the other hand, have the potential to generate significant losses for short premium traders. Volatility expansions tend to occur when there are large movements in the underlying price and uncertainty increases, causing options on that underlying to become more expensive. If traders sell premium during an expansion period once IV is already elevated , then the traders can capitalize on higher premium prices and the increased likelihood of a volatility contraction. However, if traders sell premium during a lull period, when the expected range is tight, and volatility transitions into an expansion period, then those traders will likely take large losses from the underlying price moving far outside the expected range. Additionally, to close their positions early, traders must buy back their options for more than they received in initial credit and incur a loss from the difference. Short premium traders can profit in any type of market, but the risk of significant losses for short premium traders is highest when volatility is low . Unexpected transitions from a volatility lull to an expansion do not happen often, but when they do happen, they can be detrimental to an account. It is still necessary to trade during these low‐IV periods because IV spends the majority of the time in this state, but risk management during this period is crucial. These risk management techniques will be outlined in the upcoming chapters. This cyclic trend (lull, expansion, contraction, lull) is easily observable when looking at a relatively stable volatility index, such as the VIX. However, this trend, which we will describe as IV reversion, is present in some capacity for all IV signals. IV Reversion Certain types of signals tend to revert back to a long‐term value following a significant divergence. Although this concept cannot be empirically proven or disproven, the reversion of IV is a core assumption in options trading. 7 The reversion dynamics and the minimum IV level vary across instruments, but reversion is assumed to be present in all IV signals to some extent. To understand this, first consider the probability of large magnitude returns for four assets with different risk profiles: SPY, GLD, AAPL, and AMZN. A comparison of these probabilities is shown in Table 2.3 . Table 2.3 Rates thats different assets experienced daily returns larger than 1%, 3%, and 5% in magnitude. For example, there is a 22% chance that SPY returns more than 1% or less than –1% in a single day (according to past data). Probability of Surpassing Daily Returns Magnitude (2015–2021) Asset > 1% Magnitude > 3% Magnitude > 5% Magnitude SPY 22% 3% 0.8% GLD 19% 1% 0.1% AAPL 43% 9% 2% AMZN 45% 10% 3% Compared to assets like SPY and GLD, AMZN and AAPL are more volatile. These tech stocks experience large daily returns roughly three times as often as SPY and roughly 10 times as often as GLD. Each of these assets is subject to unique risk factors, but all are expected to have reverting IV signals nonetheless. Figure 2.3 shows these volatility profiles graphically. Figure 2.3 demonstrates how IV has tended to revert back to a long‐term baseline for each of the different assets, and it also demonstrates that elevated uncertainty is unsustainable in financial markets. Events may occur that spark fear in the market and drive up the demand for insurance, but as fear inevitably dissipates and the market adapts to the new conditions, IV deflates back down. This phenomenon has significant implications for short options traders. As stated in Chapter 1 , it is controversial whether directional price assumptions are statistically valid or not as trading according to pricing forecasts has never been proven to consistently outperform the market. IV is assumed to eventually revert down following inflations from its stable volatility state unlike asset prices, which drift from their initial value with time. The timescale for these contractions is unpredictable, but this nonetheless indicates some statistical validity to make downward directional assumptions about volatility once it is elevated. Figure 2.3 also shows how volatility profiles vary greatly across instruments. More volatile assets like Apple and Amazon stocks have higher IV averages, twice that of SPY and gold in this case, and experience expansion events more often. Single‐company factors, such as quarterly earnings reports, pending mergers, acquisitions, and executive changes can all cause volatility spikes not seen in diversified assets and portfolios. However, this increased volatility also comes with higher credits and more volatility contraction opportunities for premium sellers. 8 For an example of how the propensity for expansions and contractions differs between stocks with earnings and a diversified ETF, refer to Figures 2.4 (a)–(c). Marked are the earnings report dates for each stock or the date when the company reported its quarterly profits (after‐tax net income). Figure 2.3 IV indexes for different assets with their respective averages (dashed) from 2015–2021. Assets include (a) SPY (S&P 500 ETF), (b) GLD (gold commodity ETF), (c) AAPL (Apple stock), and (d) AMZN (Amazon stock). Figure 2.4 Implied volatility indexes for different equities from 2017–2020 with earnings dates marked (if applicable). Assets include (a) AMZN (Amazon stock), (b) AAPL (Apple stock), and (c) SPY (S&P 500 ETF). With tech stocks like AMZN and AAPL, it's common for IV to increase sharply prior to earnings and contract almost immediately afterward. The previous graphs show that sharp IV expansions happen less frequently with a more diversified market ETF, such as SPY. These figures indicate that when SPY does experience a volatility expansion, it generally takes much longer to contract. From 2017 to 2020, the VIX only rose above 35 two times and, in both situations, took roughly half a month to contract down to its original level. Meanwhile, volatility levels of AMZN and AAPL rose above 40 many times and even had a few spikes above 50, or in the case of AMZN, almost 60. Takeaways IV is a proxy for the sentiment of market risk derived from supply and demand. When options prices increase, IV increases; when options prices decrease, IV decreases. IV also gives the perceived magnitude of future movement, and it is not directional. Demand for options tends to increase when the historical volatility of an underlying increases unexpectedly, particularly with large moves to the downside. IV tends to be positively correlated with historical volatility and negatively correlated with price, but it is ultimately based on the perceived market risk and not directly on price information. IV can be used to estimate the expected price range of an instrument. IV gives a one standard deviation expected range because it is based on how the market is using options to hedge against future periods of volatility. Because stock returns are assumed to be normally distributed, theoretically, there is a 68.2% chance the price of an equity lands within its expected range over a given time frame. However, historical data show that prices stay within their expected ranges more often than theoretically estimated. For example, market IV (estimated using the IV for SPY) overstated the realized move 87% of the time between 2016 and 2021. Options sellers have the long‐term statistical advantage over options buyers, with the trade‐off of exposure to unlikely, potentially significant losses. Because IV is a proxy for the demand for options and the inflation of premium, it can be used to identify opportune times to sell insurance. Premium sellers can also use IV to structure positions so they are likely to expire worthless, the ideal outcome for the short position. Volatility profiles differ significantly between assets, but all IV signals are assumed to revert back to some long‐term value following significant diversions. Stated differently, IV tends to contract back to a long‐term value following significant expansions from its lull volatility state. This phenomenon indicates that there is some degree of statistical validity when making downward directional assumptions about volatility once it's inflated. Notes 1 Implied volatility (IV), like historical volatility, is a percentage and pertains to log returns. It is common to represent IV as either a decimal (0.X) or percentage (X%). An IV index, which is an instrument that tracks IV and will be introduced later in this chapter, is typically represented using points (X) but should be understood as a percentage (X%). 2 It is possible to get directional expected move information about an underlying by analyzing the IV across various strikes. This will be elaborated on more in the appendix. 3 IV yields a rough approximation for the expected price range, but this is not how the expected range is typically calculated on most trading platforms. Refer to the appendix for more information about how expected range is calculated more precisely. For the time being, we are using this simplified formula since it is most intuitive. 4 When ignoring the risk‐free rate, the expected price range over T days for a stock with price S and volatility σ can be estimated by . The formula in Equation (2.2) is an approximation because, for small x values, e x ≈ 1 + x . This approximation becomes less valid when x is large, meaning this expected range calculation is less accurate when IV is high. This will be explored more in the appendix. 5 Note that volatility indices, such as the VIX, will be represented using points but are meant to be understood as a percentage. For example, a VIX of 30 corresponds to an annualized implied volatility of 30%. 6 It's important to note that the threshold for high IV is different for every asset because each instrument is subject to unique risk factors. Evaluating IV can be difficult because there is so much variability between assets, but there will be a more in‐depth discussion of this in the following chapter. 7 The value that the signal reverts back to is roughly the long‐term mode of the distribution, or the volatility that has occurred most often historically. 8 Such underlyings can be used for earnings plays, which will be discussed in a Chapter 9 . ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml SCORE: 33.00 ================================================================================ Chapter 3 Trading Short Premium Options are highly versatile instruments. They can be used to hedge the directional risk of a stock, or they can be used as a source of profits. As alluded to in the example of hurricane insurance, short premium positions can be used to generate small, consistent profits for those willing to accept the tail risk. The mechanics of short premium trading are subtle, but many of the core concepts can be introduced in an intuitive way with some simple gambling analogies. For example, when using options for profit generation (i.e., not risk mitigation), the long‐term performance of long and short options can be analogized with slot machines. Buying Options for profit is like playing the slot machines. Gamblers who play enough times may hit the jackpot and receive a huge payout. However, despite the potential payouts, most players average a loss in the long run because they are taking small losses the majority of the time. Investors who buy options are betting on large, often directional moves in the underlying asset. Those assumptions may be correct and yield significant profits occasionally, but underlying prices ultimately stay within their expected ranges most of the time. This results in small, frequent losses on unused contracts and an average loss over time. Selling Options for profit is like owning the slot machines. Casino owners have the long‐run statistical advantage for every game, an edge particularly high for slots. Owners may occasionally pay out large jackpots, but as long as people play enough and the payouts are manageable, they are compensated for taking on this risk with nearly guaranteed profit in the long term. Similarly, because short options carry tail risk but provide small, consistent profits from implied volatility (IV) overstatement, then they should average a profit in the long run if risk is managed appropriately. Long premium strategies have a high profit potential but cannot be consistently timed to ensure profit in the long term. This is because outlier underlying moves and IV expansions that benefit long premium positions are strongly linked to external events (such as natural disasters or political conflict), which are relatively difficult to reliably predict. Short premium strategies, on the other hand, profit more often and have the long‐term statistical advantage if investors manage risks appropriately. Similar to the slot machine owner, a short premium trader must reduce the impact of outlier losses to reach a large number of occurrences (trades) and realize the positive long‐term averages. This is most effectively done by limiting position size and by adjusting portfolio exposure according to current market conditions. This chapter will, therefore, cover the following broader concepts in volatility trading: Trading in high IV: Identifying favorable conditions for opening short premium trades. Number of occurrences: Reaching the minimum number of trades required to achieve long‐term averages. Portfolio allocation and position sizing: Establishing an appropriate level of risk for the given market conditions. Active management and efficient capital allocation: Understanding the benefits of managing trades prior to expiration. IV plays a crucial role in trading short premium. Remember that IV is a measure of the sentiment of uncertainty in the market. It is a proxy for the amount of fear among premium buyers (or excitement , depending on your personality) and a measure of opportunity for premium sellers. When market uncertainty increases, premium prices also increase, and premium sellers receive more compensation for being exposed to large losses. However, IV is also instrumental when managing exposure to extreme losses and establishing appropriate position sizes. Background: A Note on Visualizing Option Risk When discussing the risk‐reward trade‐off of trading short premium, it is helpful to contextualize concepts and statistics with respect to a specific strategy. The next few chapters will focus on a short strangle , an options strategy consisting of a short out‐of‐the‐money (OTM) call and a short OTM put: A short OTM call (the right to buy an asset at a certain price) has a bearish directional assumption. The seller profits when the underlying price stays below the specified strike price. A short OTM put (the right to sell an asset at a certain price) has a bullish directional assumption. The seller profits when the underlying price stays above the specified strike price. These two contracts combine to form a strangle. This is an example of an undefined risk strategy, where the loss is theoretically unlimited. The short call has undefined risk because stock prices can increase indefinitely, meaning the potential loss to the upside is unknown. Though short puts technically cannot lose more than 100 times the strike price, this potential loss is large enough that they are also considered undefined risk. Defined risk strategies, where the maximum loss is limited by the construction of the trade, have pros and cons that will be discussed in Chapter 5 . For simplicity, the strangle is used to formulate most examples in this book. Strangles have a neutral directional assumption for the contract seller, meaning it is typically profitable when the price of the underlying stays within the range defined by the short call strike and short put strike. Investors often define the strikes of a strangle according to the expected range of the underlying price (or some multiple of the expected range) over the contract duration. The one standard deviation expected range can be approximated with the current implied volatility of the underlying, as shown in Chapter 2 . Figure 3.1 The price of SPY in the last five months of 2019. Included is the 45‐day expected move cone calculated from the IV of SPY in December 2019. The edges of the cones are labeled according to appropriate strikes for an example strangle. Figure 3.1 shows that SPY was priced at roughly $315 around December 2019, when the current IV for SPY was 12% (corresponding to a VIX level of 12). This means the price for SPY was forecasted to move between –4.2% and +4.2% over the next 45 days with a 68% certainty. This is equivalent to a 45‐day forecast of the price of SPY staying between $302 and $328 approximately. A contract with a strike price corresponding to the expected move range is approximately a 16 contract. In this scenario, a 45 days to expiration (DTE) short SPY call with a strike price of $328 is a –16 contract roughly, and a 45 DTE short SPY put with a strike price of $302 is approximately a 16 contract. The two positions combined form a delta‐neutral position known as a 45 DTE 16 SPY strangle. 1 The strangle buyer and seller are making different bets: The strangle buyer assumes that SPY's price will move beyond expectation within the next 45 days, either to the upside or the downside. More specifically, the long strangle yields profit if the price of SPY significantly increases above $328 or decreases below $302 prior to expiration. The strangle seller profits if the position expires when the underlying price is within or near its expected range or if the position is closed when the contract is trading for a cheaper price than when it was opened (IV contraction). Because there is a 68% chance the underlying will stay within its expected range, the short position theoretically has a 68% chance of being profitable. However, since the underlying price tends to stay in its expected range more often than theoretically predicted, this results in the probability of profit (POP) of short strangles held to expiration being much higher. For example, consider the profit and loss (P/L) distributions for the short 45 DTE 16 SPY strangle in Figures 3.2 (a)–(c). These distributions were generated using historical options data and are useful for visualizing the long‐term risk‐reward profile and likely trade‐by‐trade outcomes for this type of contract. Each occurrence in the histogram corresponds to the final P/L of a short strangle held to expiration. 2 P/L can be represented as a raw dollar amount or as a percentage of initial credit (the fraction of option premium that the seller ultimately kept). 3 Figure 3.2 (a) Historical P/L distribution (% of initial credit) for short 45 DTE 16 SPY strangles, held to expiration from 2005–2021. (b) Historical P/L distribution ($) for short 45 DTE 16 SPY strangles, held to expiration from 2005–2021. (c) The same distribution as in (b) but zoomed in near $0. The percentage of occurrences on either side of $0 have been labeled. Figure 3.2 (c) shows that 81% of occurrences are positive and only 19% are negative . This means this strategy has historically profited 81% of the time and only taken losses 19% of the time, significantly higher than the 68% POP that the simplified theory suggests. Over the long run, this strategy was profitable and averaged a P/L of $44 (or 28% of the initial credit) per trade. However, notice the P/L distributions for this strategy are highly skewed and carry significant tail risk. As shown in Figure 3.2 (a), these tail losses are unlikely but could potentially amount to –1,000% or even –4,000% of the initial credit. In other words, if a trader receives $100 in initial credit for selling a SPY strangle, there is a slim chance of losing upward of $4,000 on that trade according to historical behavior. This is the trade‐off for the high POPs of short premium strategies. The possibility of outlier losses should not be surprising because placing a short premium trade is betting against large, unexpected price swings. For a relatively stable asset like SPY, these types of swings rarely happen. When they do, things can fly off the handle rapidly, such as during the 2008 recession or 2020 sell‐off. Consequently, the most important goals for a short premium trader are to profit consistently enough to cover moderate, more likely losses and to construct a portfolio that can survive those unlikely extreme losses. Background: A Note on Quantifying Option Risk Approximating the historical risk of a stock or exchange-traded fund (ETF) is relatively straightforward. Equity log returns distributions are fairly symmetric and resemble a normal distribution, thus justifying that standard deviation of returns (historical volatility) be used to approximate historical risk. However, a short option P/L distribution is highly skewed and subject to substantial outlier risk. Due to this more complex risk profile, using option P/L standard deviation as a lone proxy for risk significantly misrepresents the true risk of the strategy. Therefore, the following metrics will be used to more thoroughly discuss the risk of short options: standard deviation of P/L, skew, and conditional value at risk (CVaR). 4 The standard deviation of P/L encompasses the range that the majority of endings P/Ls fall within for a given strategy historically. The standard deviation for financial strategies is commonly interpreted relative to the normal distribution, where one standard deviation accounts for 34% of the distribution on either side of the mean. For options P/L distributions, however, the one standard deviation of P/L typically accounts for more than 68% of the total occurrences and the density of occurrences is not symmetric about the mean. Again, consider the P/L distribution for the short 45 DTE 16 SPY strangle. Figure 3.3 Historical P/L distribution ($) for 45 DTE 16 SPY strangles, held to expiration from 2005–2021. The distribution has been zoomed in near the mean (solid line), and the percentage of occurrences within of the mean has been labeled. For 45 DTE 16 SPY strangles from 2005–2021, the average P/L was $44, and the standard deviation of P/L was $614. As shown in Figure 3.3 , the one standard deviation range accounts for nearly 96% of all occurrences, significantly higher than the range for the normal distribution. Additionally, because the distribution is highly asymmetric, the P/Ls in the range are less likely than the P/Ls in the range. Due to these factors, the interpretation of standard deviation as a measure of risk must be adjusted. Standard deviation overestimates the magnitude of the most likely losses (e.g., a $500 loss is unlikely, but the standard deviation range does not clarify that) and does not account negative tail risk. It does yield a range for the most likely profits and losses on a trade‐by‐trade basis for a given strategy. Therefore, traders can generally form more reliable P/L expectations for strategies with a lower P/L standard deviation. Skew and CVaR are used to estimate the historical tail risk of a strategy. As covered in Chapter 1 , skew is a measure of the asymmetry of a distribution. Strategies with a larger magnitude of negative skew in their P/L distribution have more historical outlier loss exposure. CVaR gives an estimate of the potential loss of a position over a given time frame at a specific likelihood level based on historical behavior. CVaR can be used to approximate the magnitude of an expected worst‐case loss and contextualize skew. For example, consider the two example short strangles outlined in Table 3.1 . Table 3.1 Two example short strangles. For Strangle A, CVaR estimates losing at least $200 at most 5% of the time. In this example, the time frame for this loss has not been specified, but one may assume the time frame is identical for both strategies. Risk Factors Strangle A Strangle B Skew –5.0 –1.0 CVaR (5%) –$200 –$2,000 Strangle A has a larger magnitude of negative skew, indicating that this strategy is more susceptible to tail risk and outlier losses compared to Strangle B. However, there is 10 times more capital at risk in an extreme loss scenario for Strangle B compared to Strangle A perhaps because the underlying for Strangle B is more expensive. Generally speaking, strategies with less skew are preferable because those strategies are less susceptible to large, unpredictable losses and perform more consistently. However, the optimal trade ultimately depends on the acceptable amount of per‐trade capital at risk according to the trader's personal preferences. Also note it is difficult to accurately model outlier loss events because they happen rarely. P/L distributions can give an idea of the magnitude of extreme losses, but these statistics are averaged over a broad range of market conditions and volatility environments. They are not necessarily representative of outlier risk at the present time. Buying power reduction (BPR), which will be covered in the next chapter, yields an estimate for the worst‐case loss of a trade according to current market conditions. Similar to implied volatility, BPR is a forward‐looking metric designed to encompass the most likely scope of losses for an undefined risk position. Trading in High IV Selling premium once IV is elevated comes with several advantages. Before that discussion, there are subtleties to note when evaluating “how high” the IV of an asset is. Contextualizing the current IV for an asset like SPY is somewhat straightforward because it has a well‐known and widely available IV index. The VIX has historically ranged from approximately 10 to 90, has an average of roughly 18, is typically below 20, and rarely surpasses 40. Therefore, a trader can intuitively interpret a level of 15 as fairly low and a level of 35 as fairly high relative to the long‐term behavior of the VIX. But how do traders contextualize the current IV relative to a shorter timescale, such as the last year? And how do traders contextualize the current IV for a less popular IV index with a totally different risk profile? For example, is 35 high for VXAZN, the IV index for AMZN? One way to gauge the degree of IV elevation with respect to some timescale is by converting raw implied volatility into a relative measure such as IV percentile (IVP). IVP is the percentage of days in the past year where the IV was below the current IV level, calculated with the following equation. Note that 252 is the number of trading days in a year. (3.1) IVP ranges from 0% to 100%, with a higher number indicating a higher relative IV. This metric normalizes raw IV to put the current level in context, and unlike raw IV, it is comparable between assets. For example, consider the raw IV indexes and the corresponding IVP values for SPY and AMZN shown in Figure 3.4 . Figure 3.4 The VIX (solid) and VXAZN (dashed) from 2015–2016. Labeled are the IVP values for each index at the end of 2015. When the VIX was roughly 18 SPY had an IVP of 74%, and VXAZN was roughly 36 AMZN had an IVP of 67%. At the end of 2015, the VIX was near its long‐term average of 18 and would have been considered low. However, market IV was below average for the majority of 2015, and a VIX level of 18 was higher than nearly 74% of occurrences from the previous year. A SPY IVP of 74% indicates that IV is fairly elevated relative to the recent market conditions, suggesting that volatility may contract following this expansion period. Comparatively, the volatility index for AMZN at the end of 2015 was 37. This is significantly higher than the VIX at the time but is actually less elevated relative to its volatility history from the past year according to the AMZN IVP of 67%. SPY and AMZN have dramatically different volatility profiles, with VXAZN frequently exceeding 35 and the VIX rarely doing so. This makes raw IV a poor metric for comparing relative volatility and a metric like IVP necessary. Another commonly used relative volatility metric is IV rank (IVR), which compares the current IV level to the historical implied volatility range for that underlying. It is calculated according to the following formula: (3.2) Similar to IVP, IVR normalizes raw IV on a 0% to 100% scale and is comparable between assets. IVR gives a better direct metric for evaluating the price of an option compared to IVP. However, IVP is more robust than IVR because IVR is more sensitive to outlier moves and prone to skew. Both metrics are suitable for practical decision making because they assist traders with evaluating current volatility levels and selecting a suitable strategy/underlying for those conditions. They are also useful for identifying suitable, high IV underlyings for a portfolio because most assets do not have well‐known volatility indices. However, both metrics are fairly unstable, sensitive to timescale, and can be skewed by prolonged outlier events such as sell‐offs. Raw IV, assuming that the characteristics of the volatility profile are well understood, is generally a more stable and reliable metric for analyzing long‐term trends. Because most studies throughout this book use SPY as a baseline underlying and span several years, raw IV will be used rather than a relative metric. As previously mentioned, trading short premium when IV is elevated comes with the added benefits of higher credits and more profit potential for sellers. This is shown in Figure 3.5 , which includes average credits for 16 SPY strangles from 2010–2020 in different volatility environments. Trading short premium in elevated IV is an effective way to capitalize on higher premium prices and the increased likelihood of a significant volatility contraction. Trading when credits are higher also means common losses tend to be larger (as a dollar amount), but the exposure to outlier risk actually tends to be lower when IV is elevated compared to when it's closer to equilibrium. This may seem counterintuitive: If market uncertainty is elevated and there is higher perceived risk, wouldn't short premium strategies carry more outlier risk? Although moves in the underlying tend to be more dramatic when IV is high, the expected range adjusts to account for the new volatility almost immediately, which in many cases reduces the risk of an outlier loss. To understand this, consider Figures 3.6 (a) and (b), showing extreme losses for 16 SPY strangles from 2005–2021, with an emphasis on the 2008 recession. Figure 3.5 SPY IV from 2010–2020. The average prices for 45 DTE 16 SPY strangles are labeled at different VIX levels: 10–20, 20–30, and 30–40. When the VIX was between 30 and 40, the average initial credit per one lot for the 16 SPY strangle was roughly 42% higher than when the VIX was between 10 and 20. A short 16 SPY strangle rarely incurs a loss over $1,000. From 2005–2021, this occurred less than 1% of the time. However, 84% of these losses occurred when the VIX was below 25. During the initial IV expansion of the 2008 recession (late August to early October), strangles incurred these large losses approximately 56% of the time. Notice in Figure 3.6 that these extreme losses were confined to the initial IV expansion (when the VIX increased from roughly 20 to 35). This is because the market was not anticipating the large downside moves of the recession, as reflected by the VIX being near its long‐term average of 18. Because these large swings happened when the expected move range was tight, the historical volatility of the market well exceeded its expected range, and long strangles were highly profitable. Once market uncertainty adjusted to the new conditions and initial credits and expected ranges increased to reflect the perceived risks, the outlier losses for short strangles diminished. Figure 3.6 (a) SPY IV from 2005–2021. Labeled are the extreme losses for 45 DTE 16 SPY strangles held to expiration, meaning losses that are worse than $1,000. (b) The same figure as shown in (a) but zoomed in to 2008–2010, during the 2008 recession. These unexpected periods of high market volatility are the primary source of extreme loss for short premium positions. These events typically happen when there are large price swings in the underlying and the expected move range is tight (low IV). These extreme expansion events are rare, and trading short premium once IV is elevated tends to reduce this type of exposure. Another way to demonstrate this concept is to consider the amount of skew in the P/L distribution of the 16 SPY strangle at different IV levels. Figures 3.7 (a)–(d) illustrate that strangle P/L distributions have less negative skew and smaller tail losses as IV increases. This means that, historically, the exposure to negative tail risk was much higher when the VIX was closer to the lower end of its range compared to when the VIX already expanded. The P/L distribution becomes more symmetric as IV increases, indicated by the decreasing magnitude of negative skew. This means that higher IV conditions facilitate more dependable profit and loss expectations than lower IV conditions. As an important note, observe that there are significantly fewer occurrences when the VIX was over 35 (a few hundred occurrences) compared to when the VIX was between 0 and 25 (thousands of occurrences). This brings us to the next point to consider: How often should one trade? Figure 3.7 Historical P/L distributions for 45 DTE 16 SPY strangles, held to expiration from 2005–2021: (a) Occurrences when the VIX is between 0 and 15 (1,603 occurrences total), (b) Occurrences when the VIX is between 15 and 25 (1,506 occurrences total). (c) Occurrences when the VIX is between 25 and 35 (416 occurrences total). (d) Occurrences when the VIX is above 35 (228 occurrences total). Number of Occurrences Table games at a casino typically have maximum bet sizes. The house has the statistical edge for every game in the casino, but the house will not necessarily profit from that edge unless patrons bet often . In blackjack, the house has an edge of 0.5% if the player's strategy is statistically optimized. So, if gamblers wager $100,000 on blackjack throughout the night, they should lose approximately $500 to the house after a sufficiently large number of hands. If the opponent plays 10 hands at $10,000 per hand, they may win eight hands, three hands, or even all 10 hands. In this case, the variance of potential outcomes is fairly large, and the casino may have to pay fairly large payouts. However, if the opponent plays 1,000 hands at $100 per hand, it is more likely the player's loss will amount to the expected $500. By capping bet sizes, the casino aims to increase the number of occurrences from a single gambler so the house is more likely to reach long‐run averages for each game, a consequence of the law of large numbers and the central limit theorem. When a small number of events is randomly sampled from a probability distribution repeatedly and the averages of those samples are compared, the variance of those averages tends to be quite large. But as the number of occurrences increases, the variance of the averages decreases and the sampled means converge to the expected value of the distribution. 5 Just as the casino aims to realize the long‐term edge of table games by capping bet sizes and increasing the number of plays, short premium traders should make many small trades to maximize their chances of realizing the positive long‐run expected averages of short premium strategies. For an example of why this is crucial, refer again to the P/L distribution of the 16 SPY strangle. Figure 3.8 Historical P/L distribution for 45 DTE 16 SPY strangles, held to expiration from 2005–2021. The dotted line is the long‐term average P/L of this strategy. This strategy, shown in Figure 3.8 , has an average P/L per trade of roughly $44 and a POP of 81%. However, these long‐term averages were calculated using roughly 3,750 trades. Calculating averages with a large pool of data provides the least amount of statistical error but does not model the occurrences retail traders can realistically achieve. What P/L would short premium traders have averaged if they only placed 10 trades from 2005 to 2021? 100 trades? 500 trades? Figure 3.9 shows a plot of average P/Ls for a collection of sample portfolios, each with a different number of trades randomly selected from the P/L distribution of the 16 SPY strangle. Figure 3.9 P/L averages for portfolios with N number of trades, randomly sampled from the historical P/L distribution for 45 DTE 16 SPY strangles, held to expiration from 2005–2021. The variance among these portfolio averages is very large when a small number of trades are sampled. As more trades are sampled, the averages converge to the long‐term average P/L of this strategy. As you can see, when a small number of trades is sampled, 10 for example, the average P/L ranges from roughly –$900 to $200. This means that if two traders randomly traded 10 short strangles from 2005 to 2021, one trader may have profited by $2,000, and the other may have lost $9,000. As the number of occurrences increases, the variance of P/L averages among these sample portfolios decreases, and the averages converge toward the long‐run expected value of this strategy. In other words, if two traders randomly traded 1,000 short strangles from 2005 to 2021, it would be fairly likely for both to average a P/L near $44 per trade, the historical long‐term average P/L of this strategy. Number of occurrences is a critical factor in achieving long‐term averages, and the minimum number of occurrences needed varies with the specific strategy's standard deviation of P/L. For practical purposes, a minimum of roughly 200 occurrences is necessary to reach long‐run averages, and more is better. This puts short premium traders in a bit of a predicament because, although trading short premium in high IV is ideal, high IV environments are very uncommon as shown in Table 3.2 . Table 3.2 How often the VIX fell in a given range from 2005–2021. VIX Data (2005–2021) VIX Range % of Occurrences 0–15 43% 15–25 40% 25–35 11% 35+ 6% The VIX is at the low end of its range 43% of the time and below 18.5, its long‐term average, the majority of the time. From 2005–2021, the VIX was only above 35 roughly 6% of the time, which does not leave much opportunity for trading short premium in very high IV. To optimize the likelihood of reaching the favorable long‐term expected values of this strategy, it is clearly necessary to trade in non‐ideal, low volatility conditions. The next section covers how to trade in all market conditions while mitigating the outlier risk in low volatility environments, specifically by maintaining small position sizes and limiting the capital exposed to outlier losses. Portfolio Allocation and Position Sizing In practice, short premium traders must strike a balance between being exposed to large losses and reaching a sufficient number of occurrences. Trading in high IV tends to carry less exposure to outlier risk compared to trading in low IV, but trading in low IV is still profitable on average. Unlike long stocks, which are only profitable during bullish conditions, short options may be profitable in bullish, bearish, or neutral conditions and spanning all volatility environments. For the 16 SPY strangle from 2005–2021, for example, the majority of occurrences were profitable in all IV ranges. (See Table 3.3 .) Table 3.3 The POPs and average P/Ls in different IV ranges for 45 DTE 16 SPY strangles, held to expiration from 2005–2021. 16 SPY Strangle Data (2005–2021) VIX Range POP Average P/L 0–15 82% $20 15–25 78% $7 25–35 86% $159 35+ 89% $255 By trading short options strategies in all IV environments, profits accumulate more consistently, and the minimum number of occurrences is more achievable. To manage exposure to outlier risk throughout these environments, it's essential to keep position sizes small and limit the total amount of portfolio capital allocated to short premium positions, which can be scaled according to the current outlier risk. The percentage of portfolio capital allocated to short premium strategies should generally range from 25% to 50%, with the remaining capital either kept in cash or a low‐risk passive investment. 6 This is because allocating less than 25% severely limits upside growth, while allocating more than 50% may not leave enough capital for a portfolio to recover from an outlier loss event. Because the exposure to outlier risk tends to be higher when IV is low, scaling allocation down in low IV protects portfolio capital from the tail exposure of unexpected market volatility. Once IV increases, scaling short premium capital allocation up increases the potential to profit from higher credits, larger profits, and reduced outlier risk. Table 3.4 Guidelines for allocating portfolio capital according to market IV. VIX Range Max Portfolio Allocation 0–15 25% 15–20 30% 20–30 35% 30–40 40% 40+ 50% A portfolio should not be overly concentrated in short options strategies for the given market conditions, and the capital allocated to short premium should also not be overly concentrated in a single position. An appropriately sized position should not occupy more than 5% to 7% of portfolio capital. The exact percentage varies depending on the POP of the strategies used, and this will be covered in more detail in Chapter 8 . To understand why it's crucial to limit capital exposure and beneficial to scale portfolio allocation according to IV, look at a worst‐case scenario: the 2020 sell‐off. The 2020 sell‐off produced historic losses for short premium positions. From late February to late March 2020, the price of SPY crashed by roughly 34%. For 45 DTE 16 SPY strangles, the most extreme losses recorded for this position occurred throughout this time. A 16 SPY strangle opening on February 14, 2020, and expiring on March 20, 2020, had a P/L per one lot of roughly –$8,974, the worst recorded loss in 16 years for this type of contract. If traders allocated different percentages of a $100,000 portfolio to short SPY strangles beginning with this worst‐case loss, how would those portfolios perform in regular market conditions compared to highly volatile conditions like the 2020 sell‐off? Compare three portfolio allocation strategies: allocation by IV guidelines (25–50%), a more conservative allocation (constant 15%), and a more aggressive allocation (constant 65%). 7 Unsurprisingly, the portfolios perform markedly differently in regular conditions compared to the 2020 sell‐off. From 2017 to February of 2020, the aggressive portfolio dramatically outperformed the conservative and IV‐allocated portfolios. Throughout this three‐year period, the conservative portfolio grew by 13% and the IV‐allocated portfolio by 28%, and the aggressive portfolio increased by 78%. Comparatively, from 2017–2020, SPY grew by 50%. This means that a $100,000 portfolio fully allocated to SPY shares would have outperformed the conservative and IV-allocated portfolios but underperformed the aggressive portfolio, though it would have required significantly more capital than any of them. Figure 3.10 (a) Performances from 2017 to 2021, through the 2020 sell‐off. Each portfolio has different amounts of capital allocated to approximately 45 DTE 16 SPY strangles that are closed at expiration and reopened at the beginning of the expiration cycle. The portfolios are (a) IV‐allocated (solid), conservative (dashed), and aggressive (hashed). (b) SPY price from 2017 to 2021. (c) VIX throughout the same time frame. Upon the onset of the highly volatile market conditions of 2020, the highly exposed aggressive portfolio was immediately wiped out. The conservative and IV‐allocated portfolios were also impacted by significant losses and declined by 35% and 24%, respectively, from February to March 2020. In all the previous scenarios, each portfolio experienced some degree of loss during the extreme market conditions of the 2020 sell‐off. The important thing to note is that portfolios with less capital exposure and position concentration ultimately had the capital to recover following these losses. Following the 2020 sell‐off, the conservative portfolio recovered by 7% and the IV‐allocated by 20% because this portfolio was able to capitalize on the high IV and higher credits of the sell‐off recovery. For profit goals to be reached consistently , it's crucial to construct a portfolio that is robust in every type of market. A highly exposed portfolio takes extraordinary profits in more regular market conditions, but there is a high risk of going under in the rare event of a sell‐off or major correction. A more conservative portfolio is well suited for extreme market conditions, but upside profits are limited the majority of the time. Comparatively, scaling capital allocation according to market IV is an effective way to capitalize on higher profits when IV is high, protect capital from outlier losses when IV is low, and achieve reasonable growth with lower capital requirements than purchasing equities directly. More importantly, limiting capital exposure and maintaining appropriate position sizes are arguably the most effective ways to minimize the impact from extreme events. These concepts will be explored in more detail in Chapter 7 . Active Management and Efficient Capital Allocation Up until now, this book has discussed option risk and profitability for contracts held to expiration. However, short premium traders can also close, or manage, their positions early by purchasing long options with the same underlying, strike, and date of expiration. This can often be profitable as a result of partial theta decay and IV contractions, and it also tends to reduce P/L variability per trade. Options tend to have more P/L fluctuations in the second half of the contract duration compared to the first half, a result of increasing gamma risk. Gamma, as discussed in earlier chapters, is a measure of how sensitive a contract's delta is to changes in the price of the underlying. Gamma increases for near‐the‐money options as expiration approaches, meaning that delta (and, therefore, the price sensitivity of the option) becomes more unstable in response to moves in the underlying toward the end of the contract. Managing short positions actively, such as closing a trade prior to expiration and redeploying capital to new positions, is one way to reduce the P/L swings throughout the trade duration, as well as the per‐trade loss potential and ending P/L standard deviation. Early management strategies will not necessarily reduce risk in the long term because the cumulative losses of many shorter‐term trades may exceed the single loss of a longer‐term trade, but they do make per‐trade loss potentials more reasonable. This strategy effectively allows traders to assess the viability of a trade before P/L swings become more extreme and assess whether it is an efficient use of portfolio capital to remain in the trade. Compare how the P/Ls of 45 DTE 16 SPY strangles are distributed when the contracts are held to expiration versus managed around halfway to expiration (21 DTE). Table 3.5 Comparison of management strategies for 45 DTE 16 SPY strangles from 2005–2021 that are held to expiration and managed early. Statistics include POP, average P/L, standard deviation of P/L, and CVaR at the 5% likelihood level. 16 SPY Strangle Statistics (2005–2021) Statistics Held to Expiration Managed at 21 DTE POP 81% 79% Average P/L $44 $30 Average Daily P/L $1.29 $1.60 Standard Deviation of P/L $614 $260 CVaR (5%) –$1,535 –$695 According to the statistics in Table 3.5 , strangles managed at 21 DTE carry significantly less negative tail risk and P/L standard deviation on a trade‐by‐trade basis than strangles held to expiration. Additionally, although early‐managed contracts collect less on average per trade, they actually average more profit on a daily basis and allow for more occurrences due to the shorter duration. Managing trades early has several benefits, most of which will be covered in Chapter 6 . Much of this decision depends on the acceptable amount of capital to risk on a single trade and whether it is an efficient use of capital to remain in the existing trade. Notice from this example that managed trades take 24 days (21 days remaining on a 45‐day duration trade corresponds to an elapsed duration of 24 days) to profit $30 on average and held contracts 45 days to make $44 on average. Trades may accumulate the majority of their profit potential well before expiration, depending on the market and staying in the position for the remainder of the duration may limit upside potential. Closing trades prior to expiration and redeploying capital to a new position in the same underlying is an effective method for increasing the number of occurrences in a given time frame. Redeploying that capital to a position in a different underlying with more favorable characteristics (such as higher IV) can be a more efficient use of capital and can offer elements of risk reduction in certain situations. Taking an active approach to investing and trade management provides more control over portfolio capital allocation and the flexibility to modify trades given new information. Takeaways Compared to long premium strategies, short premium strategies yield more consistent profits and have the long‐term statistical advantage. The trade‐off for receiving consistent profits is exposure to large and sometimes undefined losses, which is why the most important goals of a short premium trader are to (1) profit consistently enough to cover moderate and more likely losses and (2) to construct a portfolio that can survive unlikely extreme losses. Unexpected periods of high market volatility are the primary source of extreme loss for short premium positions. These events are highly unlikely but typically happen when large price swings occur in the underlying while the expected move range is tight (low IV). Trading short premium once IV is elevated is one way to consistently reduce this exposure. The profitability of short options strategies depends on having a large number of occurrences to reach positive statistical averages. At minimum, approximately 200 occurrences are needed for the average P/L of a strategy to converge to long‐term profit targets and more is better. Although trading short premium in high IV is ideal, high IV environments are somewhat uncommon. This means that short premium traders must strike a balance between being exposed to large losses and reaching a sufficient number of occurrences. Trading short options strategies in all IV environments accumulates profits more consistently and makes it more likely to reach the minimum number of occurrences. To manage exposure to outlier risk when adopting this strategy, it's essential to maintain small position sizes and limit the amount of capital allocated to short premium positions. This strategy can also be improved by scaling the amount of capital allocated to short premium according to the current market conditions. Managing positions actively is one way to reduce P/L uncertainty on a trade‐by‐trade basis, use capital more efficiently, and achieve more occurrences in a given time frame. The choice of whether to close a position early and redeploy capital depends on the acceptable amount of capital to risk on a single trade and whether it is an efficient use of capital to remain in the existing trade. These concepts will be explored more in Chapter 6 . Notes 1 These are approximate strikes for the 16Δ SPY strangle calculated using the equation from Chapter 2 . The actual strikes for a 16Δ SPY strangle are calculated using more complex estimations for expected range, which will be touched on in the appendix. 2 It is difficult to make a one‐to‐one comparison between equity returns and option P/Ls because these instruments operate over different timescales. The closest option analog to an equity returns distribution is a distribution for the ending P/Ls of a particular strategy. 3 Statistics represented as a percentage of initial credit are more representative of long‐term values than those represented with dollars. Equity prices drift with time, meaning the prices for their options do as well. Normalizing P/L statistics by the initial credit makes them more robust to changes in time but also makes comparisons between strategies less intuitive. This book will often represent option statistics in dollars, but remember these statistics are averaged over fairly long time frames. 4 These are past‐looking risk metrics. Metrics of forward‐looking risk include implied volatility and buying power reduction (BPR), which will be covered in the following chapter. Forward‐looking metrics are the focus of this book and more relevant in applied trading, but past‐looking metrics are still included for the sake of completeness and education. 5 Specifically, the standard deviation of the average of n independent occurrences is times the standard deviation of a single occurrence. 6 More specifically, the portfolio capital being referred to here is the portfolio buying power, which we will introduce in the following chapter. 7 This is a highly simplified backtest and should be taken with a grain of salt. These portfolios are highly concentrated in a single position and do not incorporate any complex management strategies. Options are highly sensitive to changes in timescale, meaning that a concurrent portfolio with strangles opened on slightly different days, closed on slightly different days, or with slightly different durations may have performed quite differently than the ones shown here. These backtests show one specific outcome and serve to compare the risk of different allocation percentages in a one‐to‐one fashion. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c04.xhtml SCORE: 16.00 ================================================================================ Chapter 4 Buying Power Reduction Having discussed the nature of implied volatility (IV) and the general risk‐reward profile of short premium positions, it's time to introduce some elements of short volatility trading in practice. Because short options are subject to significant tail risk, brokers must reserve a certain amount of capital to cover the potential losses of each position. The capital required to place and maintain a short premium trade is called the buying power reduction (BPR), and the total amount of portfolio capital available for trading is the portfolio buying power. BPR is the amount of capital required to be set aside in the account to insure a short option position, similar to escrow. BPR is used to evaluate short premium risk on a trade‐by‐trade basis in two ways: BPR acts as a fairly reliable metric for the worst‐case loss for an undefined risk position in current market conditions. BPR is used to determine if a position is appropriate for a portfolio with a certain buying power. Though BPR is the option counterpart of stock margin, the distinction between the two cannot be overstated , as short options positions can never be traded with borrowed money. BPR is not borrowed money nor does it accrue interest. It is your capital that is out of play for the duration of the short option trade. Margin, mostly used for stock trading, is money borrowed from brokers to purchase stock valued beyond the cash in an account. Interest does accrue on margin (usually between a 5% to 7% annual rate), and traders are required to pay back the margin plus interest regardless of whether the stock trade was profitable. Margin and BPR are conceptually different: Margin amplifies stock purchasing power, and BPR lowers purchasing power to account for the additional risk of short options. The definition of BPR and its usage differs depending on whether the strategy is long or short and whether the strategy has defined or undefined risk. For long options, the maximum loss is simply the cost of the option, so that is the BPR. Defining the BPR for short options is more complicated, particularly for undefined risk positions, because the loss is theoretically unlimited. Defined risk trades, which will be covered in the next chapter, are short premium trades with a known maximum loss. These are simply short premium contracts (undefined risk trades) combined with cheaper, long premium contracts that will cap the excess losses when the underlying price moves past the further strike. BPR is the maximum loss for a defined risk strategy, but only an estimate for maximum loss for an undefined risk trade. Because the undefined risk case is more complicated, this chapter explains the BPR as it relates to undefined risk strategies, specifically short strangles. Up until now, options trading has predominantly been discussed within the context of strangles, an undefined risk strategy with limited gain and theoretically unlimited loss. In this case, the BPR is calculated such that it is unlikely that the loss of a position will exceed that threshold. More specifically, BPR is intended to account for roughly 95% of potential losses with exchange-traded fund (ETF) underlyings and 90% of potential losses with stock underlyings. 1 The historical effectiveness of BPR for an ETF underlying is seen in Figure 4.1 by looking at losses for 45 days to expiration (DTE) 16 SPY strangle from 2005–2021. Figure 4.1 Loss as a % of BPR for 45 DTE 16 SPY strangles held to expiration from 2005–2021. In this example, most losses ranged from 0% to 20% of the BPR. Roughly 95% of all these losses were accounted for by the BPR when this position was held to expiration, as expected. Though BPR did not always capture the full extent of realized losses, it is an effective proxy for worst‐case loss on a trade‐by‐trade basis in most cases. This metric works fairly well for SPY strangles, but strangles with more volatile underlyings and strangles with tighter strikes may be more likely to have losses that breach BPR (hence the 90% efficacy rate for stocks). BPR corresponds to the capital required to place a trade, and that quantity varies depending on the specific strategy. The BPR for short strangles can be approximated as 20% of the price of the underlying, but mathematically, BPR depends on three variables: the stock price, put/call prices, and the put/call strike prices. 2 Because the strangle is composed of the short out‐of‐the‐money (OTM) call and short OTM put, the BPR required to sell a strangle is simply the larger of the short put BPR and the short call BPR. The short call/put BPR is the largest of three different values: , which is the expected loss from a 20% move in the underlying price. , which is the expected loss from a 10% strike breach. , which ensures that there is a minimum BPR for cheap options. As BPR is intended to encompass the largest likely loss for an undefined risk contract, the largest of these values is taken. This can be mathematically represented using the max function, which takes the largest of the given values: (4.1) (4.2) Combining these formulas, the BPR of the strangle is given by: (4.3) Clearly, this equation is hairy, but using some numerical examples, one can infer how strangle BPR and, therefore, option risk changes with more intuitive variables, such as the historical and implied volatility of the underlying. Consider three potential strangle trades outlined in Table 4.1 . Table 4.1 Three examples of approximate 45 DTE 16 strangle trades with different parameters and the resulting BPR. Scenario A Scenario B Scenario C Stock Price $150 $150 $300 Call Strike $160 $175 $320 Put Strike $140 $130 $280 Call Price $1 $2 $2 Put Price $1 $2 $2 BPR $2,000 $1,750 $4,000 IV 20% 45% 20% The underlying in Scenario B is priced the same as that of Scenario A, but the strikes for the 16 strangle are further apart (consistent with a higher implied volatility). The underlying in Scenario C is twice as expensive as the underlyings in Scenarios A and B, but the IV in Scenario C is the same as that of Scenario A. Because the BPR is higher in Scenario C compared to Scenario A (but the implied volatility and contract delta are the same), traders can deduce that strangle BPR tends to increase with the price of the underlying. Technically , BPR is inversely correlated with option price, but the BPR still tends to increase with the price of the underlying because more expensive instruments have larger volatilities (as a dollar amount) and, therefore, higher potential losses. BPR also decreases as the IV of the underlying increases, and both relationships can be seen in Figure 4.2 looking at BPR for 45 DTE 16 SPY strangles from 2005–2021. These charts show a strong linear relationship between BPR and underlying price and a slightly messier inverse relationship between BPR and underlying IV. This relationship is largely driven by the strikes moving further OTM for a fixed as IV increases. BPR tends to decrease exponentially as the IV of the underlying increases, and because BPR is a rough estimate for worst‐case loss, this relationship illustrates how the magnitude of potential outlier losses tends to decrease when IV increases. 3 Figure 4.2 Data from 45 DTE 16 SPY strangles from 2005–2021. (a) BPR as a function of underlying price. (b) BPR as a function of underlying IV. Short premium positions carry higher credits and larger profit potentials when IV is high, but the reduction in BPR also allows more short premium positions to be placed compared to when IV is low. Because average profit and loss (P/L) is higher on a trade‐by‐trade basis and more potentially profitable positions can be opened, it is essential to reserve a large percentage of portfolio buying power for high IV conditions. This additionally justifies increasing the percentage of portfolio capital allocated to short premium BPR as IV increases. These crucial high‐IV profits improve portfolio performance but also cushion potential future losses. Historically, when the VIX has been over 40 compared to under 15, the same amount of capital has covered the BPR of roughly twice as many 16Δ SPY strangles. The difference between the number of short premium trades allowed in these two volatility environments is even larger when taking portfolio allocation guidelines into account. For context, consider the scenarios outlined in Table 4.2 . Table 4.2 Two portfolios with the same net liquidity but different amounts of market volatility, using SPY strangle data from 2005–2021. Scenario A Scenario B Net Portfolio Liquidity $100,000 $100,000 Current VIX > 40 < 15 Portfolio Allocation $50,000 $25,000 Approx. 16 SPY Strangle BPR $1,500 $3,300 Max Number of Strangles 33 7 It's important to note that BPR can be used to compare the capital at risk for variations of the same type of strategy, but it cannot be used to compare the risk between defined risk strategies and undefined risk strategies. For example, if the BPR required to trade a short strangle with underlying A was twice the BPR required to trade a short strangle with underlying B and otherwise had identical parameters, we can conclude that A is twice as risky as B. This is a valid comparison because we are considering two trades with the same risk profile, but BPR cannot be used to compare strategies with different risk profiles (say, a short strangle versus a short put) because it does not account for factors like the probability of profit or the probability of incurring a large loss. This subtlety will be discussed in more detail in the following chapter. Understanding BPR is crucial when transitioning from options theory to applied options trading because it corresponds to the actual capital requirements of trading short options. BPR is also necessary to discuss the capital efficiency of options (option leverage) in entirety. Consider a stock trading at $100 with a volatility of 20%, and suppose a trader wanted to invest in this asset with a bullish directional assumption. The trader could achieve a bullish directional exposure to this underlying in a few different ways as shown with the examples in Table 4.3 . Table 4.3 Example trades that offer bullish directional exposure. Assume that the 50 (ATM) call and put contracts have 45 DTE durations and cover 100 shares of stock. Strategy Capital Required Max Profit Max Loss Probability of Profit (POP) 50 Shares of Long Stock $5,000 ∞ $5,000 50% Long 50 Call $280 ∞ $280 30% Short 50 Put $2,000 (BPR) $280 $9,720 60% In this one‐to‐one comparison, the effects of option leverage are clear because the long call position achieves the same profit potential as the long stock position with 94% less capital at risk. The short put position is capable of losing several times the initial investment of the trade but has a higher POP than the long stock position and requires 60% less capital. Suppose that the price of the stock increases to $105 after 45 days. The resulting profits and corresponding returns for these different positions is given below: Long stock: Long ATM call: Short ATM put: In this example, the long call position was able to achieve 88% of the long stock profit with 94% less capital, and the short put position was able to achieve 12% more profit than the long stock position with 60% less capital. Takeaways Because short premiums are subject to significant tail risk, brokers must reserve capital to cover the potential losses of each position. This capital is called BPR. The total amount of portfolio capital available for trading is called portfolio buying power. BPR is used to evaluate short premium risk on a trade‐by‐trade basis in two ways: BPR is a fairly reliable metric for worst‐case loss of an undefined risk position, and BPR is used to determine if a position is appropriate for a portfolio based on its buying power. For long options, BPR is the cost of the option. For short strangles, the BPR is roughly 20% of the price of the underlying. BPR for short options encompasses roughly 95% of potential losses for ETF underlyings and 90% of losses for stock underlyings. Strangle BPR tends to increase linearly with the price of the underlying because more expensive instruments have larger volatilities (as a dollar amount) and, therefore, higher potential losses. There is an inverse relationship between strangle BPR and underlying IV; more specifically, it approximately decreases exponentially as the IV of the underlying increases. This demonstrates the advantages of trading short when IV is high because more short strangles can be opened with the same amount of capital as in low IV, and the outlier loss potential is generally lower. BPR can be used to compare capital at risk for variations of the same strategy, but it cannot be used to compare the risk of different strategies with different risk profiles. The leveraged nature of options allows traders to achieve a desired risk‐return profile with significantly less capital than an equivalent stock position. Notes 1 This statistic will vary with the IV of the underlying, but this is a suitable approximation for general cases. 2 This is the FINRA (Financial Industry Regulatory Authority) regulatory minimum. Brokers typically follow this formula, but occasionally (especially when IV is very high) they will increase the capital requirements for contracts on specific underlyings. 3 This relationship between BPR and IV is specific to strangles. The next chapter discusses how these relationships may differ for certain defined risk strategies. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml SCORE: 89.00 ================================================================================ Chapter 5 Constructing a Trade This book has covered a number of topics but how does one tie all these concepts together and actually build a trade? Options are unique in that they have tunable risk‐reward profiles, and the type of strategy and choice of contract parameters hugely impact the characteristics of that profile. This chapter describes some common short premium strategies and how varying each contract feature tends to alter the risk‐reward properties of a short position. Some basic guidelines are also included, but the ideal trade selection ultimately depends on personal profit goals, loss tolerances, account size, and the existing positions in a portfolio. Each new trade should complement existing positions, ideally contributing some degree of diversification to the overall risk profile. However, first this chapter outlines the mechanics of building individual trades; portfolio management will be discussed later. The general procedure for constructing a trade can be summarized as follows: Choose an asset universe. Choose an underlying. Choose a contract duration. Choose a defined or undefined risk strategy. Choose a directional assumption. Choose a delta. All these factors impact the overall profile of a trade, and strategies are rarely constructed in a linear manner. Traders build trades according to their personal preferences and the size of their account, making the process of constructing a position unique. For instance, if the priority is an undefined risk trade, the choice of underlying will have more constraints. If the priority is trading a particular underlying under a certain directional assumption , the delta and the risk definition will have more constraints. Choose an Asset Universe Before choosing an underlying, it's important to start with an appropriate asset universe or a set of tradable securities with desirable characteristics. The assets suitable for retail options trading must have highly liquid options markets, meaning the contracts for the security can be easily converted into cash without significantly affecting market price. To understand why liquidity is crucial, consider an example of an illiquid asset, such as a house. Selling a home at fair market value in a saturated housing market requires significant time and effort. Sellers run the additional risk of having to reduce the asking price significantly to secure a buyer quickly. Options illiquidity carries risk for similar reasons, and selectively trading assets with liquid options markets ensures that contract orders will be filled efficiently and at a fair market price. Options liquidity is not equivalent to underlying liquidity. An underlying is considered liquid if it has the following characteristics: A high daily volume, meaning many shares traded daily (>1 million). A tight bid‐ask spread, meaning a small difference between the maximum a buyer is willing to pay and the minimum a seller is willing to take (<0.1% of the asset price). Some examples of liquid underlyings include AMZN, IBM, SPY, and TSLA, as shown in Table 5.1 below. Table 5.1 Pricing, bid‐ask spread, and daily volume data for different equities collected on February 10, 2020, at 1 p.m. Asset Previous Closing Price Bid‐Ask Spread Spread/Close (% of Closing Price) Daily Trading Volume AMZN $3,322.94 $0.32 0.01% 1,240,935 IBM $121.98 $0.05 0.04% 2,484,505 SPY $390.51 $0.02 0.005% 16,619,920 TSLA $863.42 $0.51 0.06% 9,371,760 It is relatively straightforward to verify underlying liquidity using daily volume and bid‐ask spread as a percentage of closing price. However, a liquid underlying may not have an equally liquid options market. Sufficiently liquid options underlyings must have contract prices with tight bid‐ask spreads and high daily volumes. The options selection should also offer flexible time frames and strike prices. An underlying with a liquid options market is thus classified by the following properties: A high open interest or volume across strikes (at least a few hundred per strike). A tight bid‐ask spread (<1% of the contract price). Available contracts with several strike prices and expiration dates. Options liquidity ensures that traders have a wide selection of contracts to choose from and that short premium positions can be opened (i.e., contracts can be sold to a buyer) easily. Additionally, liquidity minimizes the risk of being stuck in a position because it allows traders to close short premium positions (i.e., identical contracts can be bought back) quickly. The asset universe presented in this book is equity‐based and mostly consists of stock and exchange‐traded fund (ETF) underlyings, recalling that a stock represents a share of ownership for a single company, and an ETF tracks a specific set of securities, such as a sector, commodity, or market index. However, asset universes are generally product indifferent and can include any instruments with liquid options that present opportunities, such as commodities, digital currencies, and futures. Choose an Underlying The choice of underlying from a universe of sufficiently liquid assets is somewhat arbitrary, but traders often choose to trade short options on instruments for a preferred company, sector, or market under specific directional beliefs. Though this is a perfectly fine way to trade, it's also important to select an underlying with an appropriate amount of risk for a given account size. The two broad classes of instruments in the example asset universe, stocks and ETFs generally have different volatility profiles, and there are pros and cons to trading each, summarized in Table 5.2 . Table 5.2 General pros and cons for stock and ETF underlyings. Stocks ETFs Pros Cons Pros Cons Tend to have options with higher credits and higher profit potentials Frequent high implied volatility (IV) conditions Single‐company risk factors Earnings and dividend risk Tend to have options with higher buying power reductions (BPRs) Inherently diversified across sectors or markets Tend to have options with lower BPRs and are still highly liquid Limited selection compared to stocks High IV conditions are not common When choosing an underlying, the capital requirement of the trade is a limiting factor. A single position should generally occupy no more than 5% to 7% of portfolio capital, meaning that stock underlyings may not be suitable for small accounts because they are more expensive to trade. However, since selling premium when IV is elevated has several benefits, stock underlyings may be preferable underlyings in certain circumstances. As stocks are subject to company‐ and sector‐specific risks, they tend to have higher IVs compared to ETFs and tend to present elevated IV opportunities more often. Note that if trading stock options, investors should also be aware of the contextual information (e.g., earnings reports dates, company announcements) that may be driving these periods of IV inflation because it may impact the strategy choice. 1 This practice is less important when trading options with ETF underlyings. The additional risk factors (coupled with the fact that liquid stocks are often more expensive than ETFs) result in stock options generally having much larger profit and loss (P/L) swings throughout the contract duration, more ending P/L variability, and more tail risk. If the capital requirements of the trade are not excessive and the IV of the underlying is favorable, then these will be the next factors to consider. Overall, stock options are usually riskier but also carry a higher profit potential than ETF options. Consider the statistics outlined in Table 5.3 . Table 5.3 Options P/L and probability of profit (POP) statistics 45 days to expiration (DTE) 16 strangles with six different underlyings, held to expiration, from 2009–2020. Assets include SPY (S&P 500 ETF), GLD (gold commodity ETF), SLV (silver commodity ETF), AAPL (Apple stock), GOOGL (Google stock), and AMZN (Amazon stock). 16 Strangle Statistics, Held to Expiration (2009–2020) Underlying Average Profit Average Loss POP ETFs SPY $160 –$297 82% GLD $125 –$424 83% SLV $33 –$103 81% Stocks AAPL $431 –$1,425 76% GOOGL $1,108 –$2,886 80% AMZN $1,041 –$2,215 78% The tolerance for P/L swings, ending P/L variability, and tail exposure depends mostly on account size and personal risk preferences. If a trade approximately satisfies those preferences and the constraints previously stated, then the choice of underlying is somewhat irrelevant because of a concept called product indifference. Because IV is derived from option price, if two assets have the same IV, their options will have roughly the same price (as a percentage of underlying price). Consequently, one underlying will not give more edge with respect to options pricing inefficiencies compared to another, provided they have similarly liquid options markets. To visualize this, consider the example in Table 5.4 . Table 5.4 Two sample options underlyings with the same IV but differing stock and put prices. Option Parameters Scenario A Scenario B Stock Price $100 $200 IV 33% 33% 45 DTE 16 Put Price $1 $2 In Scenario A, the put is $1 (1% of the underlying price). Due to the efficient nature of options pricing, the short put in Scenario B will also cost 1% of the underlying price, as both assets have the same IV. Product indifference suggests that no one (liquid) underlying is inherently superior to another, merely that there are proportional trade‐offs among different assets. The high‐risk, high‐reward nature of stocks is not inherently better or worse than the relatively stable nature of ETFs, but some assets may be more suitable for an individual trader than others. We can, thus, conclude that the choice of an underlying essentially depends on five main factors (in order of significance): The liquidity of the options market The BPR of the trade relative to account size 2 The IV of the underlying 3 The preferred magnitude of P/L swings, ending P/L variability, and tail exposure per trade The preferred company, sector, or market exposure Choose a Contract Duration There are many ways to choose a contract duration, but this book approaches this process from a qualitative perspective. The three primary goals when choosing a contract duration are summarized as follows: Using portfolio buying power effectively. Maintaining consistency and reaching a large number of occurrences. Selecting a suitable time frame given contextual information. It is essential to determine what contract duration is the most effective use of portfolio buying power without exceeding risk tolerances. Premium prices tend to be more sensitive to changes in underlying price (higher gamma) for contracts that are near expiration (5 DTE) compared to contracts that are far from expiration (120 DTE). Consequently, short‐term contracts tend to have significant P/Ls swings for a larger portion of their duration compared to longer‐term contracts, which initially have more moderate P/L swings and gradually become more volatile. Most contracts also tend to exhibit an increase in P/L instability as they near expiration, which is also a consequence of higher gamma. The gamma of a contract tends to increase throughout a contract's duration, usually the result of the underlying price drifting closer to one of the strangle strikes over time. Figure 5.1 illustrates these concepts by comparing the standard deviation of daily P/Ls for different durations of the same type of contract. All of these strangles exhibit a decrease in P/L swings right before expiration. This is because options rapidly lose their extrinsic value near expiration, presuming they are not in‐the‐money (ITM), which is usually the case because 16Δ options often expire worthless. Near expiration, this exponential decline in premium from theta decay outweighs the magnitude of the P/L swings. The P/L swings at the beginning of the contract vary greatly based on the contract duration. On day seven, the daily P/L for the 15 DTE contract has a high variance, and the 30 DTE, 45 DTE, and 60 DTE contracts have much lower P/L swings around the seven‐day mark. This is because the 16 strikes in the 15 DTE contract are much closer to the at‐the‐money (ATM) than the 16 strikes in the 30+ DTE contracts. This is shown numerically in Table 5.5 . 4 Figure 5.1 Standard deviation of daily P/Ls (in dollars) for 16 SPY strangles with various durations from 2005–2021. Included are durations of (a) 15 DTE, (b) 30 DTE, (c) 45 DTE and (d) 60 DTE. Table 5.5 illustrates how the 16 strikes are closer to the stock price for the 15 DTE contract compared to longer duration strangles. Therefore, small changes in the price of the underlying will have a larger impact on the option's delta compared to contracts with longer durations and further out strike prices. The 30+ DTE contracts tend to experience larger P/L swings once they near expiration because the underlying price often drifts toward one of the strikes over time. Longer contract durations, because their P/L swings are manageable for a longer period of time, give traders more time to assess the trade and adjust to changes in market conditions. However, trade durations that are too long are not necessarily effective uses of buying power because they do not allow for as many occurrences and take a longer time to generate profits. To summarize, longer‐term contracts, which don't typically experience large changes in P/L until the latter half of their duration, tie up buying power for a long time without generating significant profit most of that time. By comparison, shorter‐term contracts exhibit volatile P/L swings for the majority of their duration and leave little time to react to new conditions. A middle ground contract duration, one between 30 and 60 days on a monthly expiration cycle, 5 is considered a suitable use of buying power. Middle ground durations offer a period of manageable P/L swings while providing a fair amount of daily premium decay and a reasonable timescale for profit. This buffer time allows traders to evaluate the viability of a trade before P/L swings become more volatile. It also allows traders to incorporate different trade management strategies, which will be covered in the next chapter. Table 5.5 Data for 16 SPY strangles with different durations from April 20, 2021. The first row is the distance between the strike for a 16 put and the price of the underlying for different contract durations (i.e., if the price of the underlying is $100 and the strike for a 16 put is $95, then the put distance is ($100 – $95)/$100 = 5%). The second row is the distance between the strike for a 16 call and the price of the underlying for different contract durations. 16 SPY Option Distance from ATM Option Type 15 DTE 30 DTE 45 DTE Put Distance 3.9% 6.5% 8.0% Call Distance 2.4% 3.9% 4.9% Another important factor to consider when choosing a contract duration is consistency and the number of occurrences. Consistently choosing similar contract time frames increases the number of occurrences and simplifies portfolio management because expiration and management times will roughly align for the majority of short premium trades in a portfolio. As discussed in Chapter 3 , a large number of occurrences is required to reduce the variance of portfolio averages and maximize the likelihood of realizing long‐term expected values. For profit and risk expectations to be dependable, it is essential to choose contract durations (and management strategies) that allow for a reasonable number of occurrences and to do so consistently. Therefore, it's good practice to choose a contract time frame that is convenient to maintain and short enough to allow for several trades to be placed throughout the trading year, presuming the duration maintains a manageable amount of tail risk exposure. The final major factor when choosing a contract duration is contextual information, particularly when trading stock options. Contextual information, such as an approaching election, earnings report date, or forecasted natural disaster cannot necessarily be used to consistently forecast price direction, but it may indicate a predictable change in price volatility. There is, therefore, utility in taking contextual information into account when choosing a contract time frame. This will be discussed in more detail in Chapter 9 . Choose Defined or Undefined Risk Long options strategies are defined risk trades, as the maximum loss is capped by the price of the contract. Short options positions may have defined or undefined risk profiles. Defined risk strategies have a fixed maximum loss, but capping downside risk has drawbacks. Undefined risk strategies have unlimited downside risk, meaning the maximum loss on a trade-by-trade basis is potentially unlimited. The pros and cons of defined and undefined risk strategies are outlined in Table 5.6 . Table 5.6 Comparison of defined and undefined risk strategies. Undefined Risk Defined Risk Pros Cons Pros Cons Higher POPs Higher profit potentials Unlimited downside risk Higher BPRs (more expensive to trade) Limited downside risk Lower BPRs (less expensive to trade) Lower POPs Lower profit potentials Can run into liquidity issues a a Defined risk trades, because they consist of short premium and long premium contracts, require more contracts to be filled than equivalent undefined risk trades. There is, therefore, a higher risk that a defined risk order will be unable to close at a good price compared to an equivalent undefined risk position. Defined risk strategies have a known maximum loss (i.e., the BPR of the trade) and will typically have a lower BPR than an undefined risk strategy with similar parameters (underlying, contract duration, strikes). Although defined risk positions expose less capital than equivalent undefined risk positions, this does not imply they carry less risk. Recall from the discussion of option risk in Chapter 3 that there are several ways to quantify the risk of an options strategy. Though defined risk strategies avoid carrying outlier risk , they are more likely to lose most or all their BPR when losses do occur. It's, therefore, essential to recognize that BPR is mathematically and functionally different for defined and undefined risk trades, and it cannot be used as a comparative risk metric between them. This will be discussed later in the chapter. Due to the differences in POP and profit potential between risk profiles, the maximum amount of portfolio capital allocated should differ depending on whether the strategy is defined or undefined risk. For undefined risk strategies, traders are compensated for the significant tail risk with high profit potentials and high POPs. It is generally recommended that undefined risk strategies constitute the majority of portfolio capital allocated to short premium strategies. More specifically, at least 75% of allocated capital should be in undefined risk strategies (with a maximum of 7% allocated per trade) and at most 25% of allocated capital should be in defined risk strategies (with a maximum of 5% allocated per trade). For a numerical example, consider the allocation scenarios for a $100,000 portfolio described in Table 5.7 . Table 5.7 Portfolio allocation for defined and undefined risk strategies with a $100,000 portfolio at different VIX levels. VIX Level Maximum Portfolio Allocation Minimum Undefined Risk Allocation Maximum Defined Risk Allocation 20 $30,000 $22,500 ($7,000 max BPR per trade) $7,500 ($5,000 max BPR per trade) 40 $50,000 $37,500 ($7,000 max BPR per trade) $12,500 ($5,000 max BPR per trade) These differences will be elaborated on in the next section, but to summarize, the following five factors are generally the most important to consider when comparing defined and undefined risk trades: The amount of BPR required for a trade relative to the net liquidity of the portfolio. The likelihood of profiting from a position. The preferred amount of downside risk. The preferred ending P/L variability and preferred magnitude of P/L swings throughout the contract duration. The profit targets. Defined risk trades typically require less capital, have more moderate P/L swings throughout the trade, and have less ending P/L standard deviation compared to undefined risk trades. Consequently, defined risk trades may be preferable for small accounts and relatively new traders. Undefined risk trades are statistically favorable and have, therefore, been the focus of this book. However, the following section discusses how to construct defined risk trades that behave like undefined risk trades while offering protection against extreme losses. For these types of strategies, and only these types of strategies, defined risk trades can be substituted for undefined risk trades in the portfolio allocation guidelines. Choose a Directional Assumption After choosing a contract underlying, duration, and risk profile, the next steps are determining the directional assumption for the price of the underlying asset and selecting a strategy consistent with that belief and the preferred risk profile. The directional assumption may be bullish, bearish or neutral, and the optimal choice is subjective and depends on one's interpretation of the efficient market hypothesis (EMH). Recall that the EMH assumes that current prices reflect some degree of available information and comes in three main forms: Weak EMH: Current prices reflect all past price information. Semi‐strong EMH: Current prices reflect all publicly available information. Strong EMH: Current prices reflect all possible information. Each form of the EMH implies some degree of limitation with respect to price predictability: Weak EMH: Past price information cannot be used to consistently predict future price information, which invalidates technical analysis. Semi‐strong EMH: Any publicly available information cannot be used to consistently predict future price information, which invalidates fundamental analysis. Strong EMH: No information can be used to consistently predict future price information, which invalidates insider trading. No form of the EMH is universally accepted or rejected, and the ideal form to trade under (if any) depends on personal preference. This book takes a semi‐strong approach to market predictability, assuming equity and option prices effectively reflect available information and that few directional assumptions are valid (e.g., the market trends bullish in the long term). As volatility reverts back to a long‐term value following significant deviations, it is more valid to make directional assumptions on IV once it's inflated rather than directional assumptions around equity prices. This book, therefore, typically focuses on directionally neutral strategies, such as the short strangle, because these types of positions profit from changes in volatility and time and are relatively insensitive to price changes. However, that is a personal choice. Multiple strategies are outlined in Table 5.8 . For reasons discussed in earlier chapters, all these strategies perform best in high IV. However, the POPs of these trades remain relatively high in all volatility environments, justifying that some percentage of capital should be allocated in all IV conditions. To elaborate on the differences between defined and undefined risk, compare statistics for the two neutral strategies: the iron condor and the strangle. An iron condor consists of a short out-of-the-money (OTM) vertical call spread and a short OTM vertical put spread (introduced in Table 5.8 ). This trade is effectively a short strangle paired with a long strangle having strikes that are further OTM (typically called wings). As with strangles, iron condors are profitable when the underlying price stays within the range defined by the short strikes or when there is a significant IV contraction or time decay. For example, a 16 strangle can be turned into a 16 iron condor with 10 wings 6 with the addition of a long call and a long put with the same duration, further from OTM (the long contracts are 10 in this case). An example of an iron condor is shown in Table 5.9 and Figure 5.2 . Table 5.8 Examples of popular short options strategies with the same delta of approximately 20. a Strategy Composition Defined or Undefined Risk Directional Assumption POP b Naked Option Short OTM put Undefined Bullish 80% Short OTM call Undefined Bearish 80% Vertical Spread Short OTM put, long further OTM put Defined Bullish 77% Short OTM call, long further OTM put Defined Bearish 77% Strangle Short OTM put, short OTM call Undefined Neutral 70% Iron Condor Short OTM vertical call spread, short OTM vertical put spread Defined Neutral 60% a The directional assumption will be flipped for the long side of a non‐neutral position. For a long neutral position, the assumption is that the underlying price will move outside of the price range defined by the contract strikes. The POP of the long side is given by 1 – (short POP). b These POPs are approximate. The POP of a defined risk strategy depends heavily on the choice of long delta(s). Contracts with wider long deltas will generally have higher POPs. This will be explored more later in the chapter. The long wings of the iron condor cap the maximum loss as either the difference between the strike prices of the vertical put spread or vertical call spread (whichever is greater) times the number of shares in the contract (typically 100) minus the net credit. The maximum loss of the short iron condor is equivalently the BPR required to open the trade. It can be summarized by the following formula: (5.1) Continuing with the same example as shown in Table 5.9 , we apply this formula to calculate some statistics for these two trades in Table 5.10 . Table 5.9 Example of a 16 SPY strangle and a 16 SPY iron condor with 10 wings when the price of SPY is $315 and its IV is 12%. All contracts must have the same duration. Contract Strikes 16 Strangle 16 Iron Condor with 10 Wings Long Call Strike ‐‐‐ $332 Short Call Strike $328 $328 Short Put Strike $302 $302 Long Put Strike ‐‐‐ $298 The short strikes were approximated with the expected range formula and the long strikes for the iron condor wings were approximated with the Black‐Scholes formula. Underlyings are often subject to strike skew, not to be confused with distribution skew, which neither of these methods really consider. This means that the strikes (both long and short) are typically not equidistant (as a dollar amount) from the price of the underlying although they were approximated in this example as such. This concept will be explored more later in the chapter. Figure 5.2 Graphical representation of the iron condor described in Table 5.9 . The 10 wings correspond to long strikes that are $17 from ATM, which is further OTM than the 16 short strikes that are $13 from ATM. Table 5.10 Initial credits for the 16 SPY strangle and the 16 SPY iron condor with 10 wings outlined in Table 5.9 . Because the difference between the vertical call spread strikes ($332–$328) and the vertical put spread strikes ($302–$298) is the same ($4), this value is used when calculating the maximum loss. Contract Credits 16 Strangle 16 Iron Condor with 10 Wings Long Call Debit ‐‐‐ −$69 Short Call Credit $122 $122 Short Put Credit $108 $108 Long Put Debit ‐‐‐ −$57 Net Credit $230 $104 Max Loss ∞ BPR $5,000 $296 The choice of wing width depends on personal profit targets and the threshold for extreme loss. Large losses generally occur once the long put or call strikes are breached by the price of the underlying, so wings that are further from ATM are exposed to larger outlier moves but are more likely to be profitable. Wings that are closer to ATM are more expensive but also reduce the maximum loss of a trade. To summarize, wings that are further out yield iron condors with a larger profit potential and a higher probability of profit but also larger possible losses. For some numerical examples, refer to the statistics in Table 5.11 . Table 5.11 Statistical comparison of 45 DTE 16 SPY iron condors with different wing widths, held to expiration from 2005–2021. Wings that have a smaller delta are further from ATM compared to wings with a larger delta. Included are 45 DTE 16 SPY strangle statistics held to expiration from 2005–2021 for comparison. 16 Iron Condor Statistics (2005–2021) 16 Strangle Statistics (2005–2021) Statistics 5 Wings 10 Wings 13 Wings POP 79% 75% 73% 81% Average P/L $35 $15 $6 $44 Standard Deviation of P/L $251 $132 $74 $614 Conditional Value at Risk (CVaR) (5%) −$771 −$399 −$220 −$1,535 If the account size allows for it, it is preferable to trade iron condors with wide wings , which have more tail risk than narrow iron condors but are historically more profitable. While iron condors with narrow wings have POPs near 70%, wide iron condors may have POPs of nearly 80%, as shown in Table 5.11 . Wider iron condors, although they have higher BPR requirements, are also less likely to reach max loss than tighter iron condors when losses do occur. Defined risk strategies tend to have lower POPs and profit potentials compared to undefined risk strategies as shown by the strangle statistics included for reference. The iron condor has roughly a third of the profit potential as the strangle on average (in the case of 10Δ wings), but it also has roughly a third of the P/L standard deviation and significantly less tail exposure. Also, as in the wide iron condor example, defined risk trades can be constructed to have similar POPs as an undefined risk strategy while still offering protection from outlier losses. Defining risk in low IV, particularly with strategies that have high POPs, is one way to manage the outlier loss exposure while capitalizing on the benefits of short premium. Defined risk strategies also come with the added benefit of being significantly cheaper to trade, which is another reason they may be a more effective use of portfolio buying power when IV is low. For a numeric reference, consider the BPR statistics in Table 5.12 . Table 5.12 Average BPR comparison of 45 DTE 16 SPY strangles and 45 DTE 16 SPY iron condors with 10 wings when held to expiration using data from 2005–2021. SPY Strangle and Iron Condor BPRs (2005–2021) VIX Range Strangle BPR Iron Condor BPR a 0–15 $3,270 $363 15–25 $2,641 $426 25–35 $2,261 $585 35–45 $1,648 $553 45+ $1,445 $615 a Iron condors with static dollar wings (e.g., $10 wings, $20 wings) have BPRs that decrease with IV as seen with strangles. Iron condors with dynamic wings that change with variables, such as IV (e.g., 10 , 5 ) have BPRs that increase with IV. Recall that the iron condor BPR is the widest short spread width minus the initial credit. Therefore, as IV increases, the widest width increases faster than the initial credit, so the BPR increases with IV. Defined risk strategies with high POPs can account for a greater percentage of portfolio allocation than defined risk strategies with lower POPs. Previously, we stated that at least 75% of allocated capital should be in undefined risk strategies (with a maximum of 7% allocated per trade) and at most 25% of allocated capital should be in defined risk strategies (with a maximum of 5% allocated per trade). However, a defined risk strategy with a POP comparable to an undefined risk strategy can share undefined risk portfolio buying power, which protects capital from extreme losses while still allowing for consistent profits. Once IV expands, traders can then transition to strangles to capitalize on the higher credits and reduced outlier risk. It's crucial to reiterate that BPR cannot be used to compare risk between strategies with different risk profiles. For instance, refer back to the example in Table 5.10 . The strangle requires roughly 17 times more buying power than the iron condor, but this is not to say that the risk of the strangle is equivalent to the risk of 17 iron condors. The strangle is more likely to be profitable and much less likely to lose the entire BPR because that would require a much larger move in the underlying (20%) compared to the iron condor (5%). Very wide iron condors have similar risk profile to strangles, but it is generally good practice to avoid directly comparing defined and undefined risk strategies using buying power. Choosing a Delta Recall that delta is a measure of directional exposure . According to the mathematical definition derived from the Black‐Scholes model, it represents the expected change in the option price given a $1 increase in the price of the underlying (assuming all other variables stay constant). 7 For example, if the price of an underlying increases by $1, the price for a long call option with a delta of 0.50 (denoted as 50 ) will increase by approximately $0.50 per share, and the price for a long put option with a delta of –0.50 (denoted as –50 , or just 50 when the sign is clear from context) will decrease by approximately $0.50 per share. 8 The delta of a contract additionally represents the perceived risk of that option in terms of shares of equity. More specifically, delta corresponds to the number of shares required to hedge the directional exposure of that option according to market sentiment. This book frequently references the 16 SPY strangle, which is a delta neutral trade consisting of a short 16 put directionally hedged with a short 16 call. Delta neutral positions profit from factors such as decreases in IV and time decay rather than directional changes in the underlying. When originally presented in Chapter 3 , the short strike prices were related to the expected range, and therefore, strike prices were shown to be equidistant from the price of the underlying as in Figure 5.3 . The strikes in this example were derived from the expected move range approximation shown in Chapter 2 . However, in practice the strikes for a 16 SPY put/call are calculated from real‐time supply and demand and are often subject to strike skew . Revisit the example from Table 5.5 to see an example of this. Table 5.5 shows that the put strikes are much further from the price of the underlying compared to the call strikes even though the call and put contracts are both 16 . According to market demand, put contracts further OTM have equivalent risk as call contracts less OTM. This skew results from market fear to the downside , meaning the market fears larger extreme moves to the downside more than extreme moves to the upside. 9 As delta is based on the market's perception of risk, strikes for a given delta are skewed according to that perception. But not all instruments will have the same degree of skew. Stocks like AAPL and GOOGL have fairly equidistant strikes, but market indexes and commodities (e.g., gold and oil) tend to have downside skew, otherwise known as put skew. Assets like GME (GameStop) and AMC (entertainment company) developed upside skew, otherwise known as call skew, during 2020. Figure 5.3 The price of SPY in the last 5 months of 2019. Included is the 45‐day expected move cone calculated from the IV of SPY in December 2019, where the strike for the 16 call is $328 and the strike for the 16 put is $302. Because delta is a measure of perceived risk in terms of share equivalency, the chosen delta is going to significantly impact the risk‐reward profile of a trade. Positions with larger deltas (closer to −100 or +100 ) are more sensitive to changes in the price of the underlying compared to positions with smaller deltas (closer to 0). To observe how this impacts per‐trade performance, consider the statistics for 45 DTE SPY strangles with different deltas outlined in Tables 5.13 – 5.15 . Table 5.13 Statistical comparison of 45 DTE SPY strangles of different deltas, held to expiration from 2005–2021. SPY Strangle Statistics (2005–2021) Statistics 16 20 30 POP 81% 76% 68% Average P/L $44 $49 $54 Standard Deviation of P/L $614 $659 $747 CVaR (5%) −$1,535 −$1,673 −1,931 Table 5.14 Average BPRs of 45 DTE SPY strangles with different deltas, sorted by IV from 2005–2021. SPY Strangle BPRs (2005–2021) VIX Range 16 20 30 0–15 $3,270 $3,366 $3,573 15–25 $2,641 $2,756 $3,014 25–35 $2,261 $2,415 $2,794 35–45 $1,648 $1,715 $2,058 45+ $1,445 $1,421 $1,520 Table 5.15 Probability of incurring a loss exceeding the BPR for 45 DTE SPY strangles of different deltas, held to expiration from 2005–2021. SPY Strangle Statistics (2005–2021) Strangle Delta Probability of Loss Greater Than BPR 16 0.90% 20 0.93% 30 1.0% Positions with higher deltas have larger P/L swings throughout the contract duration, more ending P/L variability, higher BPRs and lower POPs compared to positions with lower deltas. However, higher delta positions also carry higher credits and larger profit potentials overall. Positions with lower deltas achieve smaller profits more often and are lower risk than higher delta trades. Positions with lower deltas also tend to have higher thetas as a percentage of the option value, meaning they may reach profit targets more quickly than positions with higher deltas (not shown in these tables). The optimal choice of delta depends on the personal profit goals and, most importantly, personal risk tolerances. ITM options (options with a delta magnitude larger than 50) generally carry more directional risk and an insufficient amount of theta (expected daily profits due to time decay) than what is suitable for a short premium trade. OTM options are typically better candidates. When trading short premium, contract deltas between 10 and 40 are typically large enough to achieve reasonable growth but small enough to have manageable P/L swings, moderate standard deviation of ending P/L, and moderate outlier risk. More risk‐tolerant traders generally trade options over 25 and more risk‐averse traders will trade under 25 . When IV increases and options become cheaper to trade, more risk‐tolerant traders may also scale delta up to capitalize on the larger credits across the entire options chain. It is also good practice to re‐center the deltas of existing positions when IV increases because increases in IV cause the strike price for a given delta to move further away from the spot price. To see an example of this, consider Table 5.16 . Table 5.16 Comparison of strike prices for two 30 DTE 16 call options with the same underlying price but different IVs. Example Parameters for a 30 DTE 16 Call Option IV Underlying Price Strike Price 10% $100 $103 50% $100 $117 The strike price for a 16 call is $17 away from the price of the underlying when the IV is 50%, compared to $3 away when the IV is 10%. This is because an increase in IV indicates an increase in the expected range for the underlying price. When this expected range becomes larger, contracts with strikes further away from the current price of the underlying are in higher demand than in lower IV conditions. This demand increases the premiums of those contracts and consequently the perceived risk. When IV increases, it is good practice to close existing positions and reopen them with adjusted strikes that better reflect the new volatility conditions. Takeaways Constructing a trade has six major steps, and the ideal choices are based on account size and the personal profit goals, risk tolerances, and market assumptions. The primary factors to consider are the asset universe, the underlying, the contract duration, the risk profile of the strategy, the directional assumption, and the delta. Traders should choose assets with highly liquid options markets, consisting of contracts that can be easily converted into cash without a significant impact on market price. Liquid options markets have a high volume across strikes, tight bid‐ask spreads, and available contracts with several strike prices and expiration dates. In an equity‐focused asset universe, traders have two main choices of equity underlyings: stocks and ETFs. Options with stock underlyings tend to have higher credits, higher profit potentials, and more frequent high IV conditions, but they also have single‐company risks and cost more to trade than options with ETF underlyings. ETFs are inherently diversified and are cheaper than stocks while being very liquid, but fewer choices are available and high IV conditions are less common. A suitable contract duration should use buying power effectively, allow for consistency and a reasonable number of occurrences, and reflect the timescale of contextual events, such as upcoming earnings reports and forecasted natural disasters. Contract durations ranging from 30 to 60 days are generally a suitable use of portfolio buying power, offering manageable P/L volatility and a reasonable timescale for profit. Short premium strategies may have defined or undefined risk. Undefined risk trades have higher POPs and higher profit potentials but also unlimited downside risk and higher BPRs, making them more expensive to trade. Defined risk strategies have limited downside risk and lower BPRs but also lower POPs and lower profit potentials with possible liquidity issues. High‐POP defined risk strategies, such as wide iron condors, can occupy the capital reserved for undefined risk trades, and this is a particularly good strategy when IV is low. Trading high‐POP defined risk trades in low IV and transitioning to undefined risk in high IV is an effective way to protect capital from outlier moves while profiting consistently. Traders must choose one of three directional assumptions for the underlying price: bullish, bearish, and neutral. The optimal choice is subjective and depends on individual interpretation of the EMH, which assumes current prices reflect some degree of available information. The delta of a contract represents the perceived risk of the option in terms of shares of equity, making the choice of delta based on personal risk tolerances and profit goals. A higher delta OTM contract is closer to ATM and more sensitive to changes in underlying price, meaning that these positions are generally riskier but have higher profit potentials. Lower delta OTM contracts are further from ATM and have more moderate P/L swings throughout the contract with lower ending P/L standard deviation generally. When trading short premium, ITM contracts are generally not suitable due to their high directional risks and low thetas. Contracts between 10 and 40 are generally large enough to achieve a reasonable amount of growth but small enough to have manageable P/L swings and moderate ending P/L variability. Notes 1 IV inflation specifically due to earnings is the basis for a type of strategy called an earnings play. Earnings plays will be discussed in Chapter 9 and for now will not be part of stock options discussions. 2 This will be explored more later in this chapter and in Chapter 7 , when covering the portfolio allocation guidelines in more detail. 3 In practice, IV is often interpreted according to the IV percentile or IV rank of the underlying. This is a more common trading metric because traders are rarely deeply familiar with the IV dynamics of different assets, and it is essential to include a range of assets in a balanced portfolio. 4 The put distance and call distance are not symmetric. This is due to strike skew, which will be discussed later in this chapter and in the appendix. 5 Common options expiration dates are divided into weekly, monthly, and quarterly cycles. Contracts with monthly expirations cycles are preferable because they are consistently liquid across liquid underlyings. For highly liquid assets, any expiration cycle is acceptable. 6 Recall that smaller deltas are further from ATM than larger deltas. 7 For contracts with deltas between approximately 10 and 40, delta can also be used as a very rough proxy for the probability that an option will expire ITM. For instance, a 25 put has about a 25% chance of expiring ITM, meaning that there is a 75% POP for the short put. A 16 strangle is composed of a 16 put and a 16 call, so there is approximately a 32% chance that it will expire ITM (consistent with the 68% POP for the short strangle). 8 Delta is between 0 and 1 for long calls and between –1 and 0 for long puts. For short calls and short puts, the numbers are flipped. 9 This is mainly the result of the history of extreme market crashes, such as the 1987 Black Monday crash, the 2008 housing crisis, and the 2020 sell‐off. Prior to 1987, the put and call strikes of the same delta were much closer to equidistant. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c06.xhtml SCORE: 16.00 ================================================================================ Chapter 6 Managing Trades Options traders can hold a position to expiration or close it prior to expiration (active management). Compared to holding a contract until expiration, an active management strategy should be considered for the following reasons: It allows for more occurrences over a given time frame (if capital is redeployed). It may allow for a more efficient use of portfolio buying power (if capital is redeployed). It tends to reduce risk on a trade‐by‐trade basis. Trades can be managed in any number of ways, but similar to choosing a contract duration, consistency is essential for reaching a large number of occurrences and realizing favorable long‐term averages. This book advocates for adopting a simple management strategy that is easily maintainable: Closing a trade at a fixed point in the contract duration. Closing a trade at a fixed profit or loss target. Some combination of these strategies. This chapter discusses different management strategies, compares trade‐by‐trade performance, and elaborates on the major factors to consider when choosing appropriate position management. Because management strategies impact the proportion of initial credit traders ultimately collect, the statistics will often be represented as an initial credit percentage rather than dollars. This chapter also predominantly focuses on undefined risk strategy management. Many of these principles also apply to defined risk positions, but defined risk positions are generally more forgiving from the perspective of trade management because they occupy a smaller percentage of portfolio buying power and have limited loss potential. Managing According to DTE As mentioned in Chapters 3 and 5 , trade profit and loss (P/L) swings tend to become more volatile as options approach expiration. For a strangle, this increase generally results from the price of the underlying drifting toward one of the strikes throughout the contract duration. Consequently, closing a trade prior to expiration, whether at a fixed point in the contract duration or at a specific profit or loss target, tends to reduce ending P/L standard deviation and outlier risk exposure on a trade‐by‐trade basis. Managing trades actively also frees portfolio buying power from existing positions, which can then be allocated more strategically as opportunities arise. The freed capital can be redeployed to the same type of initial position (increasing the number of occurrences) 1 or to a new position with more favorable short premium conditions (which may be a more efficient use of buying power). Managing a trade according to days to expiration (DTE), such as closing a position halfway to expiration, offers the benefits described previously and is straightforward to execute. This technique has a clear management timeline and requires minimal portfolio supervision, particularly when portfolio positions have comparable durations. The choice of management time greatly affects the profit potential and outlier risk exposure of a trade because trades managed closer to expiration are more likely to be profitable and have larger profits on average but are generally exposed to more tail risk. The trade‐by‐trade statistics shown in Table 6.1 compare the performance of different management times for 45 DTE 16 SPY strangles. Table 6.1 Statistics for 45 DTE 16 SPY strangles from 2005–2021 managed at different times in the contract duration. 16 SPY Strangle Statistics (2005–2021) Management DTE Probability of Profit (POP) Average P/L Average Daily P/L P/L Standard Deviation Conditional Value at Risk (CVaR) (5%) 40 DTE 67% 2.3% $0.23 73% –206% 30 DTE 73% 10% $1.75 88% –212% 21 DTE 79% 21% $1.60 96% –283% 15 DTE 78% 25% $1.51 105% –304% 5 DTE a 82% 33% $1.34 185% –514% Expiration 81% 28% $1.29 247% –708% a Strangles managed at 5 DTE seem to outperform strangles held to expiration because they have a higher POP and average P/L but lower P/L volatility and less tail risk. These results are specific to this strategy and data set, and were likely skewed by significant historical events. This trend is not generalizable across strategies, including the one presented in this table. Table 6.1 shows that managing a trade prior to expiration is less likely to profit but also has less P/L standard deviation and less tail risk, and it also collects more daily, on average, compared to holding to expiration. These statistics also demonstrate that management time generally carries a trade‐off among profit potential, loss potential, and the number of occurrences. Compared to trades managed earlier in the contract duration, trades managed later have larger profits and losses and also allow for fewer occurrences. As early‐managed positions accommodate more occurrences and average more P/L per day than positions held to expiration, closing positions prior to expiration and redeploying capital to new positions is generally a more efficient use of capital compared to extracting more extrinsic value from an existing position. If adopting this strategy, choose a management time that satisfies individual trade‐by‐trade risk tolerances, offers a suitable profit potential, and occupies buying power for a reasonable amount of time. Remember that selling premium in any capacity carries tail risk exposure even when a position is closed almost immediately (see the 40 DTE results in Table 6.1 ). To achieve a decent amount of long‐term profit and justify the tail loss exposure, consider closing trades around the contract duration midpoint. Managing According to a Profit or Loss Target Compared to allowing a trade to expire, managing a position according to a profit target simplifies profit expectations and tends to reduce per‐trade P/L variance. Closing limit orders can be set by a trader and automatically executed by the broker, but this management strategy still requires some active maintenance. This is because trades may never reach the predetermined profit benchmark and may require alternative management prior to expiration. Additionally, there is some subtlety in choosing the profit target because that choice significantly impacts the profit and loss potential of a trade, as shown in Tables 6.2 and 6.3 . Managing at a profit threshold or expiration generally carries more P/L standard deviation and outlier risk exposure on a trade‐by‐trade basis than managing at 21 DTE, although it also comes with higher POPs and higher per‐trade profit potentials depending on the profit benchmark. Short options are highly likely to reach low profit targets early in the contract duration when P/L swings and tail risk are both fairly low. Therefore, managing a trade according to a low profit target yields a higher strategy POP, lower P/L standard deviation, and less outlier risk compared to managing at a high profit target. However, despite the higher average daily P/Ls, setting the profit threshold too low does not allow traders to collect a sufficient credit to justify the inherent tail risk of the position. Average P/Ls are well below the given profit target in all cases due to the tail loss potential. When using a 25% target, for example, the contract failed to reach the target only 4% of the time. Still, those losses were significant enough to bring down the P/L average by more than half. If this management strategy is adopted, a profit threshold between 50% and 75% of the initial credit is suitable to realize a reasonable amount of long‐term average profit and reduce the impact of outlier losses. Additionally, because these mid‐range profit targets tend to be reached near the contract midpoint or shortly after, these benchmarks also allow for a reasonable number of occurrences. 2 Table 6.2 Statistics for 45 DTE 16 SPY strangles from 2005–2021 managed at different profit targets. If the profit target is not reached during the contract duration, the strangle expires. The final row includes statistics for 45 DTE 16 SPY strangles managed around halfway to expiration (21 DTE) as a reference. 16 SPY Strangle Statistics (2005–2021) Profit Target POP Average P/L P/L Standard Deviation Probability of Reaching Target CVaR (5%) 25% or Exp. 96% 11% 191% 96% −522% 50% or Exp. 91% 16% 236% 90% −654% 75% or Exp. 84% 22% 245% 80% −699% 100% (Exp.) 81% 28% 247% 52% −708% 21 DTE 79% 21% 96% N/A −283% These tests did not account for whether a P/L target was reached throughout the trading day, but rather whether a target was reached by the end of the trading day. Therefore, these statistics are not entirely representative of this management technique. Table 6.3 Average daily P/L and average duration for the contracts and management strategies described in Table 6.2 . 16 SPY Strangle Statistics (2005–2021) Profit Target Average Daily P/L Over Average Duration Average Duration (Days) 25% or Exp. $1.75 15 50% or Exp. $1.67 24 75% or Exp. $1.49 34 100% (Exp.) $1.29 44 21 DTE $1.60 24 These tests did not account for whether a P/L target was reached throughout the trading day, but rather whether a target was reached by the end of the trading day. Therefore, these statistics are not entirely representative of this management technique. Additionally, because there can be significant variability in when a contract reaches a certain profit threshold, daily P/L estimates were derived from data over the average duration of the trade. Just as trades can be managed according to a fixed profit target, they can also be managed according to a fixed loss limit (a stop loss). Defining a loss limit is trickier because option P/L swings are highly volatile. Small loss limits are reached commonly, but trades are also likely to recover. Implementing a very small loss limit may significantly limit upside growth and make losses more likely. To understand this, see Table 6.4 . Table 6.4 Statistics for 45 DTE 16 SPY strangles from 2005–2021 managed at different loss limits. If the loss limit is not reached during the contract duration, the strangle expires. The final two rows reference other management strategies for comparison. 16 SPY Strangle Statistics (2005–2021) Loss Limits POP Avg P/L P/L Standard Deviation Prob. of Reaching Target CVaR (5%) −50% or Exp. 58% 21% 90% 40% −168% −100% or Exp. 69% 25% 110% 25% −238% −200% or Exp. 76% 27% 131% 13% −338% −300% or Exp. 79% 27% 149% 8% −450% −400% or Exp. 79% 27% 160% 6% –536% None (Exp.) 81% 28% 247% N/A −708% 21 DTE 79% 21% 96% N/A −283% 50% Profit or Exp. 91% 16% 236% 90% −654% These tests did not account for whether or not a P/L amount was reached throughout the trading day, but rather whether it was reached by the end of the trading day. Therefore, these statistics are not entirely representative of this management technique. Using a low stop loss threshold, –50% for example, results in lower P/L standard deviation and outlier risk compared to holding the contract to expiration. However, in this case, losses are more common and occur roughly 42% of the time since it is not uncommon for options to reach this loss threshold, although many positions ultimately recover prior to expiration (note the higher POPs for larger limits). Implementing a stop loss also does not necessarily eliminate all tail risk exceeding that threshold. For example, despite having a stop loss of –50%, a sudden implied volatility (IV) expansion or underlying price change may cause daily loss to increase from –25% to –75%, resulting in the closure of the trade but with a final P/L past the loss threshold. Because upside potential is limited and some degree of tail exposure exists with a very small stop loss, a mid‐range stop loss of at least –200% is practical. 3 Using a stop loss and otherwise holding to expiration generally has a higher profit and larger loss potential than managing at the duration midpoint but tends to carry less tail risk than managing at a reasonable profit target. For more active trading, stop losses are not typically used alone but rather combined with another management strategy. Comparing Management Techniques and Choosing a Strategy The strangle management strategies presented thus far are relatively straightforward. These techniques can be ranked according to loss potential (from highest to lowest) and quantified using CVaR and P/L standard deviation of the positions studied: Hold until expiration. Manage at a profit target between 50% and 75%. Manage at a loss limit of –200%. Manage at 21 DTE (halfway to expiration). Remember that consistency and ease of implementation are important factors to consider when choosing a management strategy. For traders who are comfortable with active trading, strategies can be combined and more precisely tuned according to individual preferences. For instance, suppose a trader of 45 DTE 16 SPY strangles wants a management strategy with a high POP, moderate P/L standard deviation, and moderate outlier exposure. One possibility is managing at 50% of the initial credit or at 21 DTE, whichever occurs first. The statistics for this strategy are outlined in Table 6.5 . Table 6.5 Statistics for 45 DTE 16 SPY strangles from 2005–2021 managed either at 50% of the initial credit or 21 DTE, whichever comes first. Statistics for other strategies are given for comparison and ranked by CVaR. 16 SPY Strangle Statistics (2005–2021) Management Strategy POP Average P/L Average Daily P/L P/L Standard Deviation CVaR (5%) 21 DTE 79% 21% $1.60 96% –283% 21 DTE or 50% Profit 81% 18% $1.67 96% –288% –200% Loss or Exp. 76% 27% N/A 131% –338% 50% Profit or Exp. 91% 16% $1.67 236% –654% None (Exp.) 81% 28% $1.29 247% –708% In this example, the duration and profit targets are moderate, resulting in a combined strategy with smaller but slightly more likely profits than 21 DTE management and significantly less loss potential than 50% profit management. This may be appealing to risk‐averse traders because it eliminates a large fraction of the historic losses and significantly reduces tail exposure with the benefit of a slightly higher POP and higher average daily P/L. When choosing a management strategy, know that all management strategies come with trade‐offs among POP, average P/L, P/L standard deviation, and loss potential. How these factors are weighted depends on individual goals: For likely profits, profit potential must be smaller or exposure to outlier losses must be larger. For large profits, there must be fewer occurrences or more exposure to outlier losses. For a small loss potential, profit potential must be smaller or profits must be less likely. For a qualitative comparison of the different strategies, see Table 6.6 . As mentioned, a suitable management strategy depends on individual preferences for trading engagement, per‐trade P/L potential, P/L likelihood and number of occurrences. Following are example scenarios highlighting different management profiles: Table 6.6 Qualitative comparison of different management strategies. Management Strategy 21 DTE 50% or Exp. –200% or Exp. Exp. Convenience Med High a High High POP Med High Med Med Per‐Trade Loss Potential Low High Low High Per‐Trade Profit Potential Med Low High High Number of Occurrences Med Med Low Low a If limit orders are used, profit target management is very convenient. For passive traders with portfolios that can accommodate more outlier risk, it may make more sense to use only a stop loss and otherwise hold trades to expiration to extract as much extrinsic value from existing positions as possible. Active traders with portfolios that can accommodate more outlier risk may manage general positions at a fixed profit target and close higher‐risk, higher‐reward trades halfway to expiration. Very active traders may manage all undefined risk contracts at either 50% of the initial credit or halfway through the contract duration because this method prioritizes moderating outlier risk and achieving likely profits of reasonable size. Generally speaking, an active management approach is more suitable for retail traders because more occurrences can be achieved in a given time frame, it is a more efficient use of capital, average daily profits are higher, and the per‐trade loss potential is lower. It's critical to reiterate that this risk is on a trade‐by‐trade basis. Short premium losses happen infrequently and are often caused by unexpected events, making it difficult to precisely compare long‐term performance of strategies of varying timescales. The next section discusses in more detail why comparing the long‐term risks for management strategies is not straightforward. A Note about Long‐Term Risk As mentioned previously, contracts tend to have more volatile P/L swings as the contract approaches expiration. Managing trades prior to expiration, therefore, tends to have lower P/L standard deviation and outlier risk exposure on a trade‐by‐trade basis compared to holding the contract to expiration. But it's critical to note that this reduction in risk on a trade‐by‐trade basis does not necessarily translate to a reduction in risk on a long‐term basis . Though early management techniques reduce loss magnitude per trade , inherent risk factors arise from a larger number of occurrences. Consequently, one management strategy may have lower per‐trade exposure compared to another, but it may have more cumulative long‐term risk. Consider the scenarios outlined in Figures 6.1 and 6.2 . Each scenario compares the performances of two portfolios, each with $100,000 of capital invested. Both portfolios consist of short 45 DTE 16 SPY strangles continuously traded, but the trades in one portfolio are managed halfway to expiration (21 DTE) and the trades in the other are managed at expiration. The unique market conditions in each scenario affect the performance of each management strategy. 4 The IV expansion during the 2020 sell‐off was one of the largest and most rapid expansions recorded in the past 20 years, producing historic losses for SPY strangles. Due to the timing and duration of this volatility expansion, 45 DTE contracts opened in February and closed at the end of the March expiration cycle experienced the majority of the expansion and were especially affected. Shown in Figure 6.1 , the portfolio of contracts held to expiration was immediately wiped out by this extreme market volatility, and the portfolio of early‐managed contracts incurred a large drawdown of roughly 40% but ultimately survived. This scenario demonstrates how the loss potential for contracts held to expiration is significantly larger than for contracts managed early. However, this does not necessarily mean that holding to expiration results in more cumulative loss long term. Figure 6.1 (a) Two portfolios, each with $100,000 in capital invested, trading short 45 DTE 16 SPY strangles from February 2020 to January 2021. One portfolio consists of strangles managed at 21 DTE (dashed line), and the other consists of strangles held until expiration (solid line). (b) The VIX from February 2020 to January 2021. Figure 6.2 (a) Two portfolios, each with $100,000 in capital invested, trading short 45 DTE 16 SPY strangles from September 2018 to September 2019. One portfolio consists of strangles managed at 21 DTE (dashed line), and the other consists of strangles held until expiration (solid line). (b) The VIX from September 2018 to September 2019. These same strategies perform quite differently near the end of 2018 when the market experienced smaller, more frequent IV expansions. During this period, the 21 DTE management time for 45 DTE contracts consistently landed on IV peaks during this cycle of market volatility, causing the early‐managed portfolio to incur several consecutive losses. Comparatively, the 45 DTE expiration cycles were just long enough to evade these smaller peaks and the portfolio of contracts held to expiration had much stronger performance overall. This scenario demonstrates how having lower per‐trade loss potential does not guarantee stronger long‐term performance or smaller drawdowns. Comparing the long‐term risks of strategies that occur over different timescales is complicated. These examples show potential trading strategies during unique macroeconomic conditions, but any number of factors could have impacted the realized experience of someone trading during these periods. For instance, if people began trading short 45 DTE 16 SPY strangles on February 3, 2020, they would have had a final P/L of –$717 if they managed at 21 DTE and a final P/L of –$8,087 if they held the contract to expiration. If they instead began trading the same strategy one month later on March 4, 2020, they would have had a final P/L of –$2,271 if they managed at 21 DTE and a final P/L of $518 if they held the contract to expiration. Strangle risk and performance, particularly during periods of extreme market volatility, are highly sensitive to changes in timescale and IV. There is as much variation in how people choose contract duration, manage positions, and apply stop losses as there are traders. This makes it difficult to model how people would realistically trade in a statistically rigorous way and, consequently, creates complications when evaluating the long‐term risk of different management strategies. Rather than factor in long‐term risk when selecting a management strategy, the choice should ultimately be based on the following criteria: Convenience/consistency. Capital allocation preferences and desired number of occurrences. Average P/L and outlier loss exposure per trade . Takeaways Traders should choose a consistent management strategy to increase the number of occurrences and the chances of achieving favorable long‐term averages. Some management strategies include closing a trade at a fixed point in the contract duration, closing a trade at a fixed profit or loss target, or some combination of the two. Compared to trades managed early in the contract duration, trades managed later have larger profits and losses, higher POPs, and allow for fewer occurrences. Early‐managed positions accommodate more occurrences and average more P/L per day than positions held to expiration. Closing positions prior to expiration and redeploying capital to new positions is generally a more efficient use of capital compared to extracting more extrinsic value from an existing position. If managing according to DTE, consider closing trades around the contract duration midpoint to achieve a decent amount of long‐term profit and justify the tail loss exposure of short premium. To realize reasonable profits and reduce outlier losses, consider a profit threshold between 50% and 75% of the initial credit. A profit or loss target that is too small (say 25% of initial credit) reduces average P/L and per‐trade profit potential, and a profit or loss target that is too large does little to mitigate outlier risk. If implementing a stop loss, a mid‐range stop loss threshold of at least −200% is practical because there is limited upside potential and still some degree of tail exposure with a very low stop loss. A suitable management strategy depends on an individual's preferences for trade engagement, per‐trade average P/L, per‐trade outlier risk exposure, and the number of occurrences. Managing undefined risk contracts at 50% of the initial credit or halfway through the contract duration generally achieves reasonable, consistent profits and moderate outlier risk for those more comfortable with active trading. This policy of trading small and trading often also allows for more occurrences. Comparing long‐term risks of trade management strategies is complicated because unexpected events, such as the 2020 sell‐off, affect short premium strategies differently depending on the contract duration. For this reason, compare the risk and rewards of different strategies on a trade‐by‐trade basis and choose one based on convenience and consistency, capital allocation preferences, tail exposure preferences, and profit goals. The concepts outlined in this chapter are specific to undefined risk positions. These management principles can also be applied to defined risk positions, but defined risk positions are generally more forgiving because they have limited loss potential. It is not as essential to manage defined risk losses because the maximum loss is known, and in some cases, it may be better to allow a defined risk trade more time to recover rather than close the position at a loss. Notes 1 This technique is commonly known as rolling. 2 For defined risk positions, a profit target of roughly 50% or lower is more suitable because P/L swings are less volatile and higher profit targets are less likely to be reached. 3 Stop losses are not suitable for defined risk strategies. As defined risk strategies have a fixed maximum loss, it is best to allow defined risk losers to expire rather than manage them at a specific loss threshold. This gives the position more opportunity to recover. 4 Options portfolio backtests should be taken with a grain of salt. Options are highly sensitive to changes in timescale, meaning that a concurrent portfolio with strangles opened on slightly different days, closed on slightly different days, or with slightly different durations may have performed quite differently than the ones shown here. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml SCORE: 17.00 ================================================================================ Chapter 7 Basic Portfolio Management Whether adopting an equity, option, or hybrid portfolio, building a portfolio is nontrivial. Identifying a suitable collection of elements, calculating optimal portfolio weights, and maintaining that balance easily becomes hairy. Though countless ways to approach this process exist, the portfolio management tactics discussed in this book are fairly back‐of‐the‐envelope and divided between two chapters. This chapter covers necessary guidelines in portfolio management, and the following chapter covers advanced portfolio management including supplementary techniques for portfolio optimization. Basic portfolio management includes the following concepts: Capital allocation guidelines Diversification Maintaining portfolio Greeks Capital Allocation and Position Sizing The purpose of the dynamic allocation guidelines first introduced in Chapter 3 is to limit portfolio tail exposure while also allowing for reasonable long‐term growth by scaling capital allocation according to the current risks and opportunities in the market. Recall that the amount of portfolio buying power allotted to short premium positions, such as short strangles and short iron condors, should range from 25% to 50%, depending on the current market volatility, with the remaining capital either kept in cash or a low‐risk passive investment. Of the amount allocated to short premium, at least 75% should be reserved for undefined risk trades (with less than 7% of portfolio buying power allocated to a single position) and at most 25% reserved for defined risk strategies (with less than 5% of portfolio buying power allocated to a single position), although there are exceptions for high probability of profit (POP), defined risk strategies. It's worth mentioning that it is not always feasible to strictly abide by the position size caps of 5% to 7%. If a portfolio has only $10,000 in buying power and implied volatility (IV) is low (i.e., VIX<15), this rule limits the maximum per‐trade buying power reduction (BPR) to $700 for an undefined risk trade at a time when BPRs tend to be high. This guideline would severely limit the opportunities available for small accounts. Though total portfolio allocation guidelines must be followed, there is more leniency for the per‐trade allocation guidelines in smaller accounts. These guidelines limit the amount of capital exposed to outlier losses, but how capital is allocated depends on personal profit goals and loss tolerances. An options portfolio is typically composed of two types of positions: core and supplemental. Core positions are usually high‐POP trades with moderate profit and loss (P/L) standard deviation. These types of positions should offer consistent, fairly reliable profits and reasonable outlier exposure although they will vary by risk tolerance. Consider the following examples: Riskier core position: a 45 days to expiration (DTE) 20 strangle (undefined risk trade) with a diversified exchange‐traded fund (ETF) underlying, such as SPY or QQQ. More conservative core position: a 45 DTE 16 SPY iron condor with 6 wings (high‐POP, defined risk trade) with a diversified ETF underlying, such as SPY or QQQ. Core positions should comprise the majority of a portfolio and be diversified across sectors to develop more reliable portfolio profit and loss expectations and resilience to market volatility. Supplemental positions are not necessarily dependable sources of profit but rather tools for market engagement. These positions are typically higher‐risk, higher‐reward trades meant to capitalize on dynamic opportunities in the market. Some examples of supplemental positions include earnings trades (which will be discussed in more detail in Chapter 9 ) or strangles with stock underlyings, such as a 45 DTE 16 AAPL strangle. When trading stock underlyings, defined risk supplemental positions would be suitable for more risk‐averse traders. These types of positions have significantly more P/L variability than positions with ETF underlyings, resulting in more per‐trade profit potential and more loss potential with less dependable profit and loss expectations. The expected returns, P/L variability, and tail exposure of a portfolio overall primarily depend on the types of core positions, types of supplemental positions, and the ratio of core positions to supplemental positions. Portfolios for more risk‐tolerant traders may include a larger percentage of supplemental positions. However, mitigating tail risk remains the highest priority, particularly if the portfolio underlyings are not diversified well. This is why, generally speaking, at most 25% of the capital allocated to short premium should go toward supplemental positions. For example, if the VIX is valued at 45 and 50% of portfolio buying power is allotted to short premium positions (per the allocation guidelines), then at most 25% of the 50% portfolio buying power (or 12.5%) should be allocated to supplemental positions. See Table 7.1 for some numerical context. Compared to core positions, such as SPY or QQQ strangles, the supplemental positions above have significantly more profit potential, loss potential, and tail risk exposure. The average profit is larger partially as the result of supplemental underlying assets having higher per share prices. This was the case with GOOGL and AMZN, which cost more than the other equity underlyings throughout the entire backtest period. However, these instruments also carry larger profit potentials as option underlyings because they are subject to company‐specific risk factors that often inflate the values of their respective options. This was particularly the case with AAPL, which had a lower per share value than SPY, QQQ, and GLD throughout this backtest period but more option volatility. Table 7.1 Statistics for 45 DTE 16 strangles from 2011–2020, managed at expiration. Included are examples for core and supplemental position underlyings. 16 Strangle Statistics (2011–2020) Underlying POP Average Profit Average Loss Conditional Value at Risk (CVaR) (5%) Core SLV 84% $32 −$88 −$201 QQQ 74% $109 −$183 −$454 SPY 80% $162 −$320 −$800 GLD 81% $119 −$456 −$1,100 Supplemental AAPL 74% $425 −$1,443 −$4,771 GOOGL 80% $1,174 −$2,955 −$6,593 AMZN 77% $1,235 −$2,513 −$6,810 These statistics do not account for IV or stock‐specific factors, such as earnings or dividends. Due to these single‐stock risk factors and the variance reflected in the option P/Ls, stocks are generally unsuitable underlyings for core positions. Their high profit potentials make them appealing supplemental position underlyings for opportunistic investors, but mitigating the tail risk exposure from supplemental positions is key for portfolio longevity. The most effective way to accomplish this is by strictly limiting the portfolio capital allocated to high‐risk positions. To summarize, core positions should provide somewhat reliable expectations around P/L and be diversified across sectors. Supplemental positions should comprise a smaller percent of a portfolio because they bring higher profit potentials but also more risk. Diversification, particularly when trading options, is another crucial risk management strategy that can significantly reduce portfolio P/L variability and outlier exposure. The Basics of Diversification All financial instruments are subject to some degree of risk, with the risk profiles of some instruments being more flexible than others. A single equity has an immutable risk profile, and an option's risk profile can be adjusted according to multiple parameters. However in either scenario, traders are subject to the risk factors of the particular position. When trading a portfolio of assets, a trader may offset the risks of individual positions using complementary positions. Spreading portfolio capital across a variety of assets is known as diversification. Risk is divided into two broad categories: idiosyncratic and systemic. Idiosyncratic risk is specific to an individual asset, sector, or position and can be minimized using diversification. For example, a portfolio containing only Apple stock is subject to risk factors specific to Apple and the tech sector. Some of those risks can be offset with the addition of an uncorrelated or inversely correlated asset, such as a commodity ETF like GLD. In this more diversified scenario, some hypothetical company‐specific risk factors causing AAPL stock to depreciate may be reduced by the performance of GLD, which has relatively independent dynamics. Comparatively, systemic risk is inherent to the market as a whole and cannot be diversified away. All traded assets are subject to systemic risk because every economy, market, sector, and company has the potential to fail. No amount of diversification will ever remove that element of uncertainty. Instead, the purpose of diversification is to construct a robust portfolio with minimal sensitivity to company‐, sector‐, or market‐specific risk factors. The process of building a diversified portfolio depends on the types of assets comprising the target portfolio. For an equity portfolio, the most effective way to diversify against idiosyncratic risk is to distribute portfolio capital across assets that have low or inversely correlated price movements. This is because the primary concern when trading equities is the directional movement of the underlying, specifically to the downside. Diversifying portfolio assets, typically using instruments for a variety of companies, sectors, and markets, reduces some of this directional concentration and improves the stability of the portfolio. To understand the effectiveness of diversification by this method, consider the example outlined next. Table 7.2 shows different portfolio allocation percentages for two equity portfolios, Table 7.3 shows the correlation of the assets in both portfolios, and Figure 7.1 shows the comparative performance of the two portfolios. The historical directional tendencies are often estimated using the correlation coefficient, which quantifies the strength of the historical linear relationship between two variables. Recall that the correlation coefficient ranges from –1 to 1, with 1 corresponding to perfect positive correlation, –1 corresponding to perfect inverse correlation, and 0 corresponding to no measured correlation. Table 7.2 Two sample portfolios, each containing some percentage of market ETFs for reliable portfolio growth (SPY, QQQ), low volatility assets for diversification (GLD, TLT), and high volatility assets for increased profit potential (AMZN, AAPL). % Portfolio Allocation Portfolio A Portfolio B Market ETFs 40% 50% Low Volatility Assets 50% 0 High Volatility Assets 10% 50% These portfolio weights were determined intuitively and not by any particular quantitative methodology. This example demonstrates the effectiveness of diversification rather than providing a specific framework for achieving diversification in equity portfolios. Table 7.3 The five‐year correlation history for the assets in Portfolios A and B. Though these relationships fluctuate with time over short timescales, they are assumed to remain relatively constant long term. Correlation (2015–2020) SPY QQQ GLD TLT AMZN AAPL Market SPY 1.0 0.89 −0.13 −0.33 0.62 0.64 ETFs QQQ 0.89 1.0 −0.12 −0.26 0.75 0.74 Low Volatility GLD −0.13 −0.12 1.0 0.39 −0.12 −0.11 Assets TLT −0.33 −0.26 0.39 1.0 −0.18 −0.22 High Volatility AMZN 0.62 0.75 −0.12 −0.18 1.0 0.50 Assets AAPL 0.64 0.74 −0.11 −0.22 0.50 1.0 Table 7.2 outlines two portfolios: Portfolio A is a relatively diversified portfolio with conservative risk tolerances and moderate profit expectations, while Portfolio B is a risk tolerant and fairly concentrated portfolio. Table 7.3 shows how the elements in Portfolio B (SPY, QQQ, AMZN, AAPL) have fairly high mutual historic correlations and therefore similar directional tendencies. Comparatively, half of Portfolio A is allocated to low volatility assets that are uncorrelated or inversely correlated with the market ETFs and high volatility assets. Therefore, due to the diversifying contributions of those relatively independent assets, Portfolio A is less sensitive to outlier market events. Figure 7.1 shows how these portfolios would have performed from 2020–2021, importantly including the 2020 sell‐off and subsequent recovery. Figure 7.1 Performance comparison for Portfolios A and B from 2020 to 2021. Each portfolio begins with $100,000 in initial capital. Historic correlations have become stronger during financial crashes and sell‐offs. Stated differently, assets have become more correlated or more inversely correlated during volatile market periods. The correlations in Table 7.2 , therefore, underestimate the correlation magnitudes that would have been measured from 2020–2021. As a result of the COVID‐19 pandemic, market ETFs and highly correlated assets, such as large cap tech stocks incurred significant drawdowns. Portfolio B, half of which was high volatile tech stocks, crashed by roughly 25% from February to late March 2020. Comparatively, Portfolio A still experienced massive drawdowns but only declined by 14% during the same period. Portfolio B is significantly more exposed to market volatility than Portfolio A, resulting in a more rapid, but unstable recovery following the 2020 sell‐off. Throughout this year, Portfolio B grew by roughly 90% from its minimum in March while Portfolio A was growing by 44%, but Portfolio B was nearly twice as volatile. Nondiversified portfolios are generally more sensitive to sector‐ or market‐specific fluctuations compared to diversified portfolios. Diversifying a portfolio across asset classes reduces position concentration risk and tends to reduce loss potential in the event of turbulent market conditions. However, Figure 7.1 shows how more volatile, higher‐risk portfolios can pay off with higher profits. Due to their complex risk profiles, options are inherently more diversified relative to one another compared to their equity counterparts. Unlike equities, where the primary concern is directional risk, several factors may affect option P/L: Directional movement in the underlying price. Changes in IV. Changes in time to expiration. Because exposure to each of these variables can be controlled according to the contract parameters, varying factors, such as duration/management time, underlying, and strategy creates an additional reduction in P/L correlation that is not possible when trading equities exclusively. However, diversifying against directional risk of the underlyings remains most essential from the perspective of risk management, particularly outlier risk management. Diversifying against nondirectional risk by varying strategy or contract duration is supplemental. To understand why it is so essential to diversify the option underlyings of a portfolio, consider two market ETFs: SPY and QQQ. These assets have historically had highly correlated price dynamics and IV dynamics, as shown in the correlation matrix in Table 7.4 . The equity underlyings and IV indices are highly correlated, meaning that IV expansion events and outlier price moves tend to happen simultaneously for these two assets. When such events do occur, short premium positions with these two underlyings may experience simultaneous tail losses. To get an idea of how often these positions have incurred simultaneous outlier losses historically, refer to the strangle statistics shown in Table 7.5 . Table 7.4 Historic correlations between two market ETFs (SPY, QQQ) and the correlations between their implied volatility indices (VIX, VXN) from 2011 to 2020. Also included is the correlation between each market index and the respective VIX, for reference. Equity Price and IV Index Correlation (2011–2020) SPY QQQ VIX VXN Equities SPY 1.0 0.89 −0.80 QQQ 0.89 1.0 −0.76 Volatility VIX −0.80 1.0 0.89 Indices VXN −0.76 0.89 1.0 Table 7.5 The probability of outlier losses (worse than 200% of the initial credit) occurring simultaneously for 16 SPY strangles and 16 QQQ strangles from 2011 to 2020. All contracts have approximately the same duration (45 DTE), start date, and expiration date. The diagonal entries (SPY Strangle‐SPY Strangle, QQQ Strangle‐QQQ Strangle) indicate the probability of a strategy incurring an outlier loss individually, and the off‐diagonal entries correspond to the probability of the pair incurring outlier losses simultaneously. Probability of Loss Worse than 200% (2011–2020) SPY Strangle QQQ Strangle SPY Strangle 5.8% 3.9% QQQ Strangle 3.9% 8.7% Table 7.5 shows that it is reasonably unlikely for the pair of strategies to incur outlier losses simultaneously having occurred only 3.9% of the time. However, if these events were completely independent, then these compound losses would have occurred less than 1% of the time: . Additionally, when considering the outlier loss probability for each strategy on an individual basis, the effects of trading strangles with correlated underlyings becomes a bit clearer. For example, the probability of a SPY strangle incurring an outlier loss is 5.8%. What is the probability a QQQ strangle will incur a simultaneous outlier loss given that a SPY strangle has taken an outlier loss? To calculate this, one can use conditional probability. 1 In other words, SPY strangles and QQQ strangles may only have simultaneous outlier losses 3.9% of the time, but when a SPY strangle incurs an outlier loss, there is a 67% chance that a QQQ strangle also will. 2 Generally, the probability of a compound loss is fairly low, but when one short premium position takes a loss there is often a high likelihood an equivalent position with a correlated underlying will experience a loss of comparable magnitude. Because the loss potential of these compound occurrences is so large, it is essential to diversify underlying equities and maintain appropriate position sizes for correlated options to reduce the likelihood and impact of compounding outlier losses. Now consider two market ETFs (SPY and QQQ) and two diversifying ETFs that have been uncorrelated or inversely correlated to the market (GLD, TLT). The historic correlations are shown in Table 7.6 and the probability of outlier losses occurring simultaneously are shown in Table 7.7 . Table 7.6 Historic correlations among two market ETFs (SPY and QQQ), a gold ETF (GLD), and a bond ETF (TLT) from 2011 to 2020. Equity Price Correlation (2011–2020) SPY QQQ GLD TLT SPY 1.0 0.89 −0.03 −0.41 QQQ 0.89 1.0 −0.04 −0.34 GLD −0.03 −0.04 1.0 0.23 TLT −0.41 −0.34 0.23 1.0 Table 7.7 The probability of outlier losses (worse than 200% of the initial credit) occurring simultaneously for different types of 16 strangles held to expiration from 2011 to 2020. All contracts have approximately the same duration (45 DTE), open and close dates. The diagonal entries correspond to the probability of the specific strategy incurring an outlier loss individually, and the off‐diagonal entries correspond to the probability of the pair incurring outlier losses simultaneously. Probability of Loss Worse than 200% for Different Strangles (2011–2020) SPY QQQ GLD TLT SPY 5.8% 3.9% 2.1% 1.9% QQQ 3.9% 8.7% 1.9% 1.7% GLD 2.1% 1.9% 12% 4.8% TLT 1.9% 1.7% 4.8% 12% Again, it is relatively unlikely for any pair to incur simultaneous outlier losses, but this table shows the significant reduction in the conditional outlier probability when the underlying assets are uncorrelated or inversely correlated. Consider the following: If a SPY strangle incurs an outlier loss, there is a 67% chance of a compounding loss with a QQQ strangle. If a SPY strangle incurs an outlier loss, there is a 36% chance of a compounding loss with a GLD strangle. If a QQQ strangle incurs an outlier loss, there is a 20% chance of a compounding loss with a TLT strangle. Compound losses still occur when the underlying assets have low or inversely correlated price movements, but this reduction in likelihood is crucial nonetheless. Having a portfolio that includes uncorrelated or inversely correlated assets is particularly meaningful during periods of unexpected market volatility when most assets develop a stronger correlation to the market and there are widespread expansions in IV. Though options can be diversified with respect to several variables, diversifying the underlying assets is one of the most effective ways to reduce the impact of outlier events on a portfolio. Because diversification does not entirely remove the risk of compounding outlier losses, so maintaining small position sizes (at most 5% to 7% of portfolio capital allocated to a single position) remains critical. Maintaining Portfolio Greeks The Greeks form a set of risk measures that quantify different dimensions of exposure for options. Each contract has its own specific set of Greeks, but some Greeks have the convenient property of being additive across positions with different underlyings. Consequently, these metrics can be used to summarize the various sources of risk for a portfolio and guide adjustments. The following portfolio Greeks will be the focus of this section: Beta‐weighted delta ( ): Recall from Chapter 1 that beta is a measure of systematic risk and specifically quantifies the directional tendency of the stock relative to that of the overall market. Stocks with positive correlation to the market have positive beta and stocks with negative correlation have negative beta. is similar to delta, which is the expected change in the option price given a $1 change in the price of the underlying. When delta is beta‐weighted, the adjusted value corresponds to the expected change in the option price given a $1 change in some reference index, such as SPY. Theta ( ): The decline in an option's value due to the passage of time, all else being equal. This is generally represented as the expected decrease in an option's value per day. Maintaining the balance of these two variables is crucial for the long‐term health of a short options portfolio. represents the amount of directional exposure a position has relative to some index rather than the underlying itself. The cumulative portfolio delta represents the overall directional exposure of the portfolio relative to the market assuming that the beta index is a market ETF like SPY. Normalizing delta according to a standard underlying allows delta to be additive across all portfolio positions. This cannot be done with unweighted delta because $1 moves across different underlyings are not comparable, i.e., trying to add deltas of different positions is like adding inches and ounces. For example, a 50 sensitivity to underlying A and a 25 sensitivity to underlying B does not imply a 75 sensitivity to anything, unless A and B happen to be perfectly correlated. neutral portfolios are attractive to short premium traders because the portfolio is relatively insensitive to changes in the market, and profit is primarily driven by changes in IV and time. Adopting neutrality also simplifies aspects of the diversification process because a near‐zero indicates low directional market exposure. As the delta of a position drifts throughout the contract duration, the overall delta of the portfolio is skewed. To maintain neutrality, existing positions can be re‐centered (where the current trade is closed and reopened with a new delta), existing positions can be closed entirely, or new positions can be added. The most appropriate strategy depends on the current portfolio theta. Theta is also additive across positions because the units of theta are identical for all options ($/day). Because short premium traders consistently profit from time decay, the total theta across positions gives a reliable estimate for the expected daily growth of the portfolio. The theta ratio ( ) estimates the expected daily profit per unit of capital for a short premium portfolio. Options portfolios are subject to significant tail risk, so the expected daily profit should be significantly higher than a portfolio passively invested in the market to justify that risk. Therefore, one can determine the benchmark profit goals of an equivalent short options portfolio by referring to the daily P/L performance of a passively invested SPY portfolio as shown below in Table 7.8 . Table 7.8 Daily performance statistics for five portfolios passively invested in SPY from 2011–2021. Each portfolio has $100,000 in initial capital, and the amount of capital allocated in each portfolio ranges from 25% to 50%. SPY Allocation Percentage Daily Portfolio P/L (2011–2021) 25% 0.013% 30% 0.015% 35% 0.017% 40% 0.020% 50% 0.025% From 2011–2021, a passively invested SPY portfolio collected between 0.013% and 0.025% daily depending on the percentage of capital allocated. In other words, these portfolios had daily profits between $13 and $25 per $100,000 of capital over the past 10 years ( ). However, the expected daily profit per unit of capital for a short options portfolio should be significantly higher than this benchmark. For most traders, the minimum theta ratio should range from 0.05% to 0.1% of portfolio net liquidity to justify the tail risks of short premium. In other words, short premium portfolios should have a daily expected profit between $50 and $100 per $100,000 of portfolio buying power from decay. The theta ratio should not exceed 0.2%. A higher theta ratio is preferable, but it should not be too high due to hidden gamma risk. Gamma ( ) is the expected change in the option's delta given a $1 change in the price of the underlying. Delta neutral positions are rarely gamma neutral, and if the gamma of a position is especially high, then the delta of the trade is highly sensitive to changes in the underlying price and is generally unstable. A position with high delta sensitivity can easily affect the overall neutrality of a portfolio. The gammas of different derivatives cannot be compared across underlyings for similar reasons as to why raw delta cannot be compared across underlyings. Gamma cannot be accurately beta‐weighted as delta can; however, a positive relationship between gamma and theta presents a solution to this problem. Positions with large amounts of theta, such as trades with strikes that are close to at‐the‐money (ATM) or trades that are near expiration, typically also have large amounts of gamma risk. Because theta is additive across portfolio positions, the theta ratio is the most direct indicator of excessive gamma risk. This relationship between gamma and theta also demonstrates how short premium traders must balance the profitability of time decay with the P/L fluctuations resulting from gamma. To summarize, the theta ratio for an options portfolio should range from 0.05% to 0.1% and should not exceed 0.2%. Based on the theta ratio and the amount of capital currently allocated, existing positions should then be re‐centered, short premium positions should be added, or short premium positions should be removed. Given these benchmarks for expected daily profits, the procedure for modifying portfolio positions can be summarized as follows: If a properly allocated, a well‐diversified portfolio is neutral but does not provide a sufficient amount of theta, then the positions in the portfolio should be reevaluated. In this case, perhaps some defined risk trades should be replaced with undefined risk trades or undefined risk positions should be rolled to higher deltas. New delta neutral positions can also be added, such as strangles and iron condors, for example. IV and theta are also highly correlated, meaning that higher IV underlyings could also be considered if theta is too low. These measures can be reversed if the portfolio has too much theta exposure while being neutral. If the theta ratio is too low (<0.1%), then either existing positions should be re‐centered/tightened or new short premium positions should be added. If the is too large and positive (bullish), then add new negative positions (e.g., add short calls on positive beta underlyings or add short puts on negative beta underlyings). If the is too large and negative (bearish), then add new positive positions (e.g., add short puts on positive beta underlyings). If the theta ratio is too large (>0.2%), then either existing positions should be re‐centered/widened or short premium positions should be removed. If the is too large and positive (bullish), then remove positive positions (e.g., remove short puts on positive beta underlyings). If the is too large and negative (bearish), then remove negative positions (e.g., remove short calls on positive beta underlyings). If a properly allocated, well-diversified portfolio provides a sufficient amount of theta but is not neutral, then existing positions should be reevaluated. For example, skewed positions could be closed and re‐centered or replaced with new delta-neutral positions that offer comparable amounts of theta. Takeaways The amount of portfolio buying power allotted to short premium positions should range from 25% to 50% depending on the current market volatility, with the remaining capital either kept in cash or a low‐risk passive investment. Of the amount allocated, at least 75% should be reserved for undefined risk trades (with no more than 7% allocated to a single position), and at most 25% should be reserved for defined risk strategies (with no more than 5% allocated to a single position). The total portfolio allocation guidelines must be followed, but there is more leniency for the per‐trade allocation guidelines, especially in smaller accounts. An options portfolio is typically composed of two types of positions: core and supplemental. Core positions are usually high‐POP trades with moderate P/L variance that offer consistent profits and reasonable outlier exposure. Supplemental positions are not necessarily dependable sources of profit but rather tools for market engagement. At most 25% of the capital allocated to short premium should go toward supplemental positions. Unlike equity portfolios, options portfolios can be diversified with respect to multiple variables, such as duration/management time, underlying, and strategy. Diversifying the underlyings of an options portfolio remains the most essential diversification tool for portfolio risk management, particularly outlier risk management. Beta‐weighted delta ( ) represents the amount of directional exposure a position has relative to some index rather than the underlying itself. Portfolio theta ( ) represents the expected daily growth of the portfolio. The minimum theta ratio for an options portfolio should range from 0.05% to 0.1% and should not exceed 0.2%. Maintaining the balance of these two Greeks ensures the risk‐reward profile of an options portfolio remains as close to the target as possible. Notes 1 For an introduction to conditional probability, refer to the appendix. 2 A 67% conditional probability of a compound loss is very high but lower than the compound loss probability when trading the equivalent equities. SPY and QQQ are highly correlated and experience near‐identical drawdowns in periods of market turbulence. Therefore, that these options incur compound outlier losses only 70% of the time demonstrates the inherent diversification of options alluded to earlier. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c08.xhtml SCORE: 26.00 ================================================================================ Chapter 8 Advanced Portfolio Management Having covered the necessary basics of portfolio management, this chapter discusses supplemental optimization techniques for traders who can accommodate more active trading. The capital allocation guidelines, underlying diversification, and Greeks of a portfolio are essential to maintain and are relatively straightforward to employ. This chapter will introduce some less essential strategies: Additional option diversification techniques. Weighting assets according to probability of profit (POP). Advanced Diversification As stated in the previous chapter, one of the biggest strategic differences between equity portfolios and options portfolios is the ability to diversify risk with respect to factors other than price. Diversifying with respect to the underlying is the most effective way to reduce the effect of outlier events on a portfolio. Diversifying with respect to other variables, such as time and strategy, requires more active management but tends to reduce the profit and loss (P/L) correlation between positions. For example, consider the per‐day standard deviation of P/L for SPY strangles with different durations as shown in Figure 8.1 . Figure 8.1 Standard deviation of daily P/Ls (in dollars) for 16 SPY strangles with various durations from 2005–2021. Included are durations of (a) 15 days to expiration (DTE), (b) 30 DTE, (c) 45 DTE, and (d) 60 DTE. Short premium trades tend to have more volatile P/L swings as they approach expiration, a result of the position becoming more sensitive to changes in time and underlying price (larger gamma and theta). Because contracts with different durations have varying sensitivities to these factors at a given time, diversifying the timescales of portfolio positions reduces the correlations among their P/L dynamics. Because trading consistent contract durations is important for reaching many occurrences, the most effective way to diversify with respect to time is by trading contracts with consistent durations but a variety of expiration dates. This strategy achieves an assortment of contract durations in a portfolio at a given time without compromising the number of occurrences. Despite its efficacy, diversification with respect to time will not be thoroughly covered in this chapter because it is difficult to maintain conveniently and consistently. Strategy diversification, while not as essential as underlying diversification, is another risk management technique that is more straightforward than time diversification. This method effectively spreads portfolio capital across different risk profiles while maintaining the same directional assumption for a given underlying (or a highly correlated underlying). This lets traders capitalize on the directional dynamics of an asset while protecting a proportion of portfolio capital from outlier losses. To see an example of the diversification potential for this method, consider a backtest of three different portfolios. Each portfolio contains some combination of two directionally neutral SPY strategies: strangles and iron condors. The performance of these portfolios in this long‐term backtest is shown in Figure 8.2 and analyzed in Table 8.1 . The purpose of this backtest is not to demonstrate the profit or loss potential associated with combining SPY strangles and iron condors but rather to illustrate the possible effects of strategy diversification on portfolio risk according to one sample of outcomes. The impact of diversification is immediately clear, particularly when emphasizing the drawdowns of the 2020 sell‐off. Strangles and iron condors experienced massive drawdowns in early 2020 even though defined risk trades are lower‐risk, lower‐reward trades. The cumulative drawdowns as a percentage of portfolio capital are approximately the same across all three portfolios (roughly 150%). However, the drawdowns as a raw dollar amount were significantly larger for the strangle portfolio compared to the combined portfolio. During more regular market conditions, the combined portfolio also had a much larger POP and profit potential than the iron condor portfolio and less P/L variability and outlier risk than the strangle portfolio. Figure 8.2 Cumulative P/L of three different portfolios containing some combination of SPY strangles and SPY iron condors, held to expiration from 2005–2021. The strangle portfolio contains 10 strangles, the combined portfolio contains five strangles and five iron condors, and the iron condor portfolio contains 10 iron condors. All contracts are traded once per expiration cycle, opened at the beginning of the expiration cycle and closed at expiration. These positions have the same short delta (16 ), approximately the same duration (45 DTE), and the same open and close dates. The long strikes of the iron condors are roughly 10 . This example demonstrates how diversifying portfolio capital across defined and undefined risk strategies lets a trader capitalize on the directional tendencies of an underlying asset (or several highly correlated underlyings) while protecting a fraction of capital from unlikely outlier events. However, this example combines strategies in a highly simplified way as market implied volatility (IV), capital allocation guidelines, alternative management techniques, and strategy‐specific factors are not considered. In practice, defined and undefined risk strategies reach P/L targets at different rates and often require different management strategies. The percentage of capital allocated to a single position also depends on a number of factors, including the buying power reduction (BPR) of the trade (maximum of 5% for defined risk trades and 7% for undefined risk) and the correlation with the existing positions in a portfolio. For traders interested in a more quantitative approach to positional capital allocation, allocation weights can be estimated from the probability of profit of the strategy. Table 8.1 Statistical analysis of the three portfolios illustrated in Figure 8.2 . The first four statistics (POP, average P/L, standard deviation of P/L, and conditional value at risk (CVaR)) gauge portfolio performance during more regular market conditions (2005–2020). The final column gives the worst‐case drawdown from the 2020 sell‐off (the cumulative losses from February to March 2020). 2005–2020 2020 Sell‐Off Portfolio Type POP Average P/L Standard Deviation of P/L CVaR (5%) Worst‐Case Drawdowns Strangle 76% $379 $1,803 −$5,174 −$77,520 Combined 75% $221 $1,275 −$3,648 −$45,080 Iron Condor 67% $64 $799 −$2,324 −$12,640 Balancing Capital According to POP The proportion of capital to allocate to a position can be estimated from the POP of the strategy. An appropriate percentage of buying power can be estimated using the following formula, derived from the Kelly Criterion: 1 (8.1) where r is the annualized risk‐free rate of return, DTE is days to expiration or the contract duration (in calendar days), and POP is the probability of profit of the strategy. 2 Approximating the risk‐free rate is not straightforward because it is an unobservable market‐wide constant, but the long‐term bond rate is commonly used as a conservative estimate. For the remainder of this chapter, the risk‐free rate will be estimated at roughly 3% for the sake of simplicity. To see some examples of portfolio allocation percentages calculated using this equation, see Table 8.2 . Table 8.2 POPs and allocation percentages of buying power for 45 DTE 16 SPY, QQQ, and GLD strangles from 2011–2018. Strangle Statistics (2011–2018) POP Allocation Percentages SPY Strangle 79% 1.4% QQQ Strangle 73% 1.0% GLD Strangle 84% 1.9% The equation above suggests that the amount of portfolio buying power allocated to these positions should range from 1.0% to 1.9%, but those calculations don't take correlations between positions into account. Strategies with perfectly correlated underlyings should be counted against the same percentage of portfolio capital because Equation (8.1) requires that trades be independent of one another. In this example, because SPY and QQQ are highly correlated to each other but mutually uncorrelated with GLD, GLD strangles can occupy an entire 1.9% of portfolio buying power, and SPY strangles and QQQ strangles combined should occupy around 1.4% (the larger of the two allocation percentages). Because SPY and QQQ are not perfectly correlated, this is a conservative lower bound. Overall, these allocation percentages are fairly low because the Kelly Criterion advocates for placing many small, uncorrelated bets. When aiming to allocate between 25% and 50% of portfolio buying power, strictly abiding by these bet sizes is somewhat impractical; there just aren't enough uncorrelated underlyings. The value of the risk‐free rate provides a conservative estimate for the ideal capital allocation, so scaling these percentages up and adopting a more aggressive approach is justified. To scale up these percentages without violating the capital allocation guidelines, these bet sizes can be used as a heuristic to estimate proportions of capital allocation rather than the explicit percentages. For example, rather than allocating according to POP weights, a more heuristic approach would be as follows: According to initial estimates, 1.4% of portfolio buying power should be allocated to SPY strangles and 1.9% to GLD strangles. Dividing by 1.9, these weights correspond to a ratio of approximately 0.74:1.0. This means that SPY strangles should occupy roughly 0.74 times the portfolio buying power of GLD strangles. If the maximum per‐trade allocation of 7% goes toward GLD strangles, then approximately 5.2% (derived from ) should be allocated to SPY strangles. To continue this example, suppose that the capital allocated to SPY strangles is further split between SPY strangles and QQQ strangles. Although these underlyings are correlated, splitting capital between these positions achieves more diversification than allocating the entire 5.2% to one underlying. This process can also be estimated using the POP weights: According to initial estimates, 1.4% of portfolio buying power should be allocated to SPY strangles and 1.0% to QQQ strangles. Dividing by 2.4% (from ), these weights correspond to a ratio of approximately 0.58:0.42. This means that SPY strangles should occupy 58% of the capital allocation and QQQ strangles should occupy 42%. If a maximum of 5.2% can be allocated toward these positions, then 3.0% of portfolio capital should go toward SPY strangles and 2.2% to QQQ strangles. This scaling formula, when combined with position sizing caps of the capital allocation guidelines, allows traders to construct portfolio weights that scale with the POP of a strategy without overexposing capital to outlier risk. These two concepts form a simple but effective basis for options portfolio construction. Constructing a Sample Portfolio Throughout this section, simplified capital allocation guidelines, option diversification, and POP‐weighting are combined to create a sample portfolio. The sample portfolio shown here will be constructed using data from January 2011 to January 01, 2018 and backtested with data from January 02, 2018 to September 2019. This backtest will focus on implementing some of the portfolio construction techniques outlined in Chapters 7 and 8. This sample portfolio has six different core positions (all strangles), each occupying a constant amount of portfolio capital determined by the POP‐weight scaling method described in the previous section. The following three simplifications are made for ease of analysis and understanding: Neither market IV nor underlying IV will be considered. Scaling portfolio allocation up when market IV increases is an effective way to capitalize on higher premium prices, as is focusing on underlyings with inflated implied volatilities. Because a constant 30% of portfolio capital will be allotted to the same short premium positions throughout this backtest, profit potential will be significantly limited. Therefore, the focus of this analysis is risk management. This study only uses strangles with exchange‐traded fund (ETF) underlyings instead of a combination of strategies. This makes the portfolio approximately delta neutral and eliminates the need to justify specific directional assumptions or risk profiles for individual assets. By disregarding stock underlyings, stock‐specific binary events, such as earnings and dividends do not apply. This also means that the added profit potential from supplemental positions (which tend to be higher risk and include stock underlyings) will not be accounted for in this backtest. Rather than managing trades at fixed profit targets, all the trades shown in this backtest will be approximately opened on the first of the month and closed at the end of the month. Step 1: Identify suitable underlyings using past data. Core positions should have moderate P/L standard deviations and well‐diversified underlying assets. ETFs, such as the ones in Table 8.3 , are viable candidates for core position underlyings. Though the market ETFs are highly correlated, a sufficient number of uncorrelated and inversely correlated assets can achieve a reasonable reduction in idiosyncratic risk. Table 8.3 Correlations between different ETFs from 2011–2018. Included are two market ETFs (SPY, QQQ), a gold ETF (GLD), a bond ETF (TLT), a currency ETF (FXE ‐ Euro), and a utilities ETF (XLU). Correlation (2011–2018) SPY QQQ GLD TLT FXE XLU Market ETFs SPY 1.0 0.88 −0.02 −0.44 0.16 0.49 QQQ 0.88 1.0 −0.03 −0.36 0.12 0.35 Diversifying ETFs GLD −0.02 −0.03 1.0 0.19 0.34 0.08 TLT −0.44 −0.36 0.19 1.0 −0.03 −0.04 FXE 0.16 0.12 0.34 −0.03 1.0 0.18 XLU 0.49 0.35 0.08 −0.04 0.18 1.0 Step 2: Calculate the percentage of portfolio capital that should be allocated to each position. These percentages can be estimated with Equation (8.1) and scaled according to the methodology described in the previous section, as shown in Table 8.4 . The core positions shown in Table 8.4 are high‐POP, have moderate P/L standard deviation, and have well‐diversified underlyings, and the allocation amounts are below the 7% per‐trade buying power maximum. The total portfolio buying power allocated to short premium amounts to 30%, which is close enough to the minimum 25% to suffice for this backtest. With the portfolio initialized using data from 2011 to early 2018, it can now be backtested on new data from early 2018 to late 2019, bearing in mind that this test does not take dynamic management or implied volatility into account. The results of backtesting this sample portfolio are shown in Figure 8.3 and Table 8.5 . 3 Interestingly, Table 8.5 shows that the equity portfolio was the most volatile of the three and experienced the largest worst‐case drawdown despite having less tail exposure than the options portfolios. The POP‐weighted portfolio performed more consistently and had significantly less per‐trade standard deviation than either of the other two, with per‐trade POP matching the equal‐weight portfolio and average P/L comparable to the equity portfolio. Despite consisting of undefined risk strategies, the POP‐weighted portfolio had nearly half the P/L variability and worst‐case loss as the equity portfolio throughout the backtest period. The equal‐weight strangle portfolio also underperformed compared to the POP‐weighted portfolio although not experiencing any more P/L variance or severe drawdowns compared to a comparable portfolio of equities. To reiterate, the performance of both strangle portfolios can be further optimized by increasing the allocation percentage according to market volatility (which can be done with the addition of uncorrelated short premium positions) or by incorporating more complex management strategies. Still, this simplified backtest illustrates the impact of incorporating the risk management techniques of capital allocation, diversification, and POP‐weighted allocation. Table 8.4 Core position statistics for 45 DTE 16 strangles from 2011–2018. The allocation ratio is the allocation percentages normalized such that the largest bet size is set to 1.0. The portfolio weights are determined by multiplying the allocation ratio by 7% (the maximum per‐trade allocation percentage). The adjusted portfolio weights show how portfolio capital is split across assets that are highly correlated. Core Position Statistics (2011–2018) POP Allocation Percentages SPY Strangle 79% 1.4% QQQ Strangle 73% 1.0% GLD Strangle 84% 1.9% TLT Strangle 78% 1.3% FXE Strangle 83% 1.8% XLU Strangle 81% 1.6% Allocation Ratio SPY/QQQ:GLD:TLT:FXE:XLU 0.74:1.0:0.68:0.95:0.84 Portfolio Weights SPY/QQQ:GLD:TLT:FXE:XLU 5.2%:7.0%:4.8%:6.7%:5.9% Adjusted Portfolio Weights SPY:QQQ:GLD:TLT:FXE:XLU 3.0%:2.2%:7.0%:4.8%:6.7%:5.9% Figure 8.3 Portfolio performance of three different portfolios from early 2018 until September of 2019. Each portfolio has $200,000 in initial capital with 30% of the portfolio capital allocated. This initial amount of $200,000 allows at least one trade for each type of position, as $100,000 in initial capital does not. The 30% SPY equity portfolio (a) has 30% allocated to shares of SPY. The 30% equally‐weighted strangle portfolio (b) has 5% allocated to each of the six types of strangles, and the 30% POP‐weighted portfolio (c) has the 30% weighted according to the percentages in Table 8.4 . All contracts have the same delta (16 ), identical durations (roughly 45 DTE), and the same open and close dates. For the sake of comparison, the trades in the equity portfolio are opened on the first of each month and closed at the end of each month. Table 8.5 Portfolio backtest performance statistics for the three portfolios described in Figure 8.3 from 2018–2019. Portfolio Performance Comparison (2018–2019) Portfolio Type POP Average P/L Standard Deviation of P/L Worst Loss SPY Equity 60% $285 $2,879 −$6,319 Equal‐Weight 67% $26 $2,440 −$6,117 POP‐Weighted 67% $268 $1,610 −$3,561 The heuristic derived from the Kelly Criterion provides a good guide for how much capital should be allocated to a trade when initializing a portfolio, indicating that more capital should be allocated to higher POP trades and less capital should be allocated to less reliable trades. However, this method does not provide a thorough structure for dynamic portfolio management. At different points in time, trades often reach profit or loss targets, require strike re‐centering, or present new opportunities. Traders can simplify the complex management process by, for example, choosing the same contract duration or management strategy for all trades in a portfolio. However, a framework for navigating these dynamic circumstances is still necessary, and this is where the portfolio Greeks and the re‐balancing protocol outlined in Chapter 7 are particularly useful. Takeaways Options can be diversified with respect to a number of variables, but diversifying the equity underlyings of an options portfolio remains the most essential for portfolio risk management. Traders who can accommodate more involvement and are interested in further diversification can also diversify positions with respect to time and strategy. Diversification with respect to time tends to reduce the correlations between portfolio positions because contracts respond differently to changes in time, volatility, and underlying price depending on their duration. The most effective way to diversify with respect to time without compromising occurrences is by trading contracts with consistent durations but a variety of expiration dates. This strategy is difficult to maintain consistently, however, particularly when multiple management strategies are used. Diversifying portfolio capital across defined and undefined risk strategies allows traders to capitalize on the directional tendencies of an underlying asset while protecting a fraction of capital from unlikely outlier events. If implementing this diversification technique, note that defined and undefined risk strategies typically reach P/L targets at different rates and often require different management strategies. The percentage of capital allocated to a single position can be calculated from the POP of the strategy and the correlation between existing portfolio positions. The percentage of portfolio capital allocated to a single position can be estimated using Equation (8.1) ; however, this percentage can also be scaled up because the risk‐free rate yields a very conservative estimate. Notes 1 For an introduction to the Kelly Criterion, refer to the appendix. 2 The POPs used throughout this chapter are calculated from historic options data. Options data are ideal for statistical analyses but inaccessible to most people. Trading platforms often provide the theoretical POP of a strategy, which can substitute measured POP for these calculations. 3 This backtest demonstrates one specific outcome out of many possible when trading short premium. The goal of this backtest is to demonstrate how one sample portfolio performs relative to other portfolios with similar characteristics under these specific circumstances. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c09.xhtml SCORE: 8.00 ================================================================================ Chapter 9 Binary Events To this point, this book has highlighted unpredictable implied volatility (IV) expansions and their impact on short premium portfolios. However, traders can expect a certain class of IV expansions and contractions with near certainty. These expected volatility dynamics are the result of binary events . A binary event is a known upcoming event affecting a specific asset (or group of assets) that is anticipated to create a large price move. Though price variance is expected to increase, it may or may not actually do so depending on the outcome of the binary event. 1 Some examples of binary events include company earnings reports (motivating earnings trades), new product announcements, oil market reports, elections, and Federal Reserve announcements pertaining to the broader market. Because the date of the anticipated price swing is known, there is typically significant demand for contracts expiring on or after the binary event for that underlying asset. This increased demand results in an increase in the asset's IV, which usually contracts back to nonevent levels immediately after the outcome is known. This trend is shown in Figure 9.1 . The impact from a binary event volatility expansion differs from that of unexpected periods of market volatility because the options approaching binary events are priced to reflect the expectation of large moves in the underlying. However, the high credits and immediate volatility contractions that often result from binary events do not necessarily translate into higher (or even likely) profits for short premium positions. This is because the magnitude of the price move following the outcome of the binary event is unpredictable, and it may meet or diverge from expectations. On average, the market response to a binary event tends to be quite large, causing the short options strategies that capitalize on these conditions to be highly volatile and not necessarily profitable in the long run. This phenomenon also follows from the efficient market hypothesis (EMH), as the well‐understood nature of binary events challenges any consistent edge for these types of strategies. There is no strong evidence that buying or selling premium around binary events provides a consistent edge with respect to probability of profit (POP) or average profit and loss (P/L) because a lot of the IV overstatement edge is lost in the large moves following a binary event. However, binary event trades are a very time‐efficient use of capital because volatility contractions happen more rapidly and predictably than in more regular market conditions. Binary event trades may also be attractive to risk‐tolerant traders as a source of market engagement. During earnings season, a single week may present up to 20 high‐risk/high‐reward opportunities for earnings trades. Binary event trades can also be educational for new traders wanting to learn how to adjust positions in rapidly changing, high volatility conditions outside of sell‐offs. These types of trades, as they take place under unique circumstances, are structured and managed differently than typical core or supplemental positions. Figure 9.1 IV indexes for different stocks from 2017–2020. Assets include (a) AMZN (Amazon stock) and (b) AAPL (Apple stock). Option Strategies for Binary Events Because binary event trades are highly volatile and have no strong evidence of a long‐term statistical edge, they should only occupy spare portfolio capital and their position size should be kept exceptionally small. For example, if a trader's usual position size for an AAPL strangle is a five‐lot (five calls and five puts, each written for 100 shares of stock), then an AAPL earnings strangle may comprise a one‐ or two‐lot. Additionally, underlyings for binary event trades are typically stocks, with quarterly earnings reports being the most common type of binary event. Binary event trades take place over much shorter timescales than more typical trades and must be carefully monitored. Earnings trades, for example, are typically opened the day before earnings and closed the day following earnings. This strategy limits downside risk and capitalizes on the majority of the volatility contraction, which tends to occur immediately after the binary event. The long‐term success of binary event trades is difficult to verify because there are relatively few occurrences, resulting in high statistical uncertainty. AAPL, for example, has only reported earnings roughly 100 times since the mid 1990s. The Federal Reserve holds press conferences just eight times per year, and large‐scale elections take place once every two or four years. For trading strategies not built around earnings, there are thousands of data points and the statistics are more representative of long‐term expectations (the central limit theorem at work). Therefore, working with this small number of data points can yield an idea of how binary events trades have performed in the past, but they should be taken with a large grain of salt. Tables 9.1 – 9.3 demonstrate how earnings trades for three different tech companies have performed over 15 years. There is clearly significant variability in strategy performance for these three different underlyings. To reiterate, high statistical uncertainty makes it difficult to make definitive conclusions about the success of earnings trades, but some consistent trends are observable. Earnings trades are highly sensitive to changes in time. This is evidenced by the significant differences in the per‐trade statistics further from the earnings announcement and demonstrates why binary event trades must be closely monitored. The majority of earnings trades are usually profitable, but do not necessarily average a profit in the long term because of the high per‐trade standard deviation. Per‐trade variance and tail exposure also tend to increase the longer the trade is held, indicating why these types of trades should be relatively short term. This is why generally, binary event trades, such as earning trades, are closed the day following the binary event. Table 9.1 Statistics for 45 days to expiration (DTE) 16 AAPL strangles from 2005–2020. Trades are opened the day before an earnings report and closed either one, five, 10, or 20 days after earnings. AAPL Strangle Statistics (2005–2020) Day Position Is Closed Relative to Earnings POP Average P/L Standard Deviation of P/L Conditional Value at Risk (CVaR) (5%) Day After 72% $85 $203 –$405 5 Days After 70% $43 $400 –$1,027 10 Days After 61% $60 $408 –$1,025 20 Days After 56% −$34 $660 –$1,976 Table 9.2 Statistics for 45 DTE 16 AMZN strangles from 2005–2020. Trades are opened the day before an earnings report and closed either one, five, 10, or 20 days after earnings. AMZN Strangle Statistics (2005–2020) Day Position Is Closed Relative to Earnings POP Average P/L Standard Deviation of P/L CVaR (5%) Day After 65% $99 $803 –$1,927 5 Days After 65% $85 $842 –$2,154 10 Days After 72% $1 $1,446 –$4,416 20 Days After 76% $78 $1,540 –$4,477 Table 9.3 Statistics for 45 DTE 16 GOOGL strangles from 2005–2020. Trades are opened the day before an earnings report and closed either one, five, 10, or 20 days after earnings. GOOGL Strangle Statistics (2005–2020) Day Position Is Closed Relative to Earnings POP Average P/L Standard Deviation of P/L CVaR (5%) Day After 75% –$60 $1,320 –$4,639 5 Days After 67% –$113 $1,358 –$4,724 10 Days After 65% –$122 $1,275 –$3,675 20 Days After 71% –$2 $1,584 –$4,909 Takeaways A binary event is a known upcoming event affecting a specific asset (or group of assets) that is anticipated to create a large price move. This anticipation creates demand for options contracts expiring on or after the binary event and an increase in the IV of the asset. IV typically contracts back to nonevent levels immediately after the outcome is known. The high credits and immediate volatility contractions resulting from binary events do not necessarily translate to large or consistent short premium profits because the magnitude of the market response is unpredictable. Binary events trades are generally highly volatile and undependable sources of profit but can be used for market engagement or an educational experience for new traders. Binary event trades should only occupy spare portfolio capital and their position size should be kept exceptionally small. Binary event trades should also take place over much shorter timescales than more typical trades, and they must be carefully monitored. Note 1 The term binary is used to describe systems that can exist in one of two possible states (on/off, yes/no). In this context, a binary event is a type of event where price changes either remain within expectations or exceed expectations. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:c10.xhtml SCORE: 5.00 ================================================================================ Chapter 10 Conclusion and Key Takeaways Successful traders do not rely on luck. Rather, the long‐term success of traders depends on their ability to obtain a consistent, statistical edge from the tools, strategies, and information available. This book introduces the core concepts of options trading and teaches new traders how to capitalize on the versatility and capital efficiency of options in a personalized and responsible way. Options are fairly complicated instruments, but this book aims to lessen the learning curve by focusing on the most essential aspects of applied options trading. The detailed framework laid out in this book can be summarized succinctly in the following key takeaways: Implied volatility (IV) is a proxy for the sentiment of market risk derived from supply and demand for financial insurance. When options prices increase, IV increases; when options prices decrease, IV decreases. IV gives the perceived magnitude of future movements and is not directional. It can also be used to approximate the one standard deviation expected price range of an asset (although this does not take strike skew into account). The CBOE Volatility Index (VIX) is meant to track the IV for the S&P 500 and is used as a proxy for the perceived risk of the broader market. The VIX, like all volatility signals, is assumed to revert down following significant expansions, which indicates some statistical validity in making downward directional assumptions about volatility once it is inflated. Compared to long premium strategies, short premium strategies yield more consistent profits and have the long‐term statistical advantage. The trade‐off for receiving consistent profits is exposure to large and sometimes undefined losses, which is why the two most important goals of a short premium trader are to profit consistently enough to cover moderate, more likely losses and to construct a portfolio that can survive unlikely extreme losses. The profitability of short options strategies depends on having a large number of occurrences to reach positive statistical averages, a consequence of the law of large numbers and the central limit theorem. At minimum, approximately 200 occurrences are needed for the average profit and loss (P/L) of a strategy to converge to long‐term profit targets and more is better. Extreme losses for short premium positions are highly unlikely but typically happen when price swings in the underlying are large while the expected move range is tight (low IV). Because large price movements in low IV are rare and difficult to reliably model, the most effective way to reduce this exposure is to trade short premium once IV is elevated. Although high volatility environments are ideal for short premium positions, short premium positions have high probability of profits (POPs) and some statistical edge in all volatility environments. Additionally, because volatility is low the majority of the time, trading short options strategies in all IV environments allows traders to profit more consistently and increases the number of occurrences. To manage exposure to outlier risk when adopting this strategy, it is essential to maintain small position sizes and limit the amount of capital allocated to short premium positions, especially when IV is low. This strategy can be further improved by scaling the amount of capital allocated to short premium according to the current market conditions. VIX Range Maximum Portfolio Allocation 0–15 25% 15–20 30% 20–30 35% 30–40 40% 40+ 50% Buying power reduction (BPR) is the amount of portfolio capital required to place and maintain an option trade. The BPR for long options is merely the cost of the contract, and the BPR for short options is meant to encompass at least 95% of the potential losses for exchange‐traded fund (ETF) underlyings and 90% of the potential losses for stock underlyings. BPR is used to evaluate short premium risk on a trade‐by‐trade basis in two ways: BPR is a fairly reliable metric for the worst‐case loss of an undefined risk position, and BPR is used to determine if a position is appropriate for a portfolio based on its buying power. A defined risk trade should not occupy more than 5% of portfolio buying power and an undefined risk trade should not occupy more than 7%, with exceptions allowed for small accounts. The formulae for BPR are complicated and specific to the type of strategy, but the BPR for short strangles is approximately 20% of the price of the underlying. BPR can be used to compare the risk for variations of the same strategy (e.g., strangle on underlying A versus strangle on underlying B), but it cannot be used to compare risk for strategies with different risk profiles (e.g., strangle on underlying A versus iron condor on underlying A). Traders trade according to their personal profit goals, risk tolerances, and market beliefs, but it is generally good practice to be aware of the following: Only trade underlyings with liquid options markets to minimize illiquidity risk. The choice of underlying is somewhat arbitrary, but it's important to select an underlying with an appropriate level of risk. Stock underlyings tend to be higher‐risk, higher‐reward than ETF underlyings. This means stock underlyings present high IV opportunities more frequently, but they have more tail loss exposure and are more expensive to trade. Choose a contract duration that is an efficient use of buying power, allows for consistency, offers a reasonable number of occurrences, has manageable P/L swings throughout the duration, and has moderate ending P/L variability. Durations between 30 and 60 days are suitable for most traders. Compared to defined risk trades, undefined risk trades have higher POPs, higher profit potentials, unlimited downside risk, and higher BPRs. High‐POP defined risk trades, such as wide iron condors, have comparable risk profiles to undefined risk trades while also offering protection from extreme losses. Such trades can be better suited for low IV conditions compared to undefined risk trades and are allowed to occupy undefined risk portfolio capital. Contracts with higher deltas are higher-risk, higher-reward than contracts with lower deltas. When trading premium, consider contracts between 10Δ and 40Δ, which is large enough to achieve a reasonable amount of growth but small enough to have manageable P/L swings and ending P/L variability. When choosing a management strategy, the primary factors to consider are convenience and consistency, capital allocation preferences, desired number of occurrences, per‐trade average P/L, and per‐trade exposure. Early‐managed positions have lower per‐trade P/Ls but less tail risk than positions held to expiration. Because managing early also accommodates more occurrences and averages more P/L per day, closing positions prior to expiration and redeploying capital to new positions is generally a more efficient use of capital compared to extracting more value from an existing position. If managing according to days to expiration (DTE), consider closing trades around the contract duration midpoint to achieve a decent amount of long‐term profit and justify the tail loss exposure. If managing an undefined position according to a profit target, choosing a target between 50% and 75% of the initial credit allows for reasonable profits while also reducing the potential magnitude of outlier losses. Choosing a profit target that is too low reduces average P/L, and choosing a profit target that is too high does little to mitigate outlier risk. Profit targets for defined risk positions can be lower because they are generally less volatile. If combining strategies, managing undefined risk contracts at either 50% of the initial credit or halfway through the contract duration generally achieves reasonable, consistent profits and moderates outlier risk. If implementing a stop loss, a mid‐range stop loss threshold of at least −200% of the initial credit is practical. If the stop loss is too small (−50% for example), losses are more likely since options have significant P/L variance, although they often recover. It's also important to note that stop losses do not guarantee a maximum loss in cases of rapid price movements, so stop losses are typically paired with another management strategy unless trading passively. Stop losses are generally not suitable for defined risk strategies. Maintaining the capital allocation guidelines is crucial for limiting tail exposure and achieving a reasonable amount of long‐term growth: The amount of portfolio buying power allotted to short premium positions, such as short strangles and short iron condors, should range from 25% to 50% depending on the current market volatility, with the remaining capital either kept in cash or a low‐risk passive investment. [refer to Takeaway 5]. Of the amount allocated to short premium, at least 75% should be reserved for undefined risk trades (with less than 7% of portfolio buying power allocated to a single position) and at most 25% reserved for defined risk strategies (with less than 5% of portfolio buying power allocated to a single position) [refer to Takeaway 6]. Generally speaking, at most 25% of the capital allocated to short premium should go toward supplemental positions, or higher-risk, higher-reward trades that are tools for market engagement. The remainder should go toward core positions or trades with high POPs and moderate P/L variation that offer consistent profits and reasonable outlier exposure. Diversifying the underlyings of an options portfolio (i.e., trading a collection of assets with low correlations) is one of the most essential diversification tools for portfolio risk management, particularly outlier risk management. Strategy diversification and duration diversification, though not as essential as underlying diversification, are other straightforward risk management techniques. The Greeks form a set of risk measures that quantify different dimensions of exposure for options. Each contract has its own specific set of Greeks, but some Greeks are additive across positions with different underlyings. Consequently, these metrics can be used to summarize the various sources of risk for a portfolio and guide adjustments. Two key Greeks are beta‐weighted delta ( ) and theta ( ). Beta‐weighted delta represents the amount of directional exposure a position has relative to some index rather than the underlying itself. Theta represents the expected decrease in an option's value per day. neutral portfolios are attractive to investors because they are relatively insensitive to directional moves in the market and profit from changes in IV and time. Because short‐premium traders consistently profit from time decay, the total theta across positions gives a reliable estimate for the expected daily growth of a short options portfolio. The minimum theta ratio ( ) for an options portfolio should range from 0.05% to 0.1% and should not exceed 0.2% because this indicates excessive risk. If a portfolio is not meeting these theta ratio guidelines, then the positions should be adjusted as follows: If a properly allocated, well‐diversified portfolio is neutral but does not provide a sufficient amount of theta, then the positions in the portfolio should be reevaluated. In this case, perhaps some defined risk trades should be replaced with undefined risk trades or undefined risk positions be rolled to higher deltas. New delta neutral positions can also be added, such as strangles and iron condors, for example. IV and theta are also highly correlated, meaning that higher IV underlyings could also be considered if theta is too low. These measures can be reversed if the portfolio has too much theta exposure while being neutral. If the theta ratio is too low (<0.1%) and the portfolio is not neutral, then either existing positions should be re‐centered or tightened or new short premium positions should be added. If the is too large and positive (bullish), then add new negative positions (e.g., add short calls on positive beta underlyings or add short puts on negative beta underlyings). If the is too large and negative (bearish), then add new positive positions (e.g., add short puts on positive beta underlyings). If the theta ratio is too large (>0.2%) and the portfolio is not neutral, then either existing positions should be re‐centered or widened or short premium positions should be removed. If the is too large and positive (bullish), then remove positive positions (e.g., remove short puts on positive beta underlyings). If the is too large and negative (bearish), then remove negative positions (e.g., remove short calls on positive beta underlyings). If a properly allocated, well‐diversified portfolio provides a sufficient amount of theta but is not βΔ neutral, then existing positions should be reevaluated. For example, skewed positions could be closed and re‐centered or replaced with new delta-neutral positions that offer comparable amounts of theta. Binary event trades, such as trades around quarterly earnings reports, should be traded cautiously, only occupy spare portfolio capital, and their position size should be kept exceptionally small. Binary event trades must be carefully monitored and typically take place over much shorter timescales than more typical trades. They are often opened the day before a binary event and closed the day after. Options trading is not for everyone. However, for traders who are prepared to understand the complex risk profiles of options, comfortable accepting a certain level of exposure, and willing to commit the time to active trading, short premium strategies can offer a probabilistic edge and the potential to profit in any type of market. There is no “right” way to trade these instruments; all traders have unique profit goals and risk tolerances. It is our hope that this book will guide traders to make informed decisions that best align with their personal objectives. ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:b01.xhtml SCORE: 22.00 ================================================================================ Appendix I. The Logarithm, Log‐Normal Distribution, and Geometric Brownian Motion, with contributions from Jacob Perlman For the following section, let be the initial value of some asset or collection of assets and the value at time . Given the goals of investing, the most obvious statistic to evaluate an investment or portfolio is the profit or loss: . However, according to the efficient market hypothesis (EMH), assets should be judged relative to their initial size, represented using returns, . The returns of the asset from time 0 to time can also be written in terms of each individual return over that time frame. More specifically, for an integer , if then the returns, , can be split into a telescoping 1 product. (A.1) The EMH states that each term in this product should be independent and similarly distributed. The central limit theorem, and many other powerful tools in probability theory, concern long sums of independent random variables. To apply these tools to this telescoping product of random variables, it first must be converted into a sum of random variables. Logarithms offer a convenient way to accomplish this. Logarithmic functions are a class of functions with wide applications in science and mathematics. Though there are several equivalent definitions, the simplest is as the inverse of exponentiation. If and are positive numbers, and , then (read as “the log base of ”) is the number such that . For example, can be equivalently written as . The choice of base is largely arbitrary, only affecting the logarithm by a constant multiple. If is another possible base, then . In mathematics, the most common choice is Euler's constant, a special number: . Using this constant as a base results in the natural logarithm , denoted . The justification for this choice largely comes down to notational convenience, such as when taking derivatives: . In this example, as , using avoids the accumulation of cumbersome and not particularly meaningful constant factors. As , logarithms have the useful property 2 given by: (A.2) This property transforms the telescoping product given above into a sum of small independent pieces, given by the following equation: (A.3) The central limit theorem states that if a random variable is made by adding together many independently random pieces, then the result will be normally distributed. One can, therefore, conclude that log returns are normally distributed. Observe the following: (A.4) This suggests that stock prices follow a log‐normal distribution or a distribution where the logarithm of a random variable is normally distributed. Within the context of Black‐Scholes, this implies that stock log‐returns evolve as Brownian motion (normally distributed), and stock prices evolve as geometric Brownian motion (log‐normally distributed). The log‐normal distribution is more appropriate to describe stock prices because the log‐normal distribution cannot have negative values and is skewed according to the volatility of price, as shown in the comparisons in Figure A.1 . II. Expected Range, Strike Skew, and the Volatility Smile The majority of this book refers to expected range approximated with the following equation: (A.5) For a stock trading at current price with volatility and risk‐free rate , the Black‐Scholes theoretical price range at a future time for this asset is given by the following equation: (A.6) The equation in ( A.5 ) is a valid approximation of this formula when is small, which follows from the mathematical relation . Generally speaking, ( A.5 ) is a very rough approximation for expected range, and it becomes less accurate in high volatility conditions, when is larger. Though ( A.5 ) still yields a reasonable, back‐of‐the‐envelope estimate for expected range, the one standard deviation expected move range is calculated on most trading platforms according to the following: (A.7) Figure A.1 Comparison of the log‐normal distribution (a) and the normal distribution (b). The mean and standard deviation of the normal distribution are the exponentiated parameters of the log‐normal distribution. According to the EMH, this is simply the expected future price displacement, i.e., price of at‐the‐money (ATM) straddle, with additional terms (prices of near ATM strangles) to counterbalance the heavy tails pulling the expected value beyond the central 68%. To see how this formula compares with the ( A.5 ) approximation, consider the statistics in Table A.1 . Table A.1 Expected 30‐day price range approximations for an underlying with a price of $100 and implied volatility (IV) of 20%. According to the Black‐Scholes model, the per‐share prices for the 30‐day options are $4.58 for the straddle, $3.64 for the strangle one strike from ATM, and $2.85 for the strangle two strikes from ATM. 30‐Day Expected Price Range Comparison Equation (A.5) Equation (A.7) $5.73 $4.13 Compared to Equation (A.5) , Equation (A.7) is a more attractive way to calculate expected range on trading platforms because it is computationally simpler and independent of a rigid mathematical model. However, neither of these expected range calculations take skew into account. When comparing contracts across the options chain, an interesting phenomenon commonly observed is the volatility smile . According to the Black‐Scholes model, options with the same underlying and duration should have the same implied volatility, regardless of strike price (as volatility is a property of the underlying). However, because the market values each contract differently and implied volatility is derived from from options prices, the implied volatilities across strikes often vary. A volatility smile appears when the implied volatility is lowest for contracts near ATM and increases as the strikes move further out‐of‐the‐money (OTM). Similarly, a volatility smirk (also known as volatility skew) is a weighted volatility smile, where the options with lower strikes tend to have higher IV than options with higher strikes. The opposite of the volatility smirk is described as forward skew, which is relatively rare, having occurred, for example, with GME in early 2021. For an example of volatility skew, consider the SPY 30 days to expiration (DTE) OTM option data shown in Figure A.2 . Figure A.2 Volatility curve for OTM 30 DTE SPY calls and puts, collected on November 15, 2021, after the close. The volatility curve in Figure A.2 is clearly asymmetric around the ATM strike, with the options with lower strikes (OTM puts) having higher IVs than options with higher strikes (OTM calls). This type of curve is useful for analyzing the perceived value of OTM contracts. Compared to ATM volatility, OTM puts are generally overvalued while OTM calls are generally undervalued until very far OTM (near $510). This suggests that traders are willing to pay a higher premium to protect against downside risk compared to upside risk. This is an example of put skew, a consequence of put contracts further from ATM being perceived as equivalently risky as call contracts closer to ATM. Table A.2 reproduces data from Chapter 5 . Table A.2 Data for 16 SPY strangles with different durations from April 20, 2021. The first row is the distance between the strike for a 16 put and the price of the underlying for different DTEs (i.e., if the price of the underlying is $100 and the strike for a 16 put is $95, then the put distance is [$100 – $95]/$100 = 5%). The second row is the distance between the strike for a 16 call and the price of the underlying for different contract durations. 16 SPY Option Distance from ATM Option Type 15 DTE 30 DTE 45 DTE Put Distance 3.9% 6.5% 8.0% Call Distance 2.4% 3.9% 4.9% This skew results from market fear to the downside , meaning the market fears larger extreme moves to the downside more than extreme moves to the upside. According to the EMH, the skew has already been priced into the current value of the underlying. Hence, the put skew implies that the market views large moves to the downside as more likely than large moves to the upside but small moves to the upside as being the most likely outcome overall. For a given duration, the strikes for the 16 puts and calls approximately correspond to the one standard deviation expected range of that asset over that time frame. For example, since SPY was trading at approximately $413 on April 20, 2021, the 30‐day expected price move to the upside was $16 and the expected price move to the downside was $27 according to the 16 options. III. Conditional Probability Conditional probability is mentioned briefly in this book, but it is an interesting concept in probability theory worthy of a short discussion. Conditional probability is the probability that an event will occur, given that another event occurred. Consider the following examples: Given that the ground is wet, what is the probability that it rained? Given that the last roll of a fair die was six, what is the probability that the next roll will also be a six? Given that SPY had an up day yesterday, what is the probability it will have an up day tomorrow? Analyzing probabilities conditionally looks at the likelihood of a given outcome within the context of known information. For events and the conditional probability (read as the probability of , given ) is calculated as follows: (A.8) where is the probability that event occurs and is the probability that and occur. For example, suppose is the event that it rains on any given day and (20% chance of rain). Suppose is the event that there is a tornado on any given day, there is a 1% chance of a tornado occurring on any given day, and tornados never happen without rain, meaning that . Therefore, given that it is a rainy day, we have the following probability that a tornado will appear: In other words, a tornado is five times more likely to appear if it is raining than under regular circumstances. IV. The Kelly Criterion, derivation courtesy of Jacob Perlman The Kelly Criterion is a concept from information theory and was originally created to analyze signal transmission through noisy communication channels. It can be used to determine the optimal theoretical bet size for a repeated game, presuming the odds and payouts are known. The Kelly bet size is the fraction of the bankroll that maximizes the expected long‐term growth rate of the game, more specifically the logarithm of wealth. For a game with probability of winning and a probability of losing 1 (the full wager), the Kelly bet size is given as follows: (A.9) This is the theoretically optimal fraction of the bankroll to maximize the expected growth rate of the game. A brief justification for this formula follows from the paper listed in Reference 4. Consider a game with probability of winning and a probability of losing the full wager. If a player has in starting wealth and bets a fraction of that wealth, , on this game, the player's goal is to choose a value of that maximizes their wealth growth after bets. If the player has wins and losses in the plays of this game, then: Over many bets of this game, the log‐growth rate is then given by the following: following from the law of large numbers The bet size that maximizes the long‐term growth rate corresponds to . The Kelly Criterion can also be applied to asset management to determine the theoretically optimal allocation percentage for a trade with known (or approximated) probability of profit (POP) and edge. More specifically, for an option with a given duration and POP, the optimal fraction of the bankroll to allocate to this trade is approximately: (A.10) where is the risk‐free rate and is the duration of the trade in years. The derivation for this equation is outlined as follows: For a game with probability of winning and a probability of losing 1 unit, the expected change in bankroll after one play is given by . For an investment of time with the risk‐free rate given by , the expected change in value is estimated by , derived from the future value of the game with continuous compounding. Assuming that is small, then . For the bet to be fairly priced, the change in the bankroll should also equal . Therefore, if , the odds for this trade can be estimated as . Using this value for in the Kelly Criterion formula, one arrives at the following: This then yields the approximate optimal proportion of bankroll to allocate to a given trade, substituting for and POP for . Notes 1 So called because adjacent numerators and denominators cancel, allowing the long product to be collapsed like a telescope. 2 Stated abstractly, logarithms are the group homomorphisms between and . ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:b02.xhtml SCORE: 9.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\The Unlucky Investor_s Guide to Options Trading\The Unlucky Investor_s Guide to Options Trading.epub#section:b04.xhtml SCORE: 18.00 ================================================================================ Index Active management, 117 , 125 –126, 150 capital allocation, relationship, 79 –81 volatility trading concept, 58 Active traders, 125 Active trading, 2 –3, 123 , 149 Advanced portfolio management, 3 , 133 , 149 advanced diversification, 149 –153 capital (balancing), POP (usage), 153 –156 market/underlying IV, consideration (absence), 156 portfolio construction, 156 –160 positions, POP‐weighting, 156 straddle, price, 181 strategy diversification, 151 American options, exercise, 7 Assets combination, 38 correlation history, 138t illiquid asset, 94 management, Kelly Criterion (application), 185 portfolio, trading, 137 rates, experience, 52t realized moves, IV overstatement, 46t trading, 94 , 173 –174 universe, selection, 94 –95 volatility, 31 weighting, POP (usage), 149 At‐the‐money (ATM) contract description, 9 positions, 33 straddle, 181 strikes, 32 closeness, 99 –100, 146 Autocorrelation, 26 Backtest period, usage, 158 Beta ( β ) beta‐weighted delta, 38 , 144 –145, 148 , 174 index, assumption, 145 metric, 38 Bid‐ask spread, 94 , 95t Binary events, 3 EMH, relationship, 164 examples, 163 option strategies, 166 –167 outcomes, predictability (absence), 164 premium, buying/selling result (evidence), 164 stock‐specific binary events, 156 trades, 166 –167, 175 volatility expansion, impact, 164 Black‐Scholes assumptions, usage, 44 –45 Black‐Scholes equation, 29 European‐style option price evolution, relationship, 23 Black‐Scholes model, 22 –31, 35 , 42 , 179 , 181t assumptions, 23 , 27 , 35 , 44 , 45 Brownian motion (Wiener process), relationship, 23 –26 geometric Brownian motion, relationship, 27 –28 mathematical definition, derivation, 111 mechanics, 30 options fair price, estimate, 30 , 42 price dynamics approximation, 24 Black‐Scholes option pricing formalism, impact, 22 –23 Black‐Scholes options pricing model, 44 –45 Black‐Scholes theoretical price range, 179 Brownian motion Black‐Scholes model, relationship, 23 –26 cumulative horizontal displacements, 24 –25, 25f particle, 2D position, 25f price dynamics, comparison, 25 –26 stock log‐returns, evolution, 179 Bullish directional exposure, 90t Buying power, allocation percentages, 154t Buying Power Reduction (BPR), 3 , 66 , 83 , 153 average BPR comparison, 110t , 113t calculation, 84 capital coverage, 89 requirement, correspondence, 85 –86 definition, variation, 84 historical effectiveness, 84 IV comparison, 66 inverse relationship, 87 loss percentage, 85f margin, contrast, 84 maximum per‐trade BPR, limitation, 134 option price, inverse correlation, 87 options, capital efficiency (relationship), 90 portfolio capital amount, 171 reduction, impact, 89 result, 87t short call/put BPR, 86 short strangle BPR, 86 stock margin, option counterpart, 84 undefined risk strategies, relationship, 84 underlying IV function/underlying price function, 88f understanding, importance, 90 usage, 83 , 89 variables, dependence, 85 –86 Call option, 7 , 9 strike prices, comparison, 114t trading level (determination), Black‐Scholes model (usage), 31 Call skew, 112 Call strikes, comparison, 111 –112 Capital balancing, POP (usage), 153 –156 requirement, BPR (correspondence), 85 –86 Capital allocation amounts, differences, 78f control, 81 efficiency, active management (relationship), 79 –81 estimate, risk‐free rate value (usage), 154 –155 guidelines, 133 , 152 , 155 , 156 maintenance, 149 , 173 market IV, impact, 76t violation, avoidance, 155 position sizing, relationship, 134 –136 positional capital allocation, quantitative approach, 153 preferences, 129 , 131 , 172 proportions, estimation, 155 risk management techniques, incorporation (impact), 158 scaling, 79 , 134 short premium capital allocation, scaling up, 76 undefined risk capital allocation, sharing, 110 undefined risk strategy, usage, 110 volatility trading concept, 58 Capital at risk (comparison), BPR (usage), 89 Casinos long‐run statistical advantage, 58 , 72 –73 options trading, 1 –2 CBOE volatility index. See Volatility index Central limit theorem, 20 , 72 , 166 , 170 , 178 Company exposure, 98 Company‐specific risk, 96 Company‐specific uncertainty, 43 Conditional probability, 183 –184 calculation, 184 usage, 142 Conditional value at risk (CVaR), 63 inclusion, 40f metric, 38 usage, 39 –40, 65 –66, 123 VaR, contrast, 40 Contract delta, 33 –35, 79 , 111 , 114 implied volatility (IV), equivalence, 87 risk, 172 Contract duration middle ground contract duration, 101 selection, 94 , 99 –102 trading, importance, 151 Contracts average daily P/L and average duration, 121t extrinsic value, decrease, 34 prices, differences, 42t Core positions, 134 P/L standard deviations, presence, 156 –157 Covariance correlation, relationship, 35 –38 measures, 37 negative covariance, 36 positive covariance, 35 Cumulative horizontal displacement, 25f Cumulative horizontal displacements, 24 Daily P/Ls, standard deviation, 150f Daily returns, distribution, 39f , 40f Days to expiration (DTE), management usage, 118 –120 Defined risk, selection, 102 –104 Defined risk strategies, 152 maximum loss, 102 BPR, usage, 84 limitation, 59 P/L targets, attainment, 153 POP, usage, 110 portfolio allocation, 103t risk, comparison, 89 selection, 94 short premium allocation, 173 stop losses, unsuitability, 173 undefined risk strategies, comparison, 102t , 109 avoidance, 110 Delta (Δ), 31 –32, 106t basis, 112 beta‐weighted delta, 38 , 144 –145, 148 , 174 contract delta, 33 –35, 79 , 111 , 114 implied volatility (IV), equivalence, 87 contract risk, 172 contract usage, 32 directional exposure measurement, 111 drift, 145 level, 114 magnitude, 32 , 114 negative delta/positive delta, 33 neutral position, 33 , 61 , 146 , 156 neutral positions profit, 111 normalization, 145 perceived risk measure, 112 –113 raw delta, comparisons (impossibility), 146 –147 re‐centering, 114 scaling up, 114 selection, 94 , 111 –115 optimum, factors, 114 sensitivity, 146 sign, 32 value, range, 32 Derivatives, gamma comparison (impossibility), 146 –147 Deterministic price trends, 28 –29 Dice rolls, histogram, 13 , 14f , 17f , 19f , 21f Directional assumption, selection, 94 , 104 –110 Directional exposure (measurement), delta (usage), 111 Directional risk, degree (measure), 32 Distributions asymmetry (measure), skew (usage), 65 mean (histogram), 17e normal distribution, 22f , 44 –45, 180f skew, 16 –18, 20 , 39 statistics, understanding, 21 –22 Diversification, 136 –144, 158 effectiveness, understanding, 137 –138 time diversification, 151 tools, 173 Dividends payment, avoidance, 23 Downside risk amount, preference, 104 limitation, absence, 102 Downside skew, 112 Early‐managed contracts, 126 , 129 occurrences allowance, 80 Early‐managed portfolio, losses, 129 Early‐management strategies, 80 Earnings dates, marking, 54f Earnings report, 115 dates, 53 , 96 , 102 impact, 43 inclusion, 163 quarterly earnings report (single‐company factors), 52 , 166 , 175 Efficient market hypothesis (EMH), 11 –13, 177 –178, 183 binary events, relationship, 164 forms, 11 –12, 104 –105 interpretation, 104 , 116 Equities implied volatility indexes, 54f pricing/bid‐ask spread/volume data, 95t trading, 137 , 140 European call options, 29 European options, expiration (payoff), 29 European‐style option (price evolution), Black‐Scholes equation (relationship), 23 Events outcomes, 44 –45 sampling, probability distribution (usage), 72 Exchange‐traded funds (ETFs), 5 –7, 36 , 157 BPR, historical effectiveness, 84 correlations, 157t diversification, 53 –54, 134 historical risk, approximation, 63 IV overstatement rates, 46 market ETFs, 139 –142, 145 , 157 volatility assets, correlation, 139 skewed returns distribution, 22 stability, 98 underlyings, 95 , 135 , 137 , 172 advantages/disadvantages, 96t losses, 84 , 171 strangles, usage, 156 usage, 97 volatility profiles, differences, 96 Expected move cones, 44 , 45f , 60f Expected move range, 179 Expected price range, 45f Expected range, 58 , 179 –183 adjustment, 68 –69 calculation, 43 –45, 47 , 179 , 181 estimates, 44 increase, 115 short strike prices, relationship, 111 tightness, 51 underlying price expected range, 60 –61 External events, outlier underlying moves/IV expansions (relationship), 58 Financial derivative, options (comparison), 7 Financial insurance, risk‐reward trade‐off, 47 Gamma ( Γ ), 31 , 33 comparison, impossibility, 146 –147 increase, 79 magnitude, 33 risk, 146 –147 Gaussian distribution (bell curve), 20 Geometric Brownian motion, Black‐Scholes model (relationship), 27 –28 GLD returns, SPY returns (contrast), 36f Greeks, 31 –35. See also Delta ; Gamma ; Sigma ; Theta assumptions, 35 balance, 148 option Greeks, 38 portfolio Greeks, 160 maintenance, 133 , 144 –147 risk measures, 174 Heteroscedasticity, 26 High implied volatility (high IV) short premium trading, 75 trading, 66 –72, 75 Histogram daily returns/prices, 27f dice rolls, 14f , 17f , 19f , 21f Historical distribution, 73f Historical P/L distribution, 62f , 64f , 71f Historical returns, standard deviation, 28 , 30 Historical tail risk, estimation, 65 Historical volatility, 21 –22, 38 increase, 42 market historical volatility, 69 representation, 43 stock historical volatility, 30 underlying historical volatility, 31 usage, 30 , 63 Historic risk, estimation, 21 –22 Horizontal displacements, distribution, 26f Hurricane insurance price, proportion, 47 sellers, strategic room, 47 –48 Idiosyncratic risk, 137 Illiquid asset, example, 94 Illiquidity risk, minimization, 171 Implied volatility (IV), 3 , 38 , 41 , 83 , 169 –170, 181 basis, 48 BPR comparison, 66 inverse volatility, 87 contract delta, equivalence, 87 contraction, 50 conversion, 66 correlation, 42 –43 decrease/increase, 42 –43, 87 , 89 derivation, 44 –45 differences, 42t environments, short option strategies (trading), 76 expansion, 58 , 122 –123, 163 indexes, 53f , 54f , 165f indication, 30 IV‐derived price range, 44 –45 long‐term baseline reversion, 52 metric, importance, 30 –31 overstatement, 46 , 46t , 164 profits, 58 rates, 47 peak, increase, 49 price range forecast, 47 ranges, 76t realized risk measurement, 46 reversion, 51 –54 signals, capacity, 51 source, 23 SPY annualized implied volatility (tracking), 48 SPY implied volatility, 69f standard deviation range, 43 tracking, 48 trading (volatility trading concept), 58 underlying IV, 60 , 86 , 88f usage, 41 , 134 Implied volatility percentile (IVP), 66 –68 Implied volatility rank (IVR), 68 Increments, distribution, 26f Insider trading, 12 , 105 In‐the‐money (ITM), 99 contract description, 9 ITM put, price, 10 long calls ITM, 33 movement, 34 –35 options, directional risk, 114 positions, 34 relationship, 32 Iron condors, 105 , 110t , 151 cap, long wings, 106 , 108 drawdowns, experience, 151 narrow wings, POP (presence), 109 neutral SPY strategies, 151 profit potential, 109 representation, 107f risk, 110 short iron condor BPR, 108 short iron condors, range, 134 , 173 statistical comparison, 109t underlying strangle, contrast, 171 wide iron condors, 116 , 172 wide wings, inclusion (trading), 109 wings, inclusion, 106 Kelly Criterion application, 185 buying power percentage, 153 derivation, 184 –186 formula, 186 heuristic derivation, 160 uncorrelated bets, 154 Law of large numbers, 72 , 170 , 185 Liquidity importance, understanding, 94 net liquidity, 89t options liquidity, 94 –95 portfolio net liquidity, 104 , 145 theta ratio/net portfolio liquidity, 145 Log‐normal distribution, 177 comparison, 180f skew, 179 stock prices, relationship, 179 Log returns equation, 7 standard deviation, 23 Long call, 32 , 34 addition, 106 directional assumption, 8t option, price, 32 , 111 P/L, 10 –11 position, 33 profit potential, 90 Long premium contracts, impact, 84 positions, profit yield (comparison), 12 strategies, 58 , 170 trade, 8 Long put, 32 , 34 addition, 106 directional assumption, 8t option, price, 111 P/L, 10 –11 position, 33 Long stock, 32 Long strikes, 207f Loss incurring, probability, 113t targets, 122t , 123 Low‐loss targets, attainment, 122 Management P/L target, usage, 120 –124 techniques, 123 –126, 152 timeline, usage, 118 –119 Management strategies, 121t , 122t , 158 average daily P/L and average duration, 121t impact/comparison, 79 –80, 80t , 102 long‐term risks, 126 , 129 performance, scenarios (impact), 126 qualitative comparison, 125t selection, 172 usage, 117 –118 Management time, selection, 119 , 129 Margin, BPR (contrast), 84 Market conditions, risk/return expectations, 35 exposure, 98 frictionlessness, 23 historical volatility, 69 implied volatility (IV), 76t , 152 perceived uncertainty, 46 trader beliefs, 171 –172 uncertainty sentiment, IV tracking, 48 volatility amounts, differences, 89t Market ETFs, 139 –142, 145 , 157 historic correlations, 141t , 143t percentage, 138t volatility assets, correlation, 139 Market risk sentiment, IV proxy, 42 sentiment, IV proxy (usage), 169 –170 Maximum per‐trade BPR, limitation, 134 Mean (moment), 14 –15 Middle ground contract duration, 101 Mid‐range stop loss, 123 , 130 , 173 Moments, 14 –22 Near‐the‐money options, gamma (increase), 79 Negative covariance, 36 Non‐dividend‐paying stock, trading, 30 –31 Non‐fungible tokens (NFTs), 5 Normal distribution comparison, 180f mean/standard deviation, 180f plot, 22f standard deviation range, 44 –45 Occurrences, 62f , 71f , 101 compound occurrences, loss potential, 142 concentration, 20 consistency, 117 density, 64 early‐managed contract allowance, 80 final P/L, correspondence, 61 goal, 125 –126, 151 increase, 117 P/L distribution, 39 reduction/increase, 72 , 89 , 124 standard deviation range, 64 VIX level, contrast, 67 Occurrences, number, 58 , 72 –76, 99 attainment, 99 compromise, absence, 151 increase, 81 , 101 –102, 118 presence, 15 , 126 , 129 trade‐off, 119 volatility trading concept, 58 Off‐diagonal entries, 141t Options, 5 –6 buying, profit, 57 –58 capital efficiency, BPR (relationship), 90 demand, 42 –43 fair price (estimation), Black‐Scholes model (usage), 30 , 42 financial derivative, comparison, 7 Greeks, 38 illiquidity, risk, 94 leverage, effects (clarity), 90 liquidity, 94 –95 market, liquidity, 98 P/L standard deviation, usage, 73 P/L statistics, 97t price, BPR (inverse correlation), 87 profitability, 10 risk, visualization, 59 –63 traders, assumptions, 11 types, 7 underlyings, sample, 98t Options trading, 84 , 97 , 102 , 169 , 175 casinos, usage, 1 –2 diversification, importance, 136 ETF underlyings, usage, 97 gamma, awareness (importance), 33 implied volatility metric, 30 –31 reversion, 51 learning curve/math knowledge, 3 option theory, transition, 90 profitability, option pricing (impact), 11 quantitative options trading, 3 retail options trading, assets (suitability), 94 risk management, relationship, 2 usage, market performance, 12 Outlier losses, 142 capital exposure, limitation, 134 probability, 141t Outlier risk carrying, avoidance, 103 reduction, 76 Out‐of‐the‐money (OTM) contract description, 9 positions, 34 volatility curve, 182f Over‐the‐counter (OTC) options, 7 Passive investment, daily performance statistics, 146t Passive traders, 125 Perceived risk (measurement), delta (usage), 112 –113 Personal profit goals, 171 –172 Per‐trade allocation percentage, 158t Per‐trade standard deviation, 158 , 166 Per‐trade statistics, differences, 166 Per‐trade variance, 167 P/L targets, attainment, 153 Portfolio averages, variance, 74f backtest performance statistics, 159t concentration excess, avoidance, 77 construction, 12 , 156 –160 cumulative P/L, 152f delta skew, 145 expected loss, CVaR estimate, 40 Greeks, 149 , 160 maintenance, 133 , 144 –147 net liquidity, 89t , 104 , 146 passive investment, daily performance statistics, 146t performance, 159f comparison, 139f P/L averages, 74f POP‐weighted portfolio, 157 –158 risk management, diversification tools, 173 statistical analysis, 153t Portfolio allocation, 109 defined/undefined risk strategies, 103t guidelines, usage, 89 , 104 , 134 percentages, 137 –138, 138t , 154 , 154t position sizing, relationship, 75 –79 scaling, 77 , 156 strategies, comparison, 77 usage, 103 volatility trading concept, 58 Portfolio buying power, 83 , 89 , 134 allotment/allocation, 134 –135, 154 –155, 157 defined risk position occupation, 118 expected profit, 146 undefined risk strategy occupation, 110 usage, 99 , 109 , 117 Portfolio capital allocation control, 81 guidelines, market IV (impact), 76t amount, BPR (relationship), 171 diversification, 152 investment, 127f , 128f Portfolio management, 3 , 93 , 149 back‐of‐the‐envelope tactics, 133 beta ( β ) metric, importance, 38 capital allocation, 134 –136 capital balancing, POP (usage), 153 –156 concepts, 133 construction, 156 –160 diversification, usage, 136 –144, 149 –153 portfolio Greeks, maintenance, 144 –147 position sizing, 134 –136 simplification, 101 Positional capital allocation, quantitative approach, 153 Positions core position statistics, 158t delta drift, 145 delta level, 114 expected loss, CVaR estimate, 40 intrinsic value, 9 ITM, relationship, 32 long side/short side, adoption, 8 management, 118 P/L correlation, reduction, 150 POP‐weighting, 156 profiting, likelihood, 104 sizing capital allocation, relationship, 134 –136 portfolio allocation, relationship, 75 –79 volatility trading concept, 58 Positive covariance, 35 Premium sellers, profit, 50 Premium, trading, 172 Price dynamics Black‐Scholes model approximation, 24 Brownian motion, comparison, 25 –26 Price predictability (limitation), EMH implications, 105 Probabilistic system, probability distribution, 14 Probability distribution, 13 –22 asymmetry, 16 events sampling, 72 Gaussian distribution (bell curve), 20 mean (moment), 14 –15 normal distribution, 20 skew (moment), 16 –22 variance (moment), 15 –16 Probability of profit (POP), 89 , 164 , 185 asset weighting, 149 buying power, allocation percentages, 154t capital, balancing, 153 –156 decrease, 114 dependence, 77 heuristic, 160 IV ranges, 76t level, elevation, 61 , 90 , 105 , 108 –109, 120 , 123 –124, 151 percentage, 62 , 73 , 109 POP‐weighted allocation, 158 POP‐weighted portfolio, 157 –158, 159t POP‐weight scaling method, 156 positions, POP‐weighting, 156 profit potential, differences, 103 selection, 2 statistics, 80t , 97t , 153t trade‐off, 63 trades, level (elevation), 134 usage, 110 , 149 , 153 , 185 –186 weights, usage, 155 yield, 121 Product indifference, 97 –98 Profitability, considerations, 8t Profit and loss (P/L) average daily P/L, 121t average P/L, 76t , 164 averages, 74f cumulative P/L, 152f daily P/Ls, standard deviation, 150f distribution skew, 62 –63 expectations, 135 frequency, 124 historical distribution, 73f historical P/L distribution, 62f , 64f , 71f IV ranges, 76t per‐day standard deviation, 150 standard deviation, 134 , 153t , 157 carrying, 120 –121 core position usage, 156 –157 reduction, 118 –119, 122 , 126 trade‐offs, 124 usage, 63 –65, 74 –75, 80t , 99 , 100t , 123 swings, 79 , 97 magnitude, 98 tolerance, 97 –98 Profit potential, POP differences, 103 level, elevation, 151 Profit targets, 104 , 120t , 123 Put options, 9 Put prices, differences, 98t Put skew, 112 Puts (option type), 7 QQQ returns, SPY returns (contrast), 36f , 37 strangles, outlier losses, 142 Quantitative options trading, 3 Quarterly earnings report (single‐company factors), 52 , 166 , 175 Random variable, probability distribution, 13 Realized moves, IV overstatement, 46t Realized risk (measurement), IV (usage), 46 Realized volatility, IV overstatement, 46 Reference index, usage, 144 Relative volatility, metrics, 66 –68 Retail options trading, assets (suitability), 94 Returns distributions skews, 22 past volatility/future volatility, 43 standard deviation, 21 –22 usage, 63 Risk approximation, 30 categories, 137 measures, 38 –40 minimization, liquidity (impact), 95 reduction, trade‐by‐trade basis, 117 sentiment, measure, 30 –31 tolerances, 171 –172 trade‐off, 12 Risk‐free rate, 29 approximation, 154 value, usage, 154 –155 Risk management, 2 –3, 37 , 140 , 156 importance, 51 strategy/technique, 136 , 151 , 158 , 174 Risk‐reward trade‐off, 59 Sector exposure, 98 Sector‐specific risk, 96 Sell‐offs 2020 sell‐off, performances (2017‐2021), 78f volatility conditions, 164 Semi‐strong EMH, 12 , 104 –105 Short call, 32 , 34 addition, 147 , 175 BPR, 86 directional assumption, 8t P/L, 10 –11 position, 33 removal, 175 short put, pairing, 33 strike, 60 undefined risk, 59 Short‐call/put BPR, 86 Short iron condors, range, 134 , 173 Short options P/L distribution skew, 63 trading, capital requirements, 90 Short option strategies, 106t profitability, factors, 170 trading, 76 , 170 Short premium allocation, 173 capital allocation, scaling up, 76 positions, losses (unlikelihood), 170 risk (evaluation), BPR (usage), 83 strategies, POP trade‐off, 63 traders, profit, 51 Short premium trading, 48 , 114 benefits, 68 implied volatility elevation, impact, 71 importance, 59 mechanics, 57 risk‐reward trade‐off, 59 Short put, 34 addition, 147 , 174 –175 BPR, 86 bullish strategy, 32 directional assumption, 8t position, 33 removal, 175 strike, 60 Short strangles, POP level (elevation), 61 Short strike prices, expected range (relationship), 111 Short volatility trading, 83 Sigma ( σ ), 15 Single‐company factors, 52 –53 Single company risk factors, impact, 46 Skew, 68 amount, consideration, 71 contextualization, 65 distribution skew, 16 –18, 20 , 39 log‐normal distribution skew, 179 magnitude, decrease, 72 moment, 16 –22 P/L distribution skew, 62 –63 portfolio delta skew, 145 pure number, 17 reduction, 71 –72 returns distribution skews, 22 strike skew, 111 –112, 179 –183 tail skew, usage, 39 usage, 65 –66 volatility skew (volatility smirk), 181 SPDR S&P 500 (SPY) annualized implied volatility, tracking, 48 daily returns distribution, 39f , 40f expected move cone, 45f expected price ranges, 44 histogram, daily returns/prices, 27f implied volatility (IV), 69f , 70f iron condors, wings (inclusion), 107t –110t neutral SPY strategies, 151 price, 112f change, 60f , 78f trends, 24 returns, QQQ/TLT/GLD returns (contrast), 36f , 37 trading level, 183 SPDR S&P 500 (SPY) strangles, 64f , 73f BPR loss, 85f data (2005‐2021), 88f , 89t deltas (differences), statistical comparison, 113t durations, differences, 183t example, 107t initial credits, 108t management statistics, 119t , 120t , 122t , 124t , 125t strategies, comparison, 80t outlier losses, 142 P/L per‐day standard deviation, 150 stability, 63 VIX level labeling, 69f Standard deviation, 20 –21 daily P/Ls, standard deviation, 150 estimates, 16 expected move range, 179 expected range, 60 strikes, correspondence, 183 histogram, 17f historical returns, standard deviation, 28 , 30 indication, 16 interpretation, 18 –19, 64 –65 log returns, standard deviation, 23 normal distribution usage, 180f per‐trade standard deviation, 158 , 166 P/L per‐day standard deviation, 150 P/L standard deviation, 63 –65, 74 –75, 80t , 99 , 100t , 134 , 153t , 157 carrying, 120 –121 reduction, 118 –119, 122 , 126 trade‐offs, 124 usage, 123 probabilities, 22f range, sigma ( σ ), 37 , 43 –45, 64 –65 representation, 15 returns, standard deviation, 21 –22 sigma ( σ ), 15 usage, 63 –65 Steady‐state value, 48 Stocks, 5 –6 historical risk, approximation, 63 historical volatility, 30 IV overstatement rates, 46 liquidity, 94 –95 log returns, 23 options, trading, 96 –97 prices differences, 98t log‐normal distribution, relationship, 179 skewed returns distributions, 22 stock‐specific binary events, 156 trading, 90 , 179 margin, usage, 84 underlyings advantages/disadvantages, 96t trading, 135 volatility profiles, differences, 96 Stop loss, 122 application, 129 implementation, 122 , 130 , 173 mid‐range stop loss, 123 , 130 , 173 threshold, usage, 122 –123 usage, 123 –125 Straddles ATM straddle, price, 181 trades, BPR result, 87t Strangles, 105 buyer assumption, 61 drawdowns, experience, 151 durations, differences, 101t magnitude, 65 management strategies, 123 neutral SPY strategies, 151 P/L distributions, skew/tail losses, 71 –72 sale, BPR requirement, 86 seller, profit, 61 short strangle BPR, 86 statistics, 167t management, 122t , 136t trades, examples, 87t trading, effects, 142 usage, 156 Strategy‐specific factors, 152 –153 Strike skew, 111 –112, 179 –183 Strikes long strikes, 107f prices, comparison, 114t range, 104 standard deviation, expected range (correspondence), 183 Strong EMH, 12 , 104 –105 Supplemental positions, 134 Swaptions, 5 Systemic risk, 137 Tail exposure limitation, capital allocation guidelines (maintenance), 173 magnitude, 98 Tail losses CVaR sensitivity, 40 reduction, 71 –72 Tail risk, 83 , 103 , 121 , 145 acceptance, 57 carrying, 58 , 62 , 120 elimination, 122 –123 exposure, 102 , 135 historical tail risk, estimation, 65 increase, 97 , 108 –109, 119 inherent tail risk, justification, 121 mitigation, 135 –136 negative tail risk, 65 , 72 , 80 Tail skew, usage, 39 Theta ( Θ ), 31 , 34 , 144 , 174 additivity, 145 –147 ratio, size (reaction), 147 theta ratio/net liquidity, 174 theta ratio/net portfolio liquidity, 145 Time diversification, 151 TLT returns, SPY returns (contrast), 36f Trade‐by‐trade basis, 79 –80, 117 , 125 –126 Trade‐by‐trade performance, comparison, 118 Trade‐by‐trade risk tolerances, 119 –120 Trades BPR, 98 bullish directional exposure, 90t management, 3 , 80 –81, 117 –118 strategies, usage, 101 maximum loss, reduction, 108 Trades, construction, 93 asset universe, selection, 94 –95 contract duration, selection, 99 –102 defined risk, selection, 102 –104 delta, selection, 111 –115 directional assumption, selection, 104 –110 procedure, 94 undefined risk, selection, 102 –104 underlying, selection, 96 –98 Trading engagement, preferences, 124 mechanics, 48 platforms, usage, 179 , 181 strategies, 129 , 166 Uncertainty sentiment, IV tracking, 48 Undefined risk capital allocation, sharing, 110 selection, 102 –104 Undefined risk strategies, 59 , 152 BPR, relationship, 84 , 103 defined risk strategies, comparison, 102t , 109 avoidance, 110 downside risk, limitation (absence), 102 gain, limitation, 84 loss, limitation (absence), 59 , 84 management, focus, 118 P/L targets, attainment, 153 portfolio allocation, 103t risk, comparison, 89 selection, 94 short premium allocation, 173 trader compensation, 103 Underlying historical volatility, 31 increase, 42 implied volatility (IV), 98 option underlyings, sample, 98t selection, 94 , 96 –98 strangle, iron condor (contrast), 171 Underlying price BPR function, 88f expected range, 60 –61, 181t Upside skew, 112 Value at risk (VaR). See Conditional value at risk CVaR, contrast, 40 distribution statistic, 39 inclusion, 39f , 40f Variance moment, 15 –16 per‐trade variance, 166 –167 Volatility curve, 182 expansions, 50 –51 forecast, 43 realized volatility, IV overstatement, 46 reversion, 105 smile, 179 –183 smirk (volatility skew), 181 trading, 41 , 44 –48, 58 Volatility assets, market ETFs (correlation), 139 Volatility index (VIX) (CBOE volatility index), 51 , 60 , 78f 2008 sell‐off, 50 , 63 2020 sell‐off, 50 , 63 , 77 , 78f comparison, 89 contraction, 50 contracts, acceleration, 49 correlations, 141t expansion, 48 increase, 54 IVP labeling, 67f levels, 127f , 128f differences, 103t SPY strangles, labeling, 69f long‐term average, 67 , 69 long‐term behavior, 66 lull/expansion/contraction, 49 occurrences, relationship, 71f phases, 49f range, 48 , 66 , 72 , 171 reduction/increase, 69 , 134 frequency, 75t spikes, causes, 50 states, 48 –51 valuation, 135 VXAZN IVP values labeling, 67f level, 66 Weak EMH, 11 , 29 , 31 , 104 –105 Wide iron condors, 116 , 172 Wide wings, usage, 109 Wiener process, 29 Black‐Scholes model, relationship, 23 –26 increments, distribution, 26f Wings, 105 ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html SCORE: 115.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html SCORE: 56.00 ================================================================================ CHAPTER 2 Greek Philosophy My wife, Kathleen, is not an options trader. Au contraire. However, she, like just about everyone, uses them from time to time—though without really thinking about it. She was on eBay the other day bidding on a pair of shoes. The bid was $45 with three days left to go. She was concerned about the price rising too much and missing the chance to buy them at what she thought was a good price. She noticed, though, that someone else was selling the same shoes with a buy-it-now price of $49—a good-enough price in her opinion. Kathleen was effectively afforded a call option. She had the opportunity to buy the shoes at (the strike price of) $49, a right she could exercise until the offer expired. The biggest difference between the option in the eBay scenario and the sort of options discussed in this book is transferability. Actual options are tradable—they can be bought and sold. And it is the contract itself that has value—there is one more iteration of pricing. For example, imagine the $49 opportunity was a coupon or certificate that guaranteed the price of $49, which could be passed along from one person to another. And there was the chance that the $49-price guarantee could represent a discount on the price paid for the shoes—maybe a big discount—should the price of the shoes rise in the eBay auction. The certificate guaranteeing the $49 would have value. Anyone planning to buy the shoes would want the safety of knowing they were guaranteed not to pay more than $49 for the shoes. In fact, some people would even consider paying to buy the certificate itself if they thought the price of the shoes might rise significantly. Price vs. Value: How Traders Use Option-Pricing Models Like in the common-life example just discussed, the right to buy or sell an underlying security—that is, an option—can have value, too. The specific value of an option is determined by supply and demand. There are several variables in an option contract, however, that can influence a trader’s willingness to demand (desire to buy) or supply (desire to sell) an option at a given price. For example, a trader would rather own—that is, there would be higher demand for—an option that has more time until expiration than a shorter-dated option, all else held constant. And a trader would rather own a call with a lower strike than a higher strike, all else kept constant, because it would give the right to buy at a lower price. Several elements contribute to the value of an option. It took academics many years to figure out exactly what those elements are. Fischer Black and Myron Scholes together pioneered research in this area at the University of Chicago. Ultimately, their work led to a Nobel Prize for Myron Scholes. Fischer Black died before he could be honored. In 1973, Black and Scholes published a paper called “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy , that introduced the Black-Scholes option-pricing model to the world. The Black-Scholes model values European call options on non-dividend-paying stocks. Here, for the first time, was a widely accepted model illustrating what goes into the pricing of an option. Option prices were no longer wild guesswork. They could now be rationalized. Soon, additional models and alterations to the Black-Scholes model were developed for options on indexes, dividend-paying stocks, bonds, commodities, and other optionable instruments. All the option-pricing models commonly in use today have slightly different means but achieve the same end: the option’s theoretical value. For American-exercise equity options, six inputs are entered into any option-pricing model to generate a theoretical value: stock price, strike price, time until expiration, interest rate, dividends, and volatility. Theoretical value—what a concept! A trader plugs six numbers into a pricing model, and it tells him what the option is worth, right? Well, in practical terms, that’s not exactly how it works. An option is worth what the market bears. Economists call this price discovery. The price of an option is determined by the forces of supply and demand working in a free and open market. Herein lies an important concept for option traders: the difference between price and value. Price can be observed rather easily from any source that offers option quotes (web sites, your broker, quote vendors, and so on). Value is calculated by a pricing model. But, in practice, the theoretical value is really not an output at all. It is already known: the market determines it. The trader rectifies price and value by setting the theoretical value to fall between the bid and the offer of the option by adjusting the inputs to the model. Professional traders often refer to the theoretical value as the fair value of the option. At this point, please note the absence of the mathematical formula for the Black-Scholes model (or any other pricing model, for that matter). Although the foundation of trading option greeks is mathematical, this book will keep the math to a minimum—which is still quite a bit. The focus of this book is on practical applications, not academic theory. It’s about learning to drive the car, not mastering its engineering. The trader has an equation with six inputs equaling one known output. What good is this equation? An option-pricing model helps a trader understand how market forces affect the value of an option. Five of the six inputs are dynamic; the only constant is the strike price of the option in question. If the price of the option changes, it’s because one or more of the five variable inputs has changed. These variables are independent of each other, but they can change in harmony, having either a cumulative or net effect on the option’s value. An option trader needs to be concerned with the relationship of these variables (price, time, volatility, interest). This multidimensional view of asset pricing is unique to option traders. Delta The five figures commonly used by option traders are represented by Greek letters: delta, gamma, theta, vega, rho. The figures are referred to as option greeks. Vega, of course, is not an actual letter of the greek alphabet, but in the options vernacular, it is considered one of the greeks. The greeks are a derivation of an option-pricing model, and each Greek letter represents a specific sensitivity to influences on the option’s value. To understand concepts represented by these five figures, we’ll start with delta, which is defined in four ways: 1. The rate of change of an option value relative to a change in the underlying stock price. 2. The derivative of the graph of an option value in relation to the stock price. 3. The equivalent of underlying shares represented by an option position. 4. The estimate of the likelihood of an option expiring in-the-money. 1 Definition 1 : Delta (Δ) is the rate of change of an option’s value relative to a change in the price of the underlying security. A trader who is bullish on a particular stock may choose to buy a call instead of buying the underlying security. If the price of the stock rises by $1, the trader would expect to profit on the call—but by how much? To answer that question, the trader must consider the delta of the option. Delta is stated as a percentage. If an option has a 50 delta, its price will change by 50 percent of the change of the underlying stock price. Delta is generally written as either a whole number, without the percent sign, or as a decimal. So if an option has a 50 percent delta, this will be indicated as 0.50, or 50. For the most part, we’ll use the former convention in our discussion. Call values increase when the underlying stock price increases and vice versa. Because calls have this positive correlation with the underlying, they have positive deltas. Here is a simplified example of the effect of delta on an option: Consider a $60 stock with a call option that has a 0.50 delta and is trading for 3.00. Considering only the delta, if the stock price increases by $1, the theoretical value of the call will rise by 0.50. That’s 50 percent of the stock price change. The new call value will be 3.50. If the stock price decreases by $1, the 0.50 delta will cause the call to decrease in value by 0.50, from 3.00 to 2.50. Puts have a negative correlation to the underlying. That is, put values decrease when the stock price rises and vice versa. Puts, therefore, have negative deltas. Here is a simplified example of the delta effect on a −0.40-delta put: As the stock rises from $60 to $61, the delta of −0.40 causes the put value to go from $2.25 to $1.85. The put decreases by 40 percent of the stock price increase. If the stock price instead declined by $1, the put value would increase by $0.40, to $2.65. Unfortunately, real life is a bit more complicated than the simplified examples of delta used here. In reality, the value of both the call and the put will likely be higher with the stock at $61 than was shown in these examples. We’ll expand on this concept later when we tackle the topic of gamma. Definition 2 : Delta can also be described another way. Exhibit 2.1 shows the value of a call option with three months to expiration at a variable stock price. As the stock price rises, the call is worth more; as the stock price declines, the call value moves toward zero. Mathematically, for any given point on the graph, the derivative will show the rate of change of the option price. The delta is the first derivative of the graph of the option price relative to the stock price . EXHIBIT 2.1 Call value compared with stock price. Definition 3 : In terms of absolute value (meaning that plus and minus signs are ignored), the delta of an option is between 1.00 and 0. Its price can change in tandem with the stock, as with a 1.00 delta; or it cannot change at all as the stock moves, as with a 0 delta; or anything in between. By definition, stock has a 1.00 delta—it is the underlying security. A $1 rise in the stock yields a $100 profit on a round lot of 100 shares. A call with a 0.60 delta rises by $0.60 with a $1 increase in the stock. The owner of a call representing rights on 100 shares earns $60 for a $1 increase in the underlying. It’s as if the call owner in this example is long 60 shares of the underlying stock. Delta is the option’s equivalent of a position in the underlying shares . A trader who buys five 0.43-delta calls has a position that is effectively long 215 shares—that’s 5 contracts × 0.43 deltas × 100 shares. In option lingo, the trader is long 215 deltas. Likewise, if the trader were short five 0.43-delta calls, the trader would be short 215 deltas. The same principles apply to puts. Being long 10 0.59-delta puts makes the trader short a total of 590 deltas, a position that profits or loses like being short 590 shares of the underlying stock. Conversely, if the trader were short 10 0.59-delta puts, the trader would theoretically make $590 if the stock were to rise $1 and lose $590 if the stock fell by $1—just like being long 590 shares. Definition 4 : The final definition of delta is considered the trader’s definition. It’s mathematically imprecise but is used nonetheless as a general rule of thumb by option traders. A trader would say the delta is a statistical approximation of the likelihood of the option expiring in-the-money . An option with a 0.75 delta would have a 75 percent chance of being in-the-money at expiration under this definition. An option with a 0.20 delta would be thought of having a 20 percent chance of expiring in-the-money. Dynamic Inputs Option deltas are not constants. They are calculated from the dynamic inputs of the pricing model—stock price, time to expiration, volatility, and so on. When these variables change, the changes affect the delta. These changes can be mathematically quantified—they are systematic. Understanding these patterns and other quirks as to how delta behaves can help traders use this tool more effectively. Let’s discuss a few observations about the characteristics of delta. First, call and put deltas are closely related. Exhibit 2.2 is a partial option chain of 70-day calls and puts in Rambus Incorporated (RMBS). The stock was trading at $21.30 when this table was created. In Exhibit 2.2 , the 20 calls have a 0.66 delta. EXHIBIT 2.2 RMBS Option chain with deltas. Notice the deltas of the put-call pairs in this exhibit. As a general rule, the absolute value of the call delta plus the absolute value of the put delta add up to close to 1.00. The reason for this has to do with a mathematical relationship called put-call parity, which is briefly discussed later in this chapter and described in detail in Chapter 6. But with equity options, the put-call pair doesn’t always add up to exactly 1.00. Sometimes the difference is simply due to rounding. But sometimes there are other reasons. For example, the 30-strike calls and puts in Exhibit 2.2 have deltas of 0.14 and −0.89, respectively. The absolute values of the deltas add up to 1.03. Because of the possibility of early exercise of American options, the put delta is a bit higher than the call delta would imply. When puts have a greater chance of early exercise, they begin to act more like short stock and consequently will have a greater delta. Often, dividend-paying stocks will have higher deltas on some in-the-money calls than the put in the pair would imply. As the ex-dividend date—the date the stock begins trading without the dividend—approaches, an in-the-money call can become more apt to be exercised, because traders will want to own stock to capture the dividend. Here, the call begins to act more like long stock, leading to a higher delta. Moneyness and Delta The next observation is the effect of moneyness on the option’s delta. Moneyness describes the degree to which the option is in- or out-of-the-money. As a general rule, options that are in-the-money (ITM) have deltas greater than 0.50. Options that are out-of-the-money (OTM) have deltas less than 0.50. Finally, options that are at-the-money (ATM) have deltas that are about 0.50. The more in-the-money the option is, the closer to 1.00 the delta is. The more out-of-the-money, the closer the delta is to 0. But ATM options are usually not exactly 0.50. For ATMs, both the call and the put deltas are generally systematically a value other than 0.50. Typically, the call has a higher delta than 0.50 and the put has a lower absolute value than 0.50. Incidentally, the call’s theoretical value is generally greater than the put’s when the options are right at-the-money as well. One reason for this disparity between exactly at-the-money calls and puts is the interest rate. The more time until expiration, the more effect the interest rate will have, and, therefore, the higher the call’s theoretical and delta will be relative to the put. Effect of Time on Delta In a close contest, the last few minutes of a football game are often the most exciting—not because the players run faster or knock heads harder but because one strategic element of the game becomes more and more important: time. The team that’s in the lead wants the game clock to run down with no interruption to solidify its position. The team that’s losing uses its precious time-outs strategically. The more playing time left, the less certain defeat is for the losing team. Although mathematically imprecise, the trader’s definition can help us gain insight into how time affects option deltas. The more time left until an option’s expiration, the less certain it is whether the option will be ITM or OTM at expiration. The deltas of both the ITM and the OTM options reflect that uncertainty. The more time left in the life of the option, the closer the deltas tend to gravitate to 0.50. A 0.50 delta represents the greatest level of uncertainty—a coin toss. Exhibit 2.3 shows the deltas of a hypothetical equity call with a strike price of 50 at various stock prices with different times until expiration. All other parameters are held constant. EXHIBIT 2.3 Estimated delta of 50-strike call—impact of time. As shown in Exhibit 2.3 , the more time until expiration, the closer ITMs and OTMs move to 0.50. At expiration, of course, the option is either a 100 delta or a 0 delta; it’s either stock or not. Effect of Volatility on Delta The level of volatility affects option deltas as well. We’ll discuss volatility in more detail in future chapters, but it’s important to address it here as it relates to the concept of delta. Exhibit 2.4 shows how changing the volatility percentage (explained further in Chapter 3), as opposed to the time to expiration, affects option deltas. In this table, the delta of a call with 91 days until expiration is studied. EXHIBIT 2.4 Estimated delta of 50-strike call—impact of volatility. Notice the effect that volatility has on the deltas of this option with the underlying stock at various prices. In this table, at a low volatility with the call deep in- or out-of-the-money, the delta is very large or very small, respectively. At 10 percent volatility with the stock at $58 a share, the delta is 1.00. At that same volatility level with the stock at $42 a share, the delta is 0. But at higher volatility levels, the deltas change. With the stock at $58, a 45 percent volatility gives the 50-strike call a 0.79 delta—much smaller than it was at the low volatility level. With the stock at $42, a 45-percent volatility returns a 0.30 delta for the call. Generally speaking, ITM option deltas are smaller given a higher volatility assumption, and OTM option deltas are bigger with a higher volatility. Effect of Stock Price on Delta An option that is $5 in-the-money on a $20 stock will have a higher delta than an option that is $5 in-the-money on a $200 stock. Proportionately, the former is more in-the-money. Comparing two options that are in-the-money by the same percentage yields similar results. As the stock price changes because the strike price remains stable, the option’s delta will change. This phenomenon is measured by the option’s gamma. Gamma The strike price is the only constant in the pricing model. When the stock price moves relative to this constant, the option in question becomes more in-the-money or out-of-the-money. This means the delta changes. This isolated change is measured by the option’s gamma, sometimes called curvature . Gamma (Γ) is the rate of change of an option’s delta given a change in the price of the underlying security . Gamma is conventionally stated in terms of deltas per dollar move. The simplified examples above under Definition 1 of delta, used to describe the effect of delta, had one important piece of the puzzle missing: gamma. As the stock price moved higher in those examples, the delta would not remain constant. It would change due to the effect of gamma. The following example shows how the delta would change given a 0.04 gamma attributed to the call option. The call in this example starts as a 0.50-delta option. When the stock price increases by $1, the delta increases by the amount of the gamma. In this example, delta increases from 0.50 to 0.54, adding 0.04 deltas. As the stock price continues to rise, the delta continues to move higher. At $62, the call’s delta is 0.58. This increase in delta will affect the value of the call. When the stock price first begins to rise from $60, the option value is increasing at a rate of 50 percent—the call’s delta at that stock price. But by the time the stock is at $61, the option value is increasing at a rate of 54 percent of the stock price. To estimate the theoretical value of the call at $61, we must first estimate the average change in the delta between $60 and $61. The average delta between $60 and $61 is roughly 0.52. It’s difficult to calculate the average delta exactly because gamma is not constant; this is discussed in more detail later in the chapter. A more realistic example of call values in relation to the stock price would be as follows: Each $1 increase in the stock shows an increase in the call value about equal to the average delta value between the two stock prices. If the stock were to decline, the delta would get smaller at a decreasing rate. As the stock price declines from $60 to $59, the option delta decreases from 0.50 to 0.46. There is an average delta of about 0.48 between the two stock prices. At $59 the new theoretical value of the call is 2.52. The gamma continues to affect the option’s delta and thereby its theoretical value as the stock continues its decline to $58 and beyond. Puts work the same way, but because they have a negative delta, when there is a positive stock-price movement the gamma makes the put delta less negative, moving closer to 0. The following example clarifies this. As the stock price rises, this put moves more and more out-of-the-money. Its theoretical value is decreasing by the rate of the changing delta. At $60, the delta is −0.40. As the stock rises to $61, the delta changes to −0.36. The average delta during that move is about −0.38, which is reflected in the change in the value of the put. If the stock price declines and the put moves more toward being in-the-money, the delta becomes more negative—that is, the put acts more like a short stock position. Here, the put value rises by the average delta value between each incremental change in the stock price. These examples illustrate the effect of gamma on an option without discussing the impact on the trader’s position. When traders buy options, they acquire positive gamma. Since gamma causes options to gain value at a faster rate and lose value at a slower rate, (positive) gamma helps the option buyer. A trader buying one call or put in these examples would have +0.04 gamma. Buying 10 of these options would give the trader a +0.4 gamma. When traders sell options, gamma works against them. When options lose value, they move toward zero at a slower rate. When the underlying moves adversely, gamma speeds up losses. Selling options yields a negative gamma position. A trader selling one of the above calls or puts would have −0.04 gamma per option. The effect of gamma is less significant for small moves in the underlying than it is for bigger moves. On proportionately large moves, the delta can change quite a bit, making a big difference in the position’s P&(L). In Exhibit 2.1 , the left side of the diagram showed the call price not increasing at all with advances in the stock—a 0 delta. The right side showed the option advancing in price 1-to-1 with the stock—a 1.00 delta. Between the two extremes, the delta changes. From this diagram another definition for gamma can be inferred: gamma is the second derivative of the graph of the option price relative to the stock price. Put another way, gamma is the first derivative of a graph of the delta relative to the stock price. Exhibit 2.5 illustrates the delta of a call relative to the stock price. EXHIBIT 2.5 Call delta compared with stock price. Not only does the delta change, but it changes at a changing rate. Gamma is not constant. Moneyness, time to expiration, and volatility each have an effect on the gamma of an option. Dynamic Gamma When options are far in-the-money or out-of-the-money, they are either 1.00 delta or 0 delta. At the extremes, small changes in the stock price will not cause the delta to change much. When an option is at-the-money, it’s a different story. Its delta can change very quickly. ITM and OTM options have a low gamma. ATM options have a relatively high gamma. Exhibit 2.6 is an example of how moneyness translates into gamma on QQQ calls. EXHIBIT 2.6 Gamma of QQQ calls with QQQ at $44. With QQQ at $44, 92 days until expiration, and a constant volatility input of 19 percent, the 36- and 54-strike calls are far enough in- and out-of-the-money, respectively, that if the Qs move a small amount in either direction from the current price of $44, the movement won’t change their deltas much at all. The chances of their money status changing between now and expiration would not be significantly different statistically given a small stock price change. They have the smallest gammas in the table. The highest gammas shown here are around the ATM strike prices. (Note that because of factors not yet discussed, the strike that is exactly at-the-money may not have the highest gamma. The highest gamma is likely to occur at a slightly higher strike price.) Exhibit 2.7 shows a graph of the corresponding numbers in Exhibit 2.6 . EXHIBIT 2.7 Option gamma. A decrease in the time to expiration solidifies the likelihood of ITMs or OTMs remaining as such. But an ATM option’s moneyness at expiration remains to the very end uncertain. As expiration draws nearer, the gamma decreases for ITMs and OTMs and increases for the ATM strikes. Exhibit 2.8 shows the same 92-day QQQ calls plotted against 7-day QQQ calls. EXHIBIT 2.8 Gamma as time passes. At seven days until expiration, there is less time for price action in the stock to change the expected moneyness at expiration of ITMs or OTMs. ATM options, however, continue to be in play. Here, the ATM gamma is approaching 0.35. But the strikes below 41 and above 48 have 0 gamma. Similarly-priced securities that tend to experience bigger price swings may have strikes $3 away-from-the-money with seven-day gammas greater than zero. The volatility of the underlying will affect gamma, too. Exhibit 2.9 shows the same 19 percent volatility QQQ calls in contrast with a graph of the gamma if the volatility is doubled. EXHIBIT 2.9 Gamma as volatility changes. Raising the volatility assumption flattens the curve, causing ITM and OTM to have higher gamma while lowering the gamma for ATMs. Short-term ATM options with low volatility have the highest gamma. Lower gamma is found in ATMs when volatility is higher and it is lower for ITMs and OTMs and in longer-dated options. Theta Option prices can be broken down into two parts: intrinsic value and time value. Intrinsic value is easily measurable. It is simply the ITM part of the premium. Time value, or extrinsic value, is what’s left over—the premium paid over parity for the option. All else held constant, the more time left in the life of the option, the more valuable it is—there is more time for the stock to move. And as the useful life of an option decreases, so does its time value. The decline in the value of an option because of the passage of time is called time decay, or erosion. Incremental measurements of time decay are represented by the Greek letter theta (θ). Theta is the rate of change in an option’s price given a unit change in the time to expiration . What exactly is the unit involved here? That depends. Some providers of option greeks will display thetas that represent one day’s worth of time decay. Some will show thetas representing seven days of decay. In the case of a one-day theta, the figure may be based on a seven-day week or on a week counting only trading days. The most common and, arguably, most useful display of this figure is the one-day theta based on the seven-day week. There are, after all, seven days in a week, each day of which can see an occurrence with the potential to cause a revaluation in the stock price (that is, news can come out on Saturday or Sunday). The one-day theta based on a seven-day week will be used throughout this book. Taking the Day Out When the number of days to expiration used in the pricing model declines from, say, 32 days to 31 days, the price of the option decreases by the amount of the theta, all else held constant. But when is the day “taken out”? It is intuitive to think that after the market closes, the model is changed to reflect the passing of one day’s time. But, in fact, this change is logically anticipated and may be priced in early. In the earlier part of the week, option prices can often be observed getting cheaper relative to the stock price sometime in the middle of the day. This is because traders will commonly take the day out of their model during trading hours after the underlying stabilizes following the morning business. On Fridays and sometimes Thursdays, traders will take all or part of the weekend out. Commonly, by Friday afternoon, traders will be using Monday’s days to value their options. When option prices are seen getting cheaper on, say, a Friday, how can one tell whether this is the effect of the market taking the weekend out or a change in some other input, such as volatility? To some degree, it doesn’t matter. Remember, the model is used to reflect what the market is doing, not the other way around. In many cases, it’s logical to presume that small devaluations in option prices intraday can be attributed to the routine of the market taking the day out. Friend or Foe? Theta can be a good thing or a bad thing, depending on the position. Theta hurts long option positions; whereas it helps short option positions. Take an 80-strike call with a theoretical value of 3.16 on a stock at $82 a share. The 32-day 80 call has a theta of 0.03. If a trader owned one of these calls, the trader’s position would theoretically lose 0.03, or $0.03, as the time until expiration change from 32 to 31 days. This trader has a negative theta position. A trader short one of these calls would have an overnight theoretical profit of $0.03 attributed to theta. This trader would have a positive theta. Theta affects put traders as well. Using all the same modeling inputs, the 32-day 80-strike put would have a theta of 0.02. A put holder would theoretically lose $0.02 a day, and a put writer would theoretically make $0.02. Long options carry with them negative theta; short options carry positive theta. A higher theta for the call than for the put of the same strike price is common when an interest rate greater than zero is used in the pricing model. As will be discussed in greater detail in the section on rho, interest causes the time value of the call to be higher than that of the corresponding put. At expiration, there is no time value left in either option. Because the call begins with more time value, its premium must decline at a faster rate than that of the put. Most modeling software will attribute the disparate rates of decline in value all to theta, whereas some modeling interfaces will make clear the distinction between the effect of time decay and the effect of interest on the put-call pair. The Effect of Moneyness and Stock Price on Theta Theta is not a constant. As variables influencing option values change, theta can change, too. One such variable is the option’s moneyness. Exhibit 2.10 shows theoretical values (theos), time values, and thetas for 3-month options on Adobe (ADBE). In this example, Adobe is trading at $31.30 a share with three months until expiration. The more ITM a call or a put gets, the higher its theoretical value. But when studying an option’s time decay, one needs to be concerned only with the option’s time value, because intrinsic value is not subject to time decay. EXHIBIT 2.10 Adobe theos and thetas (Adobe at $31.30). The ATM options shown here have higher time value than ITM or OTM options. Hence, they have more time premium to lose in the same three-month period. ATM options have the highest rate of decay, which is reflected in higher thetas. As the stock price changes, the theta value will change to reflect its change in moneyness. If this were a higher-priced stock, say, 10 times the stock price used in this example, with all other inputs held constant, the option values, and therefore the thetas, would be higher. If this were a stock trading at $313, the 325-strike call would have a theoretical value of 16.39 and a one-day theta of 0.189, given inputs used otherwise identical to those in the Adobe example. The Effects of Volatility and Time on Theta Stock price is not the only factor that affects theta values. Volatility and time to expiration come into play here as well. The volatility input to the pricing model has a direct relationship to option values. The higher the volatility, the higher the value of the option. Higher-valued options decay at a faster rate than lower-valued options—they have to; their time values will both be zero at expiration. All else held constant, the higher the volatility assumption, the higher the theta. The days to expiration have a direct relationship to option values as well. As the number of days to expiration decreases, the rate at which an option decays may change, depending on the relationship of the stock price to the strike price. ATM options tend to decay at a nonlinear rate—that is, they lose value faster as expiration approaches—whereas the time values of ITM and OTM options decay at a steadier rate. Consider a hypothetical stock trading at $70 a share. Exhibit 2.11 shows how the theoretical values of the 75-strike call and the 70-strike call decline with the passage of time, holding all other parameters constant. EXHIBIT 2.11 Rate of decay: ATM vs. OTM. The OTM 75-strike call has a fairly steady rate of time decay over this 26-week period. The ATM 70-strike call, however, begins to lose its value at an increasing rate as expiration draws nearer. The acceleration of premium erosion continues until the option expires. Exhibit 2.12 shows the thetas for this ATM call during the last 10 days before expiration. EXHIBIT 2.12 Theta as expiration approaches. Days to Exp . ATM Theta 10 0.075 9 0.079 8 0.084 7 0.089 6 0.096 5 0.106 4 0.118 3 0.137 2 0.171 1 0.443 Incidentally, in this example, when there is one day to expiration, the theoretical value of this call is about 0.44. The final day before expiration ultimately sees the entire time premium erode. Vega Over the past decade or so, computers have revolutionized option trading. Options traded through an online broker are filled faster than you can say, “Oops! I meant to click on puts.” Now trading is facilitated almost entirely online by professional and retail traders alike. Market and trading information is disseminated worldwide in subseconds, making markets all the more efficient. And the tools now available to the common retail trader are very powerful as well. Many online brokers and other web sites offer high-powered tools like screeners, which allow traders to sift through thousands of options to find those that fit certain parameters. Using a screener to find ATM calls on same-priced stocks—say, stocks trading at $40 a share—can yield a result worth talking about here. One $40 stock can have a 40-strike call trading at around 0.50, while a different $40 stock can have a 40 call with the same time to expiration trading at more like 2.00. Why? The model doesn’t know the name of the company, what industry it’s in, or what its price-to-earnings ratio is. It is a mathematical equation with six inputs. If five of the inputs—the stock price, strike price, time to expiration, interest rate, and dividends—are identical for two different options but they’re trading at different prices, the difference must be the sixth variable, which is volatility. Implied Volatility (IV) and Vega The volatility component of option values is called implied volatility (IV). (For more on implied volatility and how it relates to vega, see Chapter 3.) IV is a percentage, although in practice the percent sign is often omitted. This is the value entered into a pricing model, in conjunction with the other variables, that returns the option’s theoretical value. The higher the volatility input, the higher the theoretical value, holding all other variables constant. The IV level can change and often does—sometimes dramatically. When IV rises or falls, option prices rise and fall in line with it. But by how much? The relationship between changes in IV and changes in an option’s value is measured by the option’s vega. Vega is the rate of change of an option’s theoretical value relative to a change in implied volatility . Specifically, if the IV rises or declines by one percentage point, the theoretical value of the option rises or declines by the amount of the option’s vega, respectively. For example, if a call with a theoretical value of 1.82 has a vega of 0.06 and IV rises one percentage point from, say, 17 percent to 18 percent, the new theoretical value of the call will be 1.88—it would rise by 0.06, the amount of the vega. If, conversely, the IV declines 1 percentage point, from 17 percent to 16 percent, the call value will drop to 1.76—that is, it would decline by the vega. A put with the same expiration month and the same strike on the same underlying will have the same vega value as its corresponding call. In this example, raising or lowering IV by one percentage point would cause the corresponding put value to rise or decline by $0.06, just like the call. An increase in IV and the consequent increase in option value helps the P&(L) of long option positions and hurts short option positions. Buying a call or a put establishes a long vega position. For short options, the opposite is true. Rising IV adversely affects P&(L), whereas falling IV helps. Shorting a call or put establishes a short vega position. The Effect of Moneyness on Vega Like the other greeks, vega is a snapshot that is a function of multiple facets of determinants influencing option value. The stock price’s relationship to the strike price is a major determining factor of an option’s vega. IV affects only the time value portion of an option. Because ATM options have the greatest amount of time value, they will naturally have higher vegas. ITM and OTM options have lower vega values than those of the ATM options. Exhibit 2.13 shows an example of 186-day options on AT&T Inc. (T), their time value, and the corresponding vegas. EXHIBIT 2.13 AT&T theos and vegas (T at $30, 186 days to Expry, 20% IV). Note that the 30-strike calls and puts have the highest time values. This strike boasts the highest vega value, at 0.085. The lower the time premium, the lower the vega—therefore, the less incremental IV changes affect the option. Since higher-priced stocks have higher time premium (in absolute terms, not necessarily in percentage terms) they will have higher vega. Incidentally, if this were a $300 stock instead of a $30 stock, the 186-day ATMs would have a 0.850 vega, if all other model inputs remain the same. The Effect of Implied Volatility on Vega The distribution of vega values among the strike prices shown in Exhibit 2.13 holds for a specific IV level. The vegas in Exhibit 2.13 were calculated using a 20 percent IV. If a different IV were used in the calculation, the relationship of the vegas to one another might change. Exhibit 2.14 shows what the vegas would be at different IV levels. EXHIBIT 2.14 Vega and IV. Note in Exhibit 2.14 that at all three IV levels, the ATM strike maintains a similar vega value. But the vegas of the ITM and OTM options can be significantly different. Lower IV inputs tend to cause ITM and OTM vegas to decline. Higher IV inputs tend to cause vegas to increase for ITMs and OTMs. The Effect of Time on Vega As time passes, there is less time premium in the option that can be affected by changes in IV. Consequently, vega gets smaller as expiration approaches. Exhibit 2.15 shows the decreasing vega of a 50-strike call on a $50 stock with a 25 percent IV as time to expiration decreases. Notice that as the value of this ATM option decreases at its nonlinear rate of decay, the vega decreases in a similar fashion. EXHIBIT 2.15 The effect of time on vega. Rho One of my early jobs in the options business was clerking on the floor of the Chicago Board of Trade in what was called the bond room. On one of my first days on the job, the trader I worked for asked me what his position was in a certain strike. I told him he was long 200 calls and long 300 puts. “I’m long 500 puts?” he asked. “No,” I corrected, “you’re long 200 calls and 300 puts.” At this point, he looked at me like I was from another planet and said, “That’s 500. A put is a call; a call is a put.” That lesson was the beginning of my journey into truly understanding options. Put-Call Parity Put and call values are mathematically bound together by an equation referred to as put-call parity. In its basic form, put-call parity states: where c = call value, PV(x) = present value of the strike price, p = put value, and s = stock price. The put-call parity assumes that options are not exercised before expiration (that is, that they are European style). This version of the put-call parity is for European options on non-dividend-paying stocks. Put-call parity can be modified to reflect the values of options on stocks that pay dividends. In practice, equity-option traders look at the equation in a slightly different way: Traders serious about learning to trade options must know put-call parity backward and forward. Why? First, by algebraically rearranging this equation, it can be inferred that synthetically equivalent positions can be established by simply adding stock to an option. Again, a put is a call; a call is a put. and For example, a long call is synthetically equal to a long stock position plus a long put on the same strike, once interest and dividends are figured in. A synthetic long stock position is created by buying a call and selling a put of the same month and strike. Understanding synthetic relationships is intrinsic to understanding options. A more comprehensive discussion of synthetic relationships and tactical considerations for creating synthetic positions is offered in Chapter 6. Put-call parity also aids in valuing options. If put-call parity shows a difference in the value of the call versus the value of the put with the same strike, there may be an arbitrage opportunity. That translates as “riskless profit.” Buying the call and selling it synthetically (short put and short stock) could allow a profit to be locked in if the prices are disparate. Arbitrageurs tend to hold synthetic put and call prices pretty close together. Generally, only professional traders can capture these types of profit opportunities, by trading big enough positions to make very small profits (a penny or less per contract sometimes) matter. Retail traders may be able to take advantage of a disparity in put and call values to some extent, however, by buying or selling the synthetic as a substitute for the actual option if the position can be established at a better price synthetically. Another reason that a working knowledge of put-call parity is essential is that it helps attain a better understanding of how changes in the interest rate affect option values. The greek rho measures this change. Rho is the rate of change in an option’s value relative to a change in the interest rate. Although some modeling programs may display this number differently, most display a rho for the call and a rho for the put, both illustrating the sensitivity to a one-percentage-point change in the interest rate. When the interest rate rises by one percentage point, the value of the call increases by the amount of its rho and the put decreases by the amount of its rho. Likewise, when the interest rate decrease by one percentage point, the value of the call decreases by its rho and the put increases by its rho. For example, a call with a rho of 0.12 will increase $0.12 in value if the interest rate used in the model is increased by one percentage point. Of course, interest rates usually don’t rise or fall one percentage point in one day. More commonly, rates will have incremental changes of 25 basis points. That means a call with a 0.12 rho will theoretically gain $0.03 given an increase of 0.25 percentage points. Mathematically, this change in option value as a product of a change in the interest rate makes sense when looking at the formula for put-call parity. and But the change makes sense intuitively, too, when a call is considered as a cheaper substitute for owning the stock. For example, compare a $100 stock with a three-month 60-strike call on that same stock. Being so far ITM, there would likely be no time value in the call. If the call can be purchased at parity, which alternative would be a superior investment, the call for $40 or the stock for $100? Certainly, the call would be. It costs less than half as much as the stock but has the same reward potential; and the $60 not spent on the stock can be invested in an interest-bearing account. This interest advantage adds value to the call. Raising the interest rate increases this value, and lowering it decreases the interest component of the value of the call. A similar concept holds for puts. Professional traders often get a short-stock rebate on proceeds from a short-stock sale. This is simply interest earned on the capital received when the stock is shorted. Is it better to pay interest on the price of a put for a position that gives short exposure or to receive interest on the credit from shorting the stock? There is an interest disadvantage to owning the put. Therefore, a rise in interest rates devalues puts. This interest effect becomes evident when comparing ATM call and put prices. For example, with interest at 5 percent, three-month options on an $80 stock that pays a $0.25 dividend before option expiration might look something like this: The ATM call is higher in theoretical value than the ATM put by $0.75. That amount can be justified using put-call parity: (Here, simple interest of $1 is calculated as 80 × 0.05 × [90 / 360] = 1.) Changes in market conditions are kept in line by the put-call parity. For example, if the price of the call rises because of an increase in IV, the price of the put will rise in step. If the interest rate rises by a quarter of a percentage point, from 5 percent to 5.25 percent, the interest calculated for three months on the 80-strike will increase from $1 to $1.05, causing the difference between the call and put price to widen. Another variable that affects the amount of interest and therefore option prices is the time until expiration. The Effect of Time on Rho The more time until expiration, the greater the effect interest rate changes will have on options. In the previous example, a 25-basis-point change in the interest rate on the 80-strike based on a three-month period caused a change of 0.05 to the interest component of put-call parity. That is, 80 × 0.0025 × (90/360) = 0.05. If a longer period were used in the example—say, one year—the effect would be more profound; it will be $0.20: 80 × 0.0025 × (360/360) = 0.20. This concept is evident when the rhos of options with different times to expiration are studied. Exhibit 2.16 shows the rhos of ATM Procter & Gamble Co. (PG) calls with various expiration months. The 750-day Long-Term Equity AnticiPation Securities (LEAPS) have a rho of 0.858. As the number of days until expiration decreases, rho decreases. The 22-day calls have a rho of only 0.015. Rho is usually a fairly insignificant factor in the value of short-term options, but it can come into play much more with long-term option strategies involving LEAPS. EXHIBIT 2.16 The effect of time on rho (Procter & Gamble @ $64.34) Why the Numbers Don’t Don’t Always Add Up There will be many times when studying the rho of options in an option chain will reveal seemingly counterintuitive results. To be sure, the numbers don’t always add up to what appears logical. One reason for this is rounding. Another is that traders are more likely to use simple interest in calculating value, whereas the model uses compound interest. Hard-to-borrow stocks and stocks involved in mergers and acquisitions may have put-call parities that don’t work out right. But another, more common and more significant fly in the ointment is early exercise. Since the interest input in put-call parity is a function of the strike price, it is reasonable to expect that the higher the strike price, the greater the effect of interest on option prices will be. For European options, this is true to a large extent, in terms of aggregate impact of interest on the call and put pair. Strikes below the price where the stock is trading have a higher rho associated with the call relative to the put, whereas strikes above the stock price have a higher rho associated with the put relative to the call. Essentially, the more in-the-money an option is, the higher its rho. But with European options, observing the aggregate of the absolute values of the call and put rhos would show a higher combined rho the higher the strike. With American options, the put can be exercised early. A trader will exercise a put before expiration if the alternative—being short stock and receiving a short stock rebate—is a wiser choice based on the price of the put. Professional traders may own stock as a hedge against a put. They may exercise deep ITM puts (1.00-delta puts) to avoid paying interest on capital charges related to the stock. The potential for early exercise is factored into models that price American options. Here, when puts get deeper in-the-money—that is, more apt to be exercised—the rho decreases. When the strike price is very high relative to the stock price—meaning the put is very deep ITM—and there is little or no time value left to the call or the put, the aggregate put-call rho can be zero. Rho is discussed in greater detail in Chapter 7. THE GREEKS DEFINED Delta (Δ) is: 1. The rate of change in an option’s value relative to a change in the underlying asset price. 2. The derivative of the graph of an option’s value in relation to the underlying asset price. 3. The equivalent of underlying asset represented by an option position. 4. The estimate of the likelihood of an option’s expiring in-the-money. Gamma (Γ) is the rate of change in an option’s delta given a change in the price of the underlying asset. Theta (θ) is the rate of change in an option’s value given a unit change in the time to expiration. Vega is the rate of change in an option’s value relative to a change in implied volatility. Rho (ρ) is the rate of change in an option’s value relative to a change in the interest rate. Where to Find Option Greeks There are many sources from which to obtain greeks. The Internet is an excellent resource. Googling “option greeks” will display links to over four million web pages, many of which have real-time greeks or an option calculator. An option calculator is a simple interface that accepts the input of the six variables to the model and yields a theoretical value and the greeks for a single option. Some web sites devoted to option education, such as MarketTaker.com/option_modeling , have free calculators that can be used for modeling positions and using the greeks. In practice, many of the option-trading platforms commonly in use have sophisticated analytics that involve greeks. Most options-friendly online brokers provide trading platforms that enable traders to conduct comprehensive manipulations of the greeks. For example, traders can look at the greeks for their positions up or down one, two, or three standard deviations. Or they can see what happens to their position greeks if IV or time changes. With many trading platforms, position greeks are updated in real time with changes in the stock price—an invaluable feature for active traders. Caveats with Regard to Online Greeks Often, online greeks are one click away, requiring little effort on the part of the trader. Having greeks calculated automatically online is a quick and convenient way to eyeball greeks for an option. But there is one major problem with online greeks: reliability. For active option traders, greeks are essential. There is no point in using these figures if their accuracy cannot be assured. Experienced traders can often spot these inaccuracies a proverbial mile away. When looking at greeks from an online source that does not require you to enter parameters into a model (as would be the case with professional option-trading platforms), special attention needs to be paid to the relationship of the option’s theoretical values to the bid and offer. One must be cautious if the theoretical value of the option lies outside the bid-ask spread. This scenario can exist for brief periods of time, but arbitrageurs tend to prevent this from occurring routinely. If several options in a chain all have theoretical values below the bid or above the offer, there is probably a problem with one or more of the inputs used in the model. Remember, an option-pricing model is just that: a model. It reflects what is occurring in the market. It doesn’t tell where an option should be trading. The complex changes that occur intraday in the market—taking the day or weekend out, changes in stock price, volatility, and the interest rate—are not always kept current. The user of the model must keep close watch. It’s not reasonable to expect the computer to do the thinking for you. Automatically calculated greeks can be used as a starting point. But before using these figures in the decision-making process, the trader may have to override the parameters that were used in the online calculation to make the theos line up with market prices. Professional traders will ignore online greeks altogether. They will use the greeks that are products of the inputs they entered in their trading software. It comes down to this: if you want something done right, do it yourself. Thinking Greek The challenge of trading option greeks is to adapt to thinking in terms of delta, gamma, theta, vega, and rho. One should develop a feel for how greeks react to changing market conditions. Greeks need to be monitored as closely as and in some cases more closely than the option’s price itself. This greek philosophy forms the foundation of option trading for active traders. It offers a logical way to monitor positions and provides a medium in and of itself to trade. Notes 1 . Please note that definition 4 is not necessarily mathematically accurate. This “trader’s definition” is included in the text because many option traders use delta as a quick rule of thumb for estimating probability without regard to the mathematical shortcomings of doing so. 2 . Note that the interest input in the equation is the interest, in dollars and cents, on the strike. Technically, this would be calculated as compounded interest, but in practice many traders use simple interest as a quick and convenient way to do the calculation. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html SCORE: 60.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html SCORE: 31.00 ================================================================================ CHAPTER 4 Option-Specific Risk and Opportunity New endeavors can be intimidating. The first day at a new job or new school is a challenge. Option trading is no different. When traders first venture into the world of options, they tend to start with what they know—trading direction. Buying stocks is at the heart of the comfort zone for many traders. Buying a call as a substitute for buying a stock is a logical progression. And for the most part, call buying is a pretty straightforward way to take a bullish position in a stock. But it’s not just a bullish position. The greeks come into play with the long call, providing both risk and opportunity. Long ATM Call Kim is a trader who is bullish on the Walt Disney Company (DIS) over the short term. The time horizon of her forecast is three weeks. Instead of buying 100 shares of Disney at $35.10 per share, Kim decides to buy one Disney March 35 call at $1.10. In this example, March options have 44 days until expiration. How can Kim profit from this position? How can she lose? Exhibit 4.1 shows the profit and loss (P&(L)) for the call at different time periods. The top line is when the trade is executed; the middle, dotted line is after three weeks have passed; and the bottom, darker line is at expiration. Kim wants Disney to rise in price, which is evident by looking at the graph for any of the three time horizons. She would anticipate a loss if the stock price declines. These expectations are related to the position’s delta, but that is not the only risk exposure Kim has. As indicated by the three different lines in Exhibit 4.1 , the call loses value over time. This is called theta risk . She has other risk exposure as well. Exhibit 4.2 lists the greeks for the DIS March 35 call. EXHIBIT 4.1 P&(L) of Disney 35 call. EXHIBIT 4.2 Greeks for 35 Disney call. Delta 0.57 Gamma 0.166 Theta −0.013 Vega 0.048 Rho 0.023 Kim’s immediate directional exposure is quantified by the delta, which is 0.57. Delta is immediate directional exposure because it’s subject to change by the amount of the gamma. The positive gamma of this position helps Kim by increasing the delta as Disney rises and decreasing it as it falls. Kim, however, has time working against her—theta. At this point, she theoretically loses $0.013 per day. Since her call is close to being at-the-money, she would anticipate her theta becoming more negative as expiration approaches if Disney’s share price remains unchanged. She also has positive vega exposure. A one-percentage-point increase in implied volatility (IV) earns Kim just under $0.05. A one-point decrease costs her about $0.05. With so few days until expiration, the 35-strike call has very little rho exposure. A full one-percentage-point change in the interest rate changes her call’s value by only $0.023. Delta Some of Kim’s risks warrant more concern than others. With this position, delta is of the greatest concern, followed by theta. Kim expects the call to rise in value and accepts the risk of decline. Delta exposure was her main rationale for establishing the position. She expects to hold it for about three weeks. Kim is willing to accept the trade-off of delta exposure for theta, which will cost her three weeks of erosion of option premium. If the anticipated delta move happens sooner than expected, Kim will have less decay. Exhibit 4.3 shows the value of her 35 call at various stock prices over time. The left column is the price of Disney. The top row is the number of days until expiration. EXHIBIT 4.3 Disney 35 call price–time matrix–value. The effect of delta is evident as the stock rises or falls. When the position is established (44 days until expiration), the change in the option price if the stock were to move from $35 to $36 is 0.62 (1.66 − 1.04). Between stock prices of $36 and $37, the option gains 0.78 (2.44 −1.66). If the stock were to decline in value from $35 to $34, the option loses 0.47 (1.04 − 0.57). The option gains value at a faster rate as the stock rises and loses value at a slower rate as the stock falls. This is the effect of gamma. Gamma With this type of position, gamma is an important but secondary consideration. Gamma is most helpful to Kim in developing expectations of what the delta will be as the stock price rises or falls. Exhibit 4.4 shows the delta at various stock prices over time. EXHIBIT 4.4 Disney call price–time matrix–delta. Kim pays attention to gamma only to gauge her delta. Why is this important to her? In this trade, Kim is focused on direction. Knowing how much her call will rise or fall in step with the stock is her main concern. Notice that her delta tends to get bigger as the stock rises and smaller as the stock falls. As time passes, the delta gravitates toward 1.00 or 0, depending on whether the call is in-the-money (ITM) or out-of-the-money (OTM). Theta Option buying is a veritable race against the clock. With each passing day, the option loses theoretical value. Refer back to Exhibit 4.3 . When three weeks pass and the time to expiration decreases from 44 days to 23, what happens to the call value? If the stock price stays around its original level, theta will be responsible for a loss of about 30 percent of the premium. If Disney is at $35 with 23 days to expiration, the call will be worth $0.73. With a big enough move in either direction, however, theta matters much less. With 23 days to expiration and Disney at $39, there is only 0.12 of time value—the premium paid over parity for the option. At that point, it is almost all delta exposure. Similarly, if the Disney stock price falls after three weeks to $33, the call will have only 0.10 of time value. Time decay is the least of Kim’s concerns if the stock makes a big move. Vega After delta and theta, vega is the next most influential contributor to Kim’s profit or peril. With Disney at $35.10, the 1.10 premium for the 35-strike call represents $1 of time value—all of which is vulnerable to changes in IV. The option’s 1.10 value returns an IV of about 19 percent, given the following inputs: Stock: $35.10 Strike: 35 Days to expiration: 44 Interest: 5.25 percent No dividend paid during this period Consequently, the vega is 0.048. What does the 0.048 vega tell Kim? Given the preceding inputs, for each point the IV rises or falls, the option’s value gains or loses about $0.05. Some of the inputs, however, will change. Kim anticipates that Disney will rise in price. She may be right or wrong. Either way, it is unlikely that the stock will remain exactly at $35.10 to option expiration. The only certainty is that time will pass. Both price and time will change Kim’s vega exposure. Exhibit 4.5 shows the changing vega of the 35 call as time and the underlying price change. EXHIBIT 4.5 Disney 35 call price–time matrix–vega. When comparing Exhibit 4.5 to Exhibit 4.3 , it’s easy to see that as the time value of the option declines, so does Kim’s exposure to vega. As time passes, vega gets smaller. And as the call becomes more in- or out-of-the-money, vega gets smaller. Since she plans to hold the position for around three weeks, she is not concerned about small fluctuations in IV in the interim. If indeed the rise in price that Kim anticipates comes to pass, vega becomes even less of a concern. With 23 days to expiration and DIS at $37, the call value is 2.21. The vega is $0.018. If IV decreases as the stock price rises—a common occurrence—the adverse effect of vega will be minimal. Even if IV declines by 5 points, to a historically low IV for DIS, the call loses less than $0.10. That’s less than 5 percent of the new value of the option. If dividend policy changes or the interest rate changes, the value of Kim’s call will be affected as well. Dividends are often fairly predictable. However, a large unexpected dividend payment can have a significant adverse impact on the value of the call. For example, if a surprise $3 dividend were announced, owning the stock would become greatly preferable to owning the call. This preference would be reflected in the call premium. This is a scenario that an experienced trader like Kim will realize is a possibility, although not a probability. Although she knows it can happen, she will not plan for such an event unless she believes it is likely to happen. Possible reasons for such a belief could be rumors or the company’s historically paying an irregular dividend. Rho For all intents and purposes, rho is of no concern to Kim. In recent years, interest rate changes have not been a major issue for option traders. In the Alan Greenspan years of Federal Reserve leadership, changes in the interest rate were usually announced at the regularly scheduled Federal Open Market Committee (FOMC) meetings, with but a few exceptions. Ben Bernanke, likewise, changed interest rates fairly predictably, when he made any rate changes at all. In these more stable periods, if there is no FOMC meeting scheduled during the life of the call, it’s unlikely that rates will change. Even if they do, the rho with 44 days to expiration is only 0.023. This means that if rates change by a whole percentage point—which is four times the most common incremental change—the call value will change by a little more than $0.02. In this case, this is an acceptable risk. With 23 days to expiration, the ATM 35 call has a rho of only 0.011. Tweaking Greeks With this position, some risks are of greater concern than others. Kim may want more exposure to some greeks and less to others. What if she is concerned that her forecasted price increase will take longer than three weeks? She may want less exposure to theta. What if she is particularly concerned about a decline in IV? She may want to decrease her vega. Conversely, she may believe IV will rise and therefore want to increase her vega. Kim has many ways at her disposal to customize her greeks. All of her alternatives come with trade-offs. She can buy more calls, increasing her greek positions in exact proportion. She can buy or sell stock or options against her call, creating a spread. The simplest way to alter her exposure to option greeks is to choose a different call to buy. Instead of buying the ATM call, Kim can buy a call with a different relationship to the current stock price. Long OTM Call Kim can reduce her exposure to theta and vega by buying an OTM call. The trade-off here is that she also reduces her immediate delta exposure. Depending on how much Kim believes Disney will rally, this may or may not be a viable trade-off. Imagine that instead of buying one Disney March 35 call, Kim buys one Disney March 37.50 call, for 0.20. There are a few observations to be made about this alternative position. First, the net premium, and therefore overall risk, is much lower, 0.20 instead of 1.10. From an expiration standpoint, the breakeven at expiration is $37.70 (the strike price plus the call premium). Since Kim plans on exiting the position after about three weeks, the exact break-even point at the expiration of the contract is irrelevant. But the concept is the same: the stock needs to rise significantly. Exhibit 4.6 shows how Kim’s concerns translate into greeks. EXHIBIT 4.6 Greeks for Disney 35 and 37.50 calls. 35 Call 37.50 Call Delta 0.57 0.185 Gamma 0.166 0.119 Theta −0.013 −0.007 Vega 0.048 0.032 Rho 0.023 0.007 This table compares the ATM call with the OTM call. Kim can reduce her theta to half that of the ATM call position by purchasing an OTM. This is certainly a favorable difference. Her vega is lower with the 37.50 call, too. This may or may not be a favorable difference. That depends on Kim’s opinion of IV. On the surface, the disparity in delta appears to be a highly unfavorable trade-off. The delta of the 37.50 call is less than one third of the delta of the 35 call, and the whole motive for entering into this trade is to trade direction! Although this strategy is very delta oriented, its core is more focused on gamma and theta. The gamma of the 37.50 call is about 72 percent that of the 35 call. But the theta of the 37.50 call is about half that of the 35 call. Kim is improving her gamma/theta relationship by buying the OTM, but with the call being so far out-of-the-money and so inexpensive, the theta needs to be taken with a grain of salt. It is ultimately gamma that will make or break this delta play. The price of the option is 0.20—a rather low premium. In order for the call to gain in value, delta has to go to work with help from gamma. At this point, the delta is small, only 0.185. If Kim’s forecast is correct and there is a big move upward, gamma will cause the delta to increase, and therefore also the premium to increase exponentially. The call’s sensitivity to gamma, however, is dynamic. Exhibit 4.7 shows how the gamma of the 37.50 call changes as the stock price moves over time. At any point in time, gamma is highest when the call is ATM. However, so is theta. Kim wants to reap as much benefit from gamma as possible while minimizing her exposure to theta. Ideally, she wants Disney to rally through the strike price—through the high gamma and back to the low theta. After three weeks pass, with 23 days until expiration, if Disney is at $37 a share, the gamma almost doubles, to 0.237. When the call is ATM, the delta increases at its fastest rate. As Disney rises above the strike, the gamma figures in the table begin to decline. EXHIBIT 4.7 Disney 37.50 call price–time matrix–gamma. Gamma helps as the stock price declines, too. Exhibit 4.8 shows the effect of time and gamma on the delta of the 37.50 call. EXHIBIT 4.8 Disney 37.50 call price–time matrix–delta. The effect of gamma is readily observable, as the delta at any point in time is always higher at higher stock prices and lower at lower stock prices. Kim benefits greatly when the delta grows from its initial level of 0.185 to above 0.50—above the point of being at-the-money. If the stock moves lower, gamma helps take away the pain of the price decline by decreasing the delta. While delta, gamma, and theta occupy Kim’s thoughts, it is ultimately dollars and cents that matter. She needs to translate her study of the greeks into cold, hard cash. Exhibit 4.9 shows the theoretical values of the 37.50 call. EXHIBIT 4.9 Disney 37.50 call price–time matrix–value. The sooner the price rise occurs, the better. It means less time for theta to eat away profits. If Kim must hold the position for the entire three weeks, she needs a good pop in the stock to make it worth her while. At a $37 share price, the call is worth about 0.50, assuming all other market influences remain constant. That’s about a 150 percent profit. At $38, Exhibit 4.9 reveals the call value to be 1.04. That’s a 420 percent profit. On one hand, it’s hard for a trader like Kim not to get excited about the prospect of making 420 percent on an 8 percent move in a stock. On the other hand, Kim has to put things in perspective. When the position is established, the call has a 0.185 delta. By the trader’s definition of delta, that means the call is estimated to have about an 18.5 percent chance of expiring in-the-money. More than four out of five times, this position will be trading below the strike at expiration. Although Kim is not likely to hold the position until expiration, this observation tells her something: she’s starting in the hole. She is more likely to lose than to win. She needs to be compensated well for her risk on the winners to make up for the more prevalent losers. Buying OTM calls can be considered more speculative than buying ITM or ATM calls. Unlike what the at-expiration diagrams would lead one to believe, OTM calls are not simply about direction. There’s a bit more to it. They are really about gamma, time, and the magnitude of the stock’s move (volatility). Long OTM calls require a big move in the right direction for gamma to do its job. Long ITM Call Kim also has the alternative to buy an ITM call. Instead of the 35 or 37.50 call, she can buy the 32.50. The 32.50 call shares some of the advantages the 37.50 call has over the 35 call, but its overall greek characteristics make it a very different trade from the two previous alternatives. Exhibit 4.10 shows a comparison of the greeks of the three different calls. EXHIBIT 4.10 Greeks for Disney 32.50, 35, and 37.50 calls. Like the 37.50 call, the 32.50 has a lower gamma, theta, and vega than the ATM 35-strike call. Because the call is ITM, it has a higher delta: 0.862. In this example, Kim can buy the 32.50 call for 3. That’s 0.40 over parity (3 − [35.10 − 32.50] = 0.40). There is not much time value, but more than the 37.50 call has. Thus, theta is of some concern. Ultimately, the ITMs have 0.40 of time value to lose compared with the 0.20 of the OTM calls. Vega is also of some concern, but not as much as in the other alternatives because the vega of the 32.50 is lower than the 35s or the 37.50s. Gamma doesn’t help much as the stock rallies—it will get smaller as the stock price rises. Gamma will, however, slow losses somewhat if the stock declines by decreasing delta at an increasing rate. In this case, the greek of greatest consequence is delta—it is a more purely directional play than the other alternatives discussed. Exhibit 4.11 shows the matrix of the delta of the 32.50 call. EXHIBIT 4.11 Disney 32.50 call price–time matrix–delta. Because the call starts in-the-money and has a relatively low gamma, the delta remains high even if Disney declines significantly. Gamma doesn’t really kick in until the stock retreats enough to bring the call closer to being at-the-money. At that point, the position will have suffered a big loss, and the higher gamma is of little comfort. Kim’s motivation for selecting the ITM call above the ATM and OTM calls would be increased delta exposure. The 0.86 delta makes direction the most important concern right out of the gate. Exhibit 4.12 shows the theoretical values of the 32.50 call. EXHIBIT 4.12 Disney 32.50 call price–time matrix–value. Small directional moves contribute to significant leveraged gains or losses. From share price $35 to $36, the call gains 0.90—from 2.91 to 3.81—about a 30 percent gain. However, from $35 to $34, the call loses 0.80, or 27 percent. With only 0.40 of time value, the nondirectional greeks (theta, gamma, and vega) are a secondary consideration. If this were a deeper ITM call, the delta would start out even higher, closer to 1.00, and the other relevant greeks would be closer to zero. The deeper ITM a call, the more it acts like the stock and the less its option characteristics (greeks) come into play. Long ATM Put The beauty of the free market is that two people can study all the available information on the same stock and come up with completely different outlooks. First of all, this provides for entertaining television on the business-news channels when the network juxtaposes an outspoken bullish analyst with an equally unreserved bearish analyst. But differing opinions also make for a robust marketplace. Differing opinions are the oil that greases the machine that is price discovery. From a market standpoint, it’s what makes the world go round. It is possible that there is another trader, Mick, in the market studying Disney, who arrives at the conclusion that the stock is overpriced. Mick believes the stock will decline in price over the next three weeks. He decides to buy one Disney March 35 put at 0.80. In this example, March has 44 days to expiration. Mick initiates this long put position to gain downside exposure, but along with his bearish position comes option-specific risk and opportunity. Mick is buying the same month and strike option as Kim did in the first example of this chapter: the March 35 strike. Despite the different directional bias, Mick’s position and Kim’s position share many similarities. Exhibit 4.13 offers a comparison of the greeks of the Disney March 35 call and the Disney March 35 put. EXHIBIT 4.13 Greeks for Disney 35 call and 35 put. Call Put Delta 0.57 −0.444 Gamma 0.166 0.174 Theta −0.013 −0.009 Vega 0.048 0.048 Rho 0.023 −0.015 The first comparison to note is the contrasting deltas. The put delta is negative, in contrast to the call delta. The absolute value of the put delta is close to 1.00 minus the call delta. The put is just slightly OTM, so its delta is just under 0.50, while that of the call is just over 0.50. The disparate, yet related deltas represent the main difference between these two trades. The difference between the gamma of the 35 put and that of the corresponding call is fairly negligible: 0.174 versus 0.166, respectively. The gamma of this ATM put will enter into the equation in much the same way as the gamma of the ATM call. The put’s negative delta will become more negative as the stock declines, drawing closer to −1.00. It will get less negative as the stock price rises, drawing closer to zero. Gamma is important here, because it helps the delta. Delta, however, still remains the most important greek. Exhibit 4.14 illustrates how the 35 put delta changes as time and price change. EXHIBIT 4.14 Disney 35 put price–time matrix–delta. Since this put is ATM, it starts out with a big enough delta to offer the directional exposure Mick desires. The delta can change, but gamma ensures that it always changes in Mick’s favor. Exhibit 4.15 shows how the value of the 35 put changes with the stock price. EXHIBIT 4.15 Disney 35 put price–time matrix–value. Over time, a decline of only 10 percent in the stock yields high percentage returns. This is due to the leveraged directional nature of this trade—delta. While the other greeks are not of primary concern, they must be monitored. At the onset, the 0.80 premium is all time value and, therefore subject to the influences of time decay and volatility. This is where trading greeks comes into play. Conventional trading wisdom says, “Cut your losses early, and let your profits run.” When trading a stock, that advice is intellectually easy to understand, although psychologically difficult to follow. Buyers of options, especially ATM options, must follow this advice from the standpoint of theta. Options are decaying assets. The time premium will be zero at expiration. ATMs decay at an increasing nonlinear rate. Exiting a long position before getting too close to expiration can cut losses caused by an increasing theta. When to cut those losses, however, will differ from trade to trade, situation to situation, and person to person. When buying options, accepting some loss of premium due to time decay should be part of the trader’s plan. It comes with the territory. In this example, Mick is willing to accept about three weeks of erosion. Mick needs to think about what his put will be worth, not just if the underlying rises or falls but also if it doesn’t move at all. At the time the position is established, the theta is 0.009, just under a penny. If Disney share price is unchanged when three weeks pass, his theta will be higher. Exhibit 4.16 shows how thetas and theoretical values change over time if DIS stock remains at $35.10. EXHIBIT 4.16 Disney 35 put—thetas and theoretical values. Mick needs to be concerned not only about what the theta is now but what it will be when he plans on exiting the position. His plan is to exit the trade in about three weeks, at which point the put theta will be −0.013. If he amortizes his theta over this three-week period, he theoretically loses an average of about 0.01 a day during this time if nothing else changes. The average daily theta is calculated here by subtracting the value of the put at 23 days to expiration from its value when the trade was established to find the loss of premium attributed to time decay, then dividing by the number of days until expiration. Since the theta doesn’t change much over the first three weeks, Mick can eyeball the theta rather easily. As expiration approaches and theta begins to grow more quickly, he’ll need to do the math. At nine days to expiration, the theoretical value of Mick’s put is about 0.35, assuming all other variables are held constant. By that time, he will have lost 0.45 (0.80 − 0.35) due to erosion over the 35-day period he held the position if the stock hasn’t moved. Mick’s average daily theta during that period is about 0.0129 (0.45 ÷ 35). The more time he holds the trade, the greater a concern is theta. Mick must weigh his assessment of the likelihood of the option’s gaining value from delta against the risk of erosion. If he holds the trade for 35 days, he must make 0.0129 on average per day from delta to offset theta losses. If the forecast is not realized within the expected time frame or if the forecast changes, Mick needs to act fast to curtail average daily theta losses. Finding the Right Risk Mick could lower the theta of his position by selecting a put with a greater number of days to expiration. This alternative has its own set of trade-offs: lower gamma and higher vega than the 44-day put. He could also select an ITM put or an OTM put. Like Kim’s call alternatives, the OTM put would have less exposure to time decay, lower vega, lower gamma, and a lower delta. It would have a lower premium, too. It would require a bigger price decline than the ATM put and would be more speculative. The ITM put would also have lower theta, vega, and gamma, but it would have a higher delta. It would take on more of the functionality of a short stock position in much the same way that Kim’s ITM call alternative did for a long stock position. In its very essence, however, an option trade, ITM or otherwise, is still fundamentally different than a stock trade. Stock has a 1.00 delta. The delta of a stock never changes, so it has zero gamma. Stock is not subject to time decay and has no volatility component to its pricing. Even though ITM options have deltas that approach 1.00 and other greeks that are relatively low, they have two important differences from an equity. The first is that the greeks of options are dynamic. The second is the built-in leverage feature of options. The relationship of an option’s strike price to the stock price can change constantly. Options that are ITM now may be OTM tomorrow and vice versa. Greeks that are not in play at the moment may be later. Even if there is no time value in the option now because it is so far away-from-the-money, there is the potential for time premium to become a component of the option’s price if the stock moves closer to the strike price. Gamma, theta, and vega always have the potential to come into play. Since options are leveraged by nature, small moves in the stock can provide big profits or big losses. Options can also curtail big losses if used for hedging. Long option positions can reap triple-digit percentage gains quickly with a favorable move in the underlying. Even though 100 percent of the premium can be lost just as easily, one option contract will have far less nominal exposure than a similar position in the stock. It’s All About Volatility What are Kim and Mick really trading? Volatility. The motivation for buying an option as opposed to buying or shorting the stock is volatility. To some degree, these options have exposure to both flavors of volatility—implied volatility and historical volatility (HV). The positions in each of the examples have positive vega. Their values are influenced, in part, by IV. Over time, IV begins to lose its significance if the option is no longer close to being at-the-money. The main objective of each of these trades is to profit from the volatility of the stock’s price movement, called future stock volatility or future realized volatility. The strategies discussed in this chapter are contingent on volatility being one directional. The bigger the move in the trader’s forecasted direction the better. Volatility in the form of an adverse directional move results in a decline in premium. The gamma in these long option positions makes volatility in the right direction more beneficial and volatility in the wrong direction less costly. This phenomenon is hardly unique to the long call and the long put. Although some basic strategies, such as the ones studied in this chapter, depend on a particular direction, many don’t. Except for interest rate strategies and perhaps some arbitrage strategies, all option trades are volatility trades in one way or another. In general, option strategies can be divided into two groups: volatility-buying strategies and volatility-selling strategies. The following is a breakdown of common option strategies into categories of volatility-buying strategies and volatility-selling strategies: Volatility-Selling Strategies Volatility-Buying Strategies Short Call, Short Put, Covered Call, Covered Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Short Straddle, Short Strangle, Guts, Ratio Call Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars. Long Call, Long Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Long Straddle, Long Strangle, Guts, Back Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars. Long option strategies appear in the volatility-buying group because they have positive gamma and positive vega. Short option strategies appear in the volatility-selling group because of negative gamma and vega. There are some strategies that appear in both groups—for example, the butterfly/condor family, which is typically associated with income generation. These particular volatility strategies are commonly instituted as volatility-selling strategies. However, depending on whether the position is bought or sold and where the stock price is in relation to the strike prices, the position could fall into either group. Some strategies, like the vertical spread family—bull and bear call and put spreads—and risk reversal/collar spreads naturally fall into either category, depending on where the stock is in relation to the strikes. The calendar spread family is unique in that it can have characteristics of each group at the same time. Direction Neutral, Direction Biased, and Direction Indifferent As typically traded, volatility-selling option strategies are direction neutral. This means that the position has the greatest results if the underlying price remains in a range—that is, neutral. Although some option-selling strategies—for example, a naked put—may have a positive or negative delta in the short term, profit potential is decidedly limited. This means that if traders are expecting a big move, they are typically better off with option-buying strategies. Option-buying strategies can be either direction biased or direction indifferent. Direction-biased strategies have been shown throughout this chapter. They are delta trades. Direction-indifferent strategies are those that benefit from increased volatility in the underlying but where the direction of the move is irrelevant to the profitability of the trade. Movement in either direction creates a winner. Are You a Buyer or a Seller? The question is: which is better, selling volatility or buying volatility? I have attended option seminars with instructors (many of whom I regard with great respect) teaching that volatility-selling strategies, or income-generating strategies, are superior to buying options. I also know option gurus that tout the superiority of buying options. The answer to the question of which is better is simple: it’s all a matter of personal preference. When I began trading on the floor of Chicago Board Options Exchange (CBOE) in the 1990s, I quickly became aware of a dichotomy among my market-making peers. Those making markets on the floor of the exchange at that time were divided into two groups: teenie buyers and teenie sellers. Teenie Buyers Before options traded in decimals (dollars and cents) like they do today, the lowest price increment in which an option could be traded was one sixteenth of a dollar—a teenie . Teenie buyers were market makers who would buy back OTM options at one sixteenth to eliminate short positions. They would sometimes even initiate long OTM option positions at a teenie, too. The focus of the teenie-buyer school of thought was the fact that long options have unlimited reward, while short options have unlimited risk. An option purchased so far OTM that it was offered at one sixteenth is unlikely to end up profitable, but it’s an inexpensive lottery ticket. At worst, the trader can only lose a teenie. Teenie buyers felt being short OTM options that could be closed by paying a sixteenth was an unreasonable risk. Teenie Sellers Teenie sellers, however, focused on the fact that options offered at one sixteenth were far enough OTM that they were very likely to expire worthless. This appears to be free money, unless the unexpected occurs, in which case potential losses can be unlimited. Teenie sellers would routinely save themselves $6.25 (one sixteenth of a dollar per contract representing 100 shares) by selling their long OTMs at a teenie to close the position. They sometimes would even initiate short OTM contracts at one sixteenth. These long-option or short-option biases hold for other types of strategies as well. Volatility-selling positions, such as the iron condor, can be constructed to have limited risk. The paradigm for these strategies is they tend to produce winners more often than not. But when the position loses, the trader loses more than he would stand to profit if the trade worked out favorably. Herein lies the issue of preference. Long-option traders would rather trade Babe Ruth–style. For years, Babe Ruth was the record holder for the most home runs. At the same time, he was also the record holder for the most strikeouts. The born fighters that are option buyers accept the fact that they will have more strikeouts, possibly many more strikeouts, than winning trades. But the strategy dictates that the profit on one winner more than makes up for the string of small losers. Short-option traders, conversely, like to have everything cool and copacetic. They like the warm and fuzzy feeling they get from the fact that month after month they tend to generate winners. The occasional loser that nullifies a few months of profits is all part of the game. Options and the Fair Game There may be a statistical advantage to buying stock as opposed to shorting stock, because the market has historically had a positive annualized return over the long run. A statistical advantage to being either an option buyer or an option seller, however, should not exist in the long run, because the option market prices IV. Assuming an overall efficient market for pricing volatility into options, there should be no statistical advantage to systematically buying or selling options. 1 Consider a game consisting of one six-sided die. Each time a one, two, or three is rolled, the house pays the player $1. Each time a four, five, or six is rolled, the house pays zero. What is the most a player would be willing to pay to play this game? If the player paid nothing, the house would be at a tremendous disadvantage, paying $1 50 percent of the time and nothing the other 50 percent of the time. This would not be a fair game from the house’s perspective, as it would collect no money. If the player paid $1, the player would get his dollar back when one, two, or three came up. Otherwise, he would lose his dollar. This is not a fair game from the player’s perspective. The chances of winning this game are 3 out of 6, or 50–50. If this game were played thousands of times, one would expect to receive $1 half the time and receive nothing the other half of the time. The average return per roll one would expect to receive would be $0.50, that’s ($1 × 50 percent + $0 × 50 percent). This becomes a fair game with an entrance fee of $0.50. Now imagine a similar game in which a six-sided die is rolled. This time if a one is rolled, the house pays $1. If any other number is rolled, the house pays nothing. What is a fair price to play this game? The same logic and the same math apply. There is a percent chance of a one coming up and the player receiving $1. And there is a percent chance of each of the other five numbers being rolled and the player receiving nothing. Mathematically, this translates to: percent percent). Fair value for a chance to play this game is about $0.1667 per roll. The fair game concept applies to option prices as well. The price of the game, or in this case the price of the option, is determined by the market in the form of IV. The odds are based on the market’s expectations of future volatility. If buying options offered a superior payout based on the odds of success, the market would put upward pressure on prices until this arbitrage opportunity ceased to exist. It’s the same for selling volatility. If selling were a fundamentally better strategy, the market would depress option prices until selling options no longer produced a way to beat the odds. The options market will always equalize imbalances. Note 1 . This is not to say that unique individual opportunities do not exist for overpriced or underpriced options, only that options are not overpriced or underpriced in general. Thus, neither an option-selling nor option-buying methodology should provide an advantage. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html SCORE: 82.00 ================================================================================ CHAPTER 5 An Introduction to Volatility-Selling Strategies Along with death and taxes, there is one other fact of life we can all count on: the time value of all options ultimately going to zero. What an alluring concept! In a business where expected profits can be thwarted by an unexpected turn of events, this is one certainty traders can count on. Like all certainties in the financial world, there is a way to profit from this fact, but it’s not as easy as it sounds. Alas, the potential for profit only exists when there is risk of loss. In order to profit from eroding option premiums, traders must implement option-selling strategies, also known as volatility-selling strategies. These strategies have their own set of inherent risks. Selling volatility means having negative vega—the risk of implied volatility rising. It also means having negative gamma—the risk of the underlying being too volatile. This is the nature of selling volatility. The option-selling trader does not want the underlying stock to move—that is, the trader wants the stock to be less volatile. That is the risk. Profit Potential Profit for the volatility seller is realized in a roundabout sort of way. The reward for low volatility is achieved through time decay. These strategies have positive theta. Just as the volatility-buying strategies covered in Chapter 4 had time working against them, volatility-selling strategies have time working in their favor. The trader is effectively paid to assume the risk of movement. Gamma-Theta Relationship There exists a trade-off between gamma and theta. Long options have positive gamma and negative theta. Short options have negative gamma and positive theta. Positions with greater gamma, whether positive or negative, tend to have greater theta values, negative or positive. Likewise, lower absolute values for gamma tend to go hand in hand with lower absolute values for theta. The gamma-theta relationship is the most important consideration with many types of strategies. Gamma-theta is often the measurement with the greatest influence on the bottom line. Greeks and Income Generation With volatility-selling strategies (sometimes called income-generating strategies), greeks are often overlooked. Traders simply dismiss greeks as unimportant to this kind of trade. There is some logic behind this reasoning. Time decay provides the profit opportunity. In order to let all of time premium erode, the position must be held until expiration. Interim changes in implied volatility are irrelevant if the position is held to term. The gamma-theta loses some significance if the position is held until expiration, too. The position has either passed the break-even point on the at-expiration diagram, or it has not. Incremental daily time decay–related gains are not the ultimate goal. The trader is looking for all the time premium, not portions of it. So why do greeks matter to volatility sellers? Greeks allow traders to be flexible. Consider short-term-momentum stock traders. The traders buy a stock because they believe it will rise over the next month. After one week, if unexpected bearish news is announced causing the stock to break through its support lines, the traders have a decision to make. Short-term speculative traders very often choose to cut their losses and exit the position early rather than risk a larger loss hoping for a recovery. Volatility-selling option traders are often faced with the same dilemma. If the underlying stays in line with the traders’ forecast, there is little to worry about. But if the environment changes, the traders have to react. Knowing the greeks for a position can help traders make better decisions if they plan to close the position before expiration. Naked Call A naked call is when a trader shorts a call without having stock or other options to cover or protect it. Since the call is uncovered, it is one of the riskier trades a trader can make. Recall the at-expiration diagram for the naked call from Chapter 1, Exhibit 1.3 : Naked TGT Call. Theoretically, there is limited reward and unlimited risk. Yet there are times when experienced traders will justify making such a trade. When a stock has been trading in a range and is expected to continue doing so, traders may wait until it is near the top of the channel, where there is resistance, and then short a call. For example, a trader, Brendan, has been studying a chart of Johnson & Johnson (JNJ). Brendan notices that for a few months the stock has trading been in a channel between $60 and $65. As he observes Johnson & Johnson beginning to approach the resistance level of $65 again, he considers selling a call to speculate on the stock not rising above $65. Before selling the call, Brendan consults other technical analysis tools, like ADX/DMI, to confirm that there is no trend present. ADX/DMI is used by some traders as a filter to determine the strength of a trend and whether the stock is overbought or oversold. In this case, the indicator shows no strong trend present. Brendan then performs due diligence. He studies the news. He looks for anything specific that could cause the stock to rally. Is the stock a takeover target? Brendan finds nothing. He then does earnings research to find out when they will be announced, which is not for almost two more months. Next, Brendan pulls up an option chain on his computer. He finds that with the stock trading around $64 per share, the market for the November 65 call (expiring in four weeks) is 0.66 bid at 0.68 offer. Brendan considers when Johnson & Johnson’s earnings report falls. Although recent earnings have seldom been a major concern for Johnson & Johnson, he certainly wants to sell an option expiring before the next earnings report. The November fits the mold. Brendan sells ten of the November 65 calls at the bid price of 0.66. Brendan has a rather straightforward goal. He hopes to see Johnson & Johnson shares remain below $65 between now and expiration. If he is right, he stands to make $660. If he is wrong? Exhibit 5.1 shows how Brendan’s calls hold up if they are held until expiration. EXHIBIT 5.1 Naked Johnson & Johnson call at expiration. Considering the risk/reward of this trade, Brendan is rightfully concerned about a big upward move. If the stock begins to rally, he must be prepared to act fast. Brendan must have an idea in advance of what his pain threshold is. In other words, at what price will he buy back his calls and take a loss if Johnson & Johnson moves adversely? He decides he will buy all 10 of his calls back at 1.10 per contract if the trade goes against him. (1.10 is an arbitrary price used for illustrative purposes. The actual price will vary, based on the situation and the risk tolerance of the trader. More on when to take profits and losses is discussed in future chapters.) He may choose to enter a good-till-canceled (GTC) stop-loss order to buy back his calls. Or he may choose to monitor the stock and enter the order when he sees the calls offered at 1.10—a mental stop order. What Brendan needs to know is: How far can the stock price advance before the calls are at 1.10? Brendan needs to examine the greeks of this trade to help answer this question. Exhibit 5.2 shows the hypothetical greeks for the position in this example. EXHIBIT 5.2 Greeks for short Johnson & Johnson 65 call (per contract). Delta −0.34 Gamma −0.15 Theta 0.02 Vega −0.07 The short call has a negative delta. It also has negative gamma and vega, but it has positive time decay (theta). As Johnson & Johnson ticks higher, the delta increases the nominal value of the call. Although this is not a directional trade per se, delta is a crucial element. It will have a big impact on Brendan’s expectations as to how high the stock can rise before he must take his loss. First, Brendan considers how much the option price can move before he covers. The market now is 0.66 bid at 0.68 offer. To buy back his calls at 1.10, they must be offered at 1.10. The difference between the offer now and the offer price at which Brendan will cover is 0.42 (that’s 1.10 − 0.68). Brendan can use delta to convert the change in the ask prices into a stock price change. To do so, Brendan divides the change in the option price by the delta. The −0.34 delta indicates that if JNJ rises $1.24, the calls should be offered at 1.10. Brendan takes note that the bid-ask spreads are typically 0.01 to 0.03 wide in near-term Johnson & Johnson options trading under 1.00. This is not necessarily the case in other option classes. Less liquid names have wider spreads. If the spreads were wider, Brendan would have more slippage. Slippage is the difference between the assumed trade price and the actual price of the fill as a product of the bid-ask spread. It’s the difference between theory and reality. If the bid-ask spread had a typical width of, say, 0.70, the market would be something more like 0.40 bid at 1.10 offer. In this case, if the stock moved even a few cents higher, Brendan could not buy his calls back at his targeted exit price of 1.10. The tighter markets provide lower transaction costs in the form of lower slippage. Therefore, there is more leeway if the stock moves adversely when there are tighter bid-ask option spreads. But just looking at delta only tells a part of the story. In reality, the delta does not remain constant during the price rise in Johnson & Johnson but instead becomes more negative. Initially, the delta is −0.34 and the gamma is −0.15. After a rise in the stock price, the delta will be more negative by the amount of the gamma. To account for the entire effect of direction, Brendan needs to take both delta and gamma into account. He needs to estimate the average delta based on gamma during the stock price move. The formula for the change in stock price is Taking into account the effect of gamma as well as delta, Johnson & Johnson needs to rise only $1.01, in order for Brendan’s calls to be offered at his stop-loss price of 1.10. While having a predefined price point to cover in the event the underlying rises is important, sometimes traders need to think on their feet. If material news is announced that changes the fundamental outlook for the stock, Brendan will have to adjust his plan. If the news leads Brendan to become bullish on the stock, he should exit the trade at once, taking a small loss now instead of the bigger loss he would expect later. If the trader is uncertain as to whether to hold or close the position, the Would I Do It Now? rule is a useful rule of thumb. Would I Do It Now? Rule To follow this rule, ask yourself, “If I did not already have this position, would I do it now? Would I establish the position at the current market prices, given the current market scenario?” If the answer is no, then the solution is simple: Exit the trade. For example, if after one week material news is released and Johnson & Johnson is trading higher, at $64.50 per share, and the November 65 call is trading at 0.75, Brendan must ask himself, based on the price of the stock and all known information, “If I were not already short the calls, would I short them now at the current price of 0.75, with the stock trading at $64.50?” Brendan’s opinion of the stock is paramount in this decision. If, for example, based on the news that was announced he is now bullish, he would likely not want to sell the calls at 0.75—he only gets $0.09 more in option premium and the stock is 0.50 closer to the strike. If, however, he is not bullish, there is more to consider. Theta can be of great use in decision making in this situation. As the number of days until expiration decreases and the stock approaches $65 (making the option more at-the-money), Brendan’s theta grows more positive. Exhibit 5.3 shows the theta of this trade as the underlying rises over time. EXHIBIT 5.3 Theta of Johnson & Johnson. When the position is first established, positive theta comforts Brendan by showing that with each passing day he gets a little closer to his goal—to have the 65 calls expire out-of-the-money (OTM) and reap a profit of the entire 66-cent premium. Theta becomes truly useful if the position begins to move against him. As Johnson & Johnson rises, the trade gets more precarious. His negative delta increases. His negative gamma increases. His goal becomes more out of reach. In conjunction with delta and gamma, theta helps Brendan decide whether the risk is worth the reward. In the new scenario, with the stock at $64.50, Brendan would collect $18 a day (1.80 × 10 contracts). Is the risk of loss in the short run worth earning $18 a day? With Johnson & Johnson at $64.50, would Brendan now short 10 calls at 0.75 to collect $18 a day, knowing that each day may bring a continued move higher in the stock? The answer to this question depends on Brendan’s assessment of the risk of the underlying continuing its ascent. As time passes, if the stock remains closer to the strike, the daily theta rises, providing more reward. Brendan must consider that as theta—the reward—rises, so does gamma: a risk factor. A small but noteworthy risk is that implied volatility could rise. The negative vega of this position would, then, adversely affect the profitability of this trade. It will make Brendan’s 1.10 cover-point approach faster because it makes the option more expensive. Vega is likely to be of less consequence because it would ultimately take the stock’s rising though the strike price for the trade to be a loser at expiration. Short Naked Puts Another trader, Stacie, has also been studying Johnson & Johnson. Stacie believes Johnson & Johnson is on its way to test the $65 resistance level yet again. She believes it may even break through $65 this time, based on strong fundamentals. Stacie decides to sell naked puts. A naked put is a short put that is not sold in conjunction with stock or another option. With the stock around $64, the market for the November 65 put is 1.75 bid at 1.80. Stacie likes the fact that the 65 puts are slightly in-the-money (ITM) and thus have a higher delta. If her price rise comes sooner than expected, the high delta may allow her to take a profit early. Stacie sells 10 puts at 1.75. In the best-case scenario, Stacie retains the entire 1.75. For that to happen, she will need to hold this position until expiration and the stock will have to rise to be trading above the 65 strike. Logically, Stacie will want to do an at-expiration analysis. Exhibit 5.4 shows Stacie’s naked put trade if she holds it until expiration. EXHIBIT 5.4 Naked Johnson & Johnson put at expiration. While harvesting the entire premium as a profit sounds attractive, if Stacie can take the bulk of her profit early, she’ll be happy to close the position and eliminate her risk—nobody ever went broke taking a profit. Furthermore, she realizes that her outlook may be wrong: Johnson & Johnson may decline. She may have to close the position early—maybe for a profit, maybe for a loss. Stacie also needs to study her greeks. Exhibit 5.5 shows the greeks for this trade. EXHIBIT 5.5 Greeks for short Johnson & Johnson 65 put (per contract). Delta 0.65 Gamma −0.15 Theta 0.02 Vega −0.07 The first item to note is the delta. This position has a directional bias. This bias can work for or against her. With a positive 0.65 delta per contract, this position has a directional sensitivity equivalent to being long around 650 shares of the stock. That’s the delta × 100 shares × 10 contracts. Stacie’s trade is not just a bullish version of Brendan’s. Partly because of the size of the delta, it’s different—specific directional bias aside. First, she will handle her trade differently if it is profitable. For example, if over the next week or so Johnson & Johnson rises $1, positive delta and negative gamma will have a net favorable effect on Stacie’s profitability. Theta is small in comparison and won’t have too much of an effect. Delta/gamma will account for a decrease in the put’s theoretical value of about $0.73. That’s the estimated average delta times the stock move, or [0.65 + (–0.15/2)] × 1.00. Stacie’s actual profit would likely be less than 0.73 because of the bid-ask spread. Stacie must account for the fact that the bid-ask is 0.05 wide (1.75–1.80). Because Stacie would buy to close this position, she should consider the 0.73 price change relative to the 1.80 offer, not the 1.75 trade price—that is, she factors in a nickel of slippage. Thus, she calculates, that the puts will be offered at 1.07 (that’s 1.80 − 0.73) when the stock is at $65. That is a gain of $0.68. In this scenario, Stacie should consider the Would I Do It Now? rule to guide her decision as to whether to take her profit early or hold the position until expiration. Is she happy being short ten 65 puts at 1.07 with Johnson & Johnson at $65? The premium is lower now. The anticipated move has already occurred, and she still has 28 days left in the option that could allow for the move to reverse itself. If she didn’t have the trade on now, would she sell ten 65 puts at 1.07 with Johnson & Johnson at $65? Based on her original intention, unless she believes strongly now that a breakout through $65 with follow-through momentum is about to take place, she will likely take the money and run. Stacie also must handle this trade differently from Brendan in the event that the trade is a loser. Her trade has a higher delta. An adverse move in the underlying would affect Stacie’s trade more than it would Brendan’s. If Johnson & Johnson declines, she must be conscious in advance of where she will cover. Stacie considers both how much she is willing to lose and what potential stock-price action will cause her to change her forecast. She consults a stock chart of Johnson & Johnson. In this example, we’ll assume there is some resistance developing around $64 in the short term. If this resistance level holds, the trade becomes less attractive. The at-expiration breakeven is $63.25, so the trade can still be a winner if Johnson & Johnson retreats. But Stacie is looking for the stock to approach $65. She will no longer like the risk/reward of this trade if it looks like that price rise won’t occur. She makes the decision that if Johnson & Johnson bounces off the $64 level over the next couple weeks, she will exit the position for fear that her outlook is wrong. If Johnson & Johnson drifts above $64, however, she will ride the trade out. In this example, Stacie is willing to lose 1.00 per contract. Without taking into account theta or vega, that 1.00 loss in the option should occur at a stock price of about $63.28. Theta is somewhat relevant here. It helps Stacie’s potential for profit as time passes. As time passes and as the stock rises, so will theta, helping her even more. If the stock moves lower (against her) theta helps ease the pain somewhat, but the further in-the-money the put, the lower the theta. Vega can be important here for two reasons: first, because of how implied volatility tends to change with market direction, and second, because it can be read as an indication of the market’s expectations. The Double Whammy With the stock around $64, there is a negative vega of about seven cents. As the stock moves lower, away from the strike, the vega gets a bit smaller. However, the market conditions that would lead to a decline in the price of Johnson & Johnson would likely cause implied volatility (IV) to rise. If the stock drops, Stacie would have two things working against her—delta and vega—a double whammy. Stacie needs to watch her vega. Exhibit 5.6 shows the vega of Stacie’s put as it changes with time and direction. EXHIBIT 5.6 Johnson & Johnson 65 put vega. If after one week passes Johnson & Johnson gaps lower to, say, $63.00 a share, the vega will be 0.043 per contract. If IV subsequently rises 5 points as a result of the stock falling, vega will make Stacie’s puts theoretically worth 21.5 cents more per contract. She will lose $215 on vega (that’s 0.043 vega × 5 volatility points × 10 contracts) plus the adverse delta/gamma move. A gap opening will cause her to miss the opportunity to stop herself out at her target price entirely. Even if the stock drifts lower, her targeted stop-loss price will likely come sooner than expected, as the option price will likely increase both by delta/gamma and vega resulting from rising volatility. This can cause her to have to cover sooner, which leaves less room for error. With this trade, increases in IV due to market direction can make it feel as if the delta is greater than it actually is as the market declines. Conversely, IV softening makes it feel as if the delta is smaller than it is as the market rises. The second reason IV has importance for this trade (as for most other strategies) is that it can give some indication of how much the market thinks the stock can move. If IV is higher than normal, the market perceives there to be more risk than usual of future volatility. The question remains: Is the higher premium worth the risk? The answer to this question is subjective. Part of the answer is based on Stacie’s assessment of future volatility. Is the market right? The other part is based on Stacie’s risk tolerance. Is she willing to endure the greater price swings associated with the potentially higher volatility? This can mean getting whipsawed, which is exiting a position after reaching a stop-loss point only to see the market reverse itself. The would-be profitable trade is closed for a loss. Higher volatility can also mean a higher likelihood of getting assigned and acquiring an unwanted long stock position. Cash-Secured Puts There are some situations where higher implied volatility may be a beneficial trade-off. What if Stacie’s motivation for shorting puts was different? What if she would like to own the stock, just not at the current market price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her trading account to secure the purchase of 1,000 shares of Johnson & Johnson if she gets assigned. The $63,250 is the $65 per share she will pay for the stock if she gets assigned, minus the 1.75 premium she received for the put × $100 × 10 contracts. Because the cash required to potentially purchase the stock is secured by cash sitting ready in the account, this is called a cash-secured put. Her effective purchase price if assigned is $63.25—the same as her breakeven at expiration. The idea with this trade is that if Johnson & Johnson is anywhere under $65 per share at expiration, she will buy the stock effectively at $63.25. If assigned, the time premium of the put allows her to buy the stock at a discount compared with where it is priced when the trade is established, $64. The higher the time premium—or the higher the implied volatility—the bigger the discount. This discount, however, is contingent on the stock not moving too much. If it is above $65 at expiration she won’t get assigned and therefore can only profit a maximum of 1.75 per contract. If the stock is below $63.25 at expiration, the time premium no longer represents a discount, in fact, the trade becomes a loser. In a way, Stacie is still selling volatility. Covered Call The problem with selling a naked call is that it has unlimited exposure to upside risk. Because of this, many traders simply avoid trading naked calls. A more common, and some would argue safer, method of selling calls is to sell them covered. A covered call is when calls are sold and stock is purchased on a share-for-share basis to cover the unlimited upside risk of the call. For each call that is sold, 100 shares of the underlying security are bought. Because of the addition of stock to this strategy, covered calls are traded with a different motivation than naked calls. There are clearly many similarities between these two strategies. The main goal for both is to harvest the premium of the call. The theta for the call is the same with or without the stock component. The gamma and vega for the two strategies are the same as well. The only difference is the stock. When stock is added to an option position, the net delta of the position is the only thing affected. Stock has a delta of one, and all its other greeks are zero. The pivotal point for both positions is the strike price. That’s the point the trader wants the stock to be above or below at expiration. With the naked call, the maximum payout is reaped if the stock is below the strike at expiration, and there is unlimited risk above the strike. With the covered call, the maximum payout is reaped if the stock is above the strike at expiration. If the stock is below the strike at expiration, the risk is substantial—the stock can potentially go to zero. Putting It on There are a few important considerations with the covered call, both when putting on, or entering, the position and when taking off, or exiting, the trade. The risk/reward implications of implied volatility are important in the trade-planning process. Do I want to get paid more to assume more potential risk? More speculative traders like the higher premiums. More conservative (investment-oriented) covered-call sellers like the low implied risk of low-IV calls. Ultimately, a main focus of a covered call is the option premium. How fast can it go to zero without the movement hurting me? To determine this, the trader must study both theta and delta. The first step in the process is determining which month and strike call to sell. In this example, Harley-Davidson Motor Company (HOG) is trading at about $69 per share. A trader, Bill, is neutral to slightly bullish on Harley-Davidson over the next three months. Exhibit 5.7 shows a selection of available call options for Harley-Davidson with corresponding deltas and thetas. EXHIBIT 5.7 Harley-Davidson calls. In this example, the May 70 calls have 85 days until expiration and are 2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80 premium would represent a 4 percent profit over this 85-day period (2.80 ÷ 69). That’s an annualized return of about 17 percent ([0.04 / 85)] × 365). Bill considers his alternatives. He can sell the April (57-day) 70 calls at 2.20 or the March (22-day) 70 calls at 0.85. Since there is a different number of days until expiration, Bill needs to compare the trades on an apples-to-apples basis. For this, he will look at theta and implied volatility. Presumably, the March call has a theta advantage over the longer-term choices. The March 70 has a theta of 0.032, while the April 70’s theta is 0.026 and the May 70’s is 0.022. Based on his assessment of theta, Bill would have the inclination to sell the March. If he wants exposure for 90 days, when the March 70 call expires, he can roll into the April 70 call and then the May 70 call (more on this in subsequent chapters). This way Bill can continue to capitalize on the nonlinear rate of decay through May. Next, Bill studies the IV term structure for the Harley-Davidson ATMs and finds the March has about a 19.2 percent IV, the April has a 23.3 percent IV, and the May has a 23 percent IV. March is the cheapest option by IV standards. This is not necessarily a favorable quality for a short candidate. Bill must weigh his assessment of all relevant information and then decide which trade is best. With this type of a strategy, the benefits of the higher theta can outweigh the disadvantages of selling the lower IV. In this case, Bill may actually like selling the lower IV. He may infer that the market believes Harley-Davidson will be less volatile during this period. So far, Bill has been focusing his efforts on the 70 strike calls. If he trades the March 70 covered call, he will have a net delta of 0.588 per contract. That’s the negative 0.412 delta from shorting the call plus the 1.00 delta of the stock. His indifference point if the trade is held until expiration is $70.85. The indifference point is the point at which Bill would be indifferent as to whether he held only the stock or the covered call. This is figured by adding the strike price of $70 to the 0.85 premium. This is the effective sale price of the stock if the call is assigned. If Bill wants more potential for upside profit, he could sell a higher strike. He would have to sell the April or May 75, since the March 75s are a zero bid. This would give him a higher indifference point, and the upside profits would materialize quickly if HOG moved higher, since the covered-call deltas would be higher with the 75 calls. The April 75 covered-call net delta is 0.796 per contract (the stock delta of 1.00 minus the 0.204 delta of the call). The May 75 covered-call delta is 0.751. But Bill is neutral to only slightly bullish. In this case, he’d rather have the higher premium—high theta is more desirable than high delta in this situation. Bill buys 1,000 shares of Harley-Davidson at $69 and sells 10 Harley-Davidson March 70 calls at 0.85. Bill also needs to plan his exit. To exit, he must study two things: an at-expiration diagram and his greeks. Exhibit 5.8 shows the P&(L) at expiration of the Harley-Davidson March 70 covered call. Exhibit 5.9 shows the greeks. EXHIBIT 5.8 Harley-Davidson covered call. EXHIBIT 5.9 Greeks for Harley-Davidson covered call (per contract). Delta 0.591 Gamma −0.121 Theta 0.032 Vega −0.066 Taking It Off If the trade works out perfectly for Bill, 22 days from now Harley-Davidson will be trading right at $70. He’d profit on both delta and theta. If the trade isn’t exactly perfect, but still good, Harley-Davidson will be anywhere above $68.15 in 22 days. It’s the prospect that the trade may not be so good at March expiration that occupies Bill’s thoughts, but a trader has to hope for the best and plan for the worst. If it starts to trend, Bill needs to react. The consequences to the stock’s trending to the upside are not quite so dire, although he might be somewhat frustrated with any lost opportunity above the indifference point. It’s the downside risk that Bill will more vehemently guard against. First, the same IV/vega considerations exist as they did in the previous examples. In the event the trade is closed early, IV/vega may help or hinder profitability. A rise in implied volatility will likely accompany a decline in the stock price. This can bring Bill to his stop-loss sooner. Delta versus theta however, is the major consideration. He will plan his exit price in advance and cover when the planned exit price is reached. There are more moving parts with the covered call than a naked option. If Bill wants to close the position early, he can leg out, meaning close only one leg of the trade (the call or the stock) at a time. If he legs out of the trade, he’s likely to close the call first. The motivation for exiting a trade early is to reduce risk. A naked call is hardly less risky than a covered call. Another tactic Bill can use, and in this case will plan to use, is rolling the call. When the March 70s expire, if Harley-Davidson is still in the same range and his outlook is still the same, he will sell April calls to continue the position. After the April options expire, he’ll plan to sell the Mays. With this in mind, Bill may consider rolling into the Aprils before March expiration. If it is close to expiration and Harley-Davidson is trading lower, theta and delta will both have devalued the calls. At the point when options are close to expiration and far enough OTM to be offered close to zero, say 0.05, the greeks and the pricing model become irrelevant. Bill must consider in absolute terms if it is worth waiting until expiration to make 0.05. If there is a lot of time until expiration, the answer is likely to be no. This is when Bill will be apt to roll into the Aprils. He’ll buy the March 70s for a nickel, a dime, or maybe 0.15 and at the same time sell the Aprils at the bid. This assumes he wants to continue to carry the position. If the roll is entered as a single order, it is called a calendar spread or a time spread. Covered Put The last position in the family of basic volatility-selling strategies is the covered put, sometimes referred to as selling puts and stock. In a covered put, a trader sells both puts and stock on a one-to-one basis. The term covered put is a bit of a misnomer, as the strategy changes from limited risk to unlimited risk when short stock is added to the short put. A naked put can produce only losses until the stock goes to zero—still a substantial loss. Adding short stock means that above the strike gains on the put are limited, while losses on the stock are unlimited. The covered put functions very much like a naked call. In fact, they are synthetically equal. This concept will be addressed further in the next chapter. Let’s looks at another trader, Libby. Libby is an active trader who trades several positions at once. Libby believes the overall market is in a range and will continue as such over the next few weeks. She currently holds a short stock position of 1,000 shares in Harley-Davidson. She is becoming more neutral on the stock and would consider buying in her short if the market dipped. She may consider entering into a covered-put position. There is one caveat: Libby is leaving for a cruise in two weeks and does not want to carry any positions while she is away. She decides she will sell the covered put and actively manage the trade until her vacation. Libby will sell 10 Harley-Davidson March (22-day) 70 puts at 1.85 against her short 1,000 shares of Harley-Davidson, which is trading at $69 per share. She knows that her maximum profit if the stock declines and assignment occurs will be $850. That’s 0.85 × $100 × 10 contracts. Win or lose, she will close the position in two weeks when there are only eight days until expiration. To trade this covered put she needs to watch her greeks. Exhibit 5.10 shows the greeks for the Harley-Davidson 70-strike covered put. EXHIBIT 5.10 Greeks for Harley-Davidson covered put (per contract). Delta −0.419 Gamma −0.106 Theta 0.031 Vega −0.066 Libby is really focusing on theta. It is currently about $0.03 per day but will increase if the put stays close-to-the-money. In two weeks, the time premium will have decayed significantly. A move downward will help, too, as the −0.419 delta indicates. Exhibit 5.11 displays an array of theoretical values of the put at eight days until expiration as the stock price changes. EXHIBIT 5.11 HOG 70 put values at 8 days to expiry. As long as Harley-Davidson stays below the strike price, Libby can look at her put from a premium-over-parity standpoint. Below the strike, the intrinsic value of the put doesn’t matter too much, because losses on intrinsic value are offset by gains on the stock. For Libby, all that really matters is the time value. She sold the puts at 0.85 over parity. If Harley-Davidson is trading at $68 with eight days to go, she can buy her puts back for 0.12 over parity. That’s a 73-cent profit, or $730 on her 10 contracts. This doesn’t account for any changes in the time value that may occur as a result of vega, but vega will be small with Harley-Davidson at $68 and eight days to go. At this point, she would likely close down the whole position—buying the puts and buying the stock—to take a profit on a position that worked out just about exactly as planned. Her risk, though, is to the upside. A big rally in the stock can cause big losses. From a theoretical standpoint, losses are potentially unlimited with this type of trade. If the stock is above the strike, she needs to have a mental stop order in mind and execute the closing order with discipline. Curious Similarities These basic volatility-selling strategies are fairly simple in nature. If the trader believes a stock will not rise above a certain price, the most straightforward way to trade the forecast is to sell a call. Likewise, if the trader believes the stock will not go below a certain price he can sell a put. The covered call and covered put are also ways to generate income on long or short stock positions that have these same price thresholds. In fact, the covered call and covered put have some curious similarities to the naked put and naked call. The similarities between the two pairs of positions are no coincidence. The following chapter sheds light on these similarities. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html SCORE: 40.00 ================================================================================ CHAPTER 6 Put-Call Parity and Synthetics In order to understand more complex spread strategies involving two or more options, it is essential to understand the arbitrage relationship of the put-call pair. Puts and calls of the same month and strike on the same underlying have prices that are defined in a mathematical relationship. They also have distinctly related vegas, gammas, thetas, and deltas. This chapter will show how the metrics of these options are interrelated. It will also explore synthetics and the idea that by adding stock to a position, a trader may trade with indifference either a call or a put to the same effect. Put-Call Parity Essentials Before the creation of the Black-Scholes model, option pricing was hardly an exact science. Traders had only a few mathematical tools available to compare the relative prices of options. One such tool, put-call parity, stems from the fact that puts and calls on the same class sharing the same month and strike can have the same functionality when stock is introduced. For example, traders wanting to own a stock with limited risk can buy a married put: long stock and a long put on a share-for-share basis. The traders have infinite profit potential, and the risk of the position is limited below the strike price of the option. Conceptually, long calls have the same risk/reward profile—unlimited profit potential and limited risk below the strike. Exhibit 6.1 is an overview of the at-expiration diagrams of a married put and a long call. EXHIBIT 6.1 Long call vs. long stock + long put (married put). Married puts and long calls sharing the same month and strike on the same security have at-expiration diagrams with the same shape. They have the same volatility value and should trade around the same implied volatility (IV). Strategically, these two positions provide the same service to a trader, but depending on margin requirements, the married put may require more capital to establish, because the trader must buy not just the option but also the stock. The stock component of the married put could be purchased on margin. Buying stock on margin is borrowing capital to finance a stock purchase. This means the trader has to pay interest on these borrowed funds. Even if the stock is purchased without borrowing, there is opportunity cost associated with the cash used to pay for the stock. The capital is tied up. If the trader wants to use funds to buy another asset, he will have to borrow money, which will incur an interest obligation. Furthermore, if the trader doesn’t invest capital in the stock, the capital will rest in an interest-bearing account. The trader forgoes that interest when he buys a stock. However the trader finances the purchase, there is an interest cost associated with the transaction. Both of these positions, the long call and the married put, give a trader exposure to stock price advances above the strike price. The important difference between the two trades is the value of the stock below the strike price—the part of the trade that is not at risk in either the long call or the married put. On this portion of the invested capital, the trader pays interest with the married put (whether actually or in the form of opportunity cost). This interest component is a pricing consideration that adds cost to the married put and not the long call. So if the married put is a more expensive endeavor than the long call because of the interest paid on the investment portion that is below the strike, why would anyone buy a married put? Wouldn’t traders instead buy the less expensive—less capital intensive—long call? Given the additional interest expense, they would rather buy the call. This relates to the concept of arbitrage. Given two effectively identical choices, rational traders will choose to buy the less expensive alternative. The market as a whole would buy the calls, creating demand which would cause upward price pressure on the call. The price of the call would rise until its interest advantage over the married put was gone. In a robust market with many savvy traders, arbitrage opportunities don’t exist for very long. It is possible to mathematically state the equilibrium point toward which the market forces the prices of call and put options by use of the put-call parity. As shown in Chapter 2, the put-call parity states where c is the call premium, PV(x) is the present value of the strike price, p is the put premium and s is the stock price. Another, less academic and more trader-friendly way of stating this equation is where Interest is calculated as Interest = Strike × Interest Rate ×(Days to Expiration/365) 1 The two versions of the put-call parity stated here hold true for European options on non-dividend-paying stocks. Dividends Another difference between call and married-put values is dividends. A call option does not extend to its owner the right to receive a dividend payment. Traders, however, who are long a put and long stock are entitled to a dividend if it is the corporation’s policy to distribute dividends to its shareholders. An adjustment must be made to the put-call parity to account for the possibility of a dividend payment. The equation must be adjusted to account for the absence of dividends paid to call holders. For a dividend-paying stock, the put-call parity states The interest advantage and dividend disadvantage of owning a call is removed from the market by arbitrageurs. Ultimately, that is what is expressed in the put-call parity. It’s a way to measure the point at which the arbitrage opportunity ceases to exist. When interest and dividends are factored in, a long call is an equal position to a long put paired with long stock. In options nomenclature, a long put with long stock is a synthetic long call. Algebraically rearranging the above equation: The interest and dividend variables in this equation are often referred to as the basis. From this equation, other synthetic relationships can be algebraically derived, like the synthetic long put. A synthetic long put is created by buying a call and selling (short) stock. The at-expiration diagrams in Exhibit 6.2 show identical payouts for these two trades. EXHIBIT 6.2 Long put vs. long call + short stock. The concept of synthetics can become more approachable when studied from the perspective of delta as well. Take the 50-strike put and call listed on a $50 stock. A general rule of thumb in the put-call pair is that the call delta plus the put delta equals 1.00 when the signs are ignored. If the 50 put in this example has a −0.45 delta, the 50 call will have a 0.55 delta. By combining the long call (0.55 delta) with short stock (–1.00 delta), we get a synthetic long put with a −0.45 delta, just like the actual put. The directional risk is the same for the synthetic put and the actual put. A synthetic short put can be created by selling a call of the same month and strike and buying stock on a share-for-share basis (i.e., a covered call). This is indicated mathematically by multiplying both sides of the put-call parity equation by −1: The at-expiration diagrams, shown in Exhibit 6.3 , are again conceptually the same. EXHIBIT 6.3 Short put vs. short call + long stock. A short (negative) put is equal to a short (negative) call plus long stock, after the basis adjustment. Consider that if the put is sold instead of buying stock and selling a call, the interest that would otherwise be paid on the cost of the stock up to the strike price is a savings to the put seller. To balance the equation, the interest benefit of the short put must be added to the call side (or subtracted from the put side). It is the same with dividends. The dividend benefit of owning the stock must be subtracted from the call side to make it equal to the short put side (or added to the put side to make it equal the call side). The same delta concept applies here. The short 50-strike put in our example would have a 0.45 delta. The short call would have a −0.55 delta. Buying one hundred shares along with selling the call gives the synthetic short put a net delta of 0.45 (–0.55 + 1.00). Similarly, a synthetic short call can be created by selling a put and selling (short) one hundred shares of stock. Exhibit 6.4 shows a conceptual overview of these two positions at expiration. EXHIBIT 6.4 Short call vs. short put + short stock. Put-call parity can be manipulated as shown here to illustrate the composition of the synthetic short call. Most professional traders earn a short stock rebate on the proceeds they receive when they short stock—an advantage to the short-put–short-stock side of the equation. Additionally, short-stock sellers must pay dividends on the shares they are short—a liability to the married-put seller. To make all things equal, one subtracts interest and adds dividends to the put side of the equation. Comparing Synthetic Calls and Puts The common thread among the synthetic positions explained above is that, for a put-call pair, long options have synthetic equivalents involving long options, and short options have synthetic equivalents involving short options. After accounting for the basis, the four basic synthetic option positions are: Because a call or put position is interchangeable with its synthetic position, an efficient market will ensure that the implied volatility is closely related for both. For example, if a long call has an IV of 25 percent, the corresponding put should have an IV of about 25 percent, because the long put can easily be converted to a synthetic long call and vice versa. The greeks will be similar for synthetically identical positions, too. The long options and their synthetic equivalents will have positive gamma and vega with negative theta. The short options and their synthetics will have negative gamma and vega with positive theta. American-Exercise Options Put-call parity was designed for European-style options. The early exercise possibility of American-style options gums up the works a bit. Because a call (put) and a synthetic call (put) are functionally the same, it is logical to assume that the implied volatility and the greeks for both will be exactly the same. This is not necessarily true with American-style options. However, put-call parity may still be useful with American options when the limitations of the equation are understood. With at-the-money American-exercise options, the differences in the greeks for a put-call pair are subtle. Exhibit 6.5 is a comparison of the greeks for the 50-strike call and the 50-strike put with the underlying at $50 and 66 days until expiration. EXHIBIT 6.5 Greeks for a 50-strike put-call pair on a $50 stock. Call Put Delta 0.554 0.457 Gamma 0.075 0.078 Theta 0.020 0.013 Vega 0.084 0.084 The examples used earlier in this chapter in describing the deltas of synthetics were predicated on the rule of thumb that the absolute values of call and put deltas add up to 1.00. To be a bit more realistic, consider that because of American exercise, the absolute delta values of put-call pairs don’t always add up to 1.00. In fact, Exhibit 6.5 shows that the call has closer to a 0.554 delta. The put struck at the same price then has a 0.457 delta. By selling 100 shares against the long call, we can create a combined-position delta (call delta plus stock delta) that is very close to the put’s delta. The delta of this synthetic put is −0.446 (0.554 − 1.00). The delta of a put will always be similar to the delta of its corresponding synthetic put. This is also true with call–synthetic-call deltas. This relationship mathematically is This holds true whether the options are in-, at-, or out-of-the-money. For example, with a stock at $54, the 50-put would have a −0.205 delta and the call would have a 0.799 delta. Selling 100 shares against the call to create the synthetic put yields a net delta of −0.201. If long or short stock is added to a call or put to create a synthetic, delta will be the only greek affected. With that in mind, note the other greeks displayed in Exhibit 6.5 —especially theta. Proportionally, the biggest difference in the table is in theta. The disparity is due in part to interest. When the effects of the interest component outweigh the effects of the dividend, the time value of the call can be higher than the time value of the put. Because the call must lose more premium than the put by expiration, the theta of the call must be higher than the theta of the put. American exercise can also cause the option prices in put-call parity to not add up. Deep in-the-money (ITM) puts can trade at parity while the corresponding call still has time value. The put-call equation can be unbalanced. The same applies to calls on dividend-paying stocks as the dividend date approaches. When the date is imminent, calls can trade close to parity while the puts still have time value. The role of dividends will be discussed further in Chapter 8. Synthetic Stock Not only can synthetic calls and puts be derived by manipulation of put-call parity, but synthetic positions for the other security in the equation—stock—can be derived, as well. By isolating stock on one side of the equation, the formula becomes After accounting for interest and dividends, buying a call and selling a put of the same strike and time to expiration creates the equivalent of a long stock position. This is called a synthetic stock position, or a combo. After accounting for the basis, the equation looks conceptually like this: This is easy to appreciate when put-call parity is written out as it is here. It begins to make even more sense when considering at-expiration diagrams and the greeks. Exhibit 6.6 illustrates a long stock position compared with a long call combined with a short put position. EXHIBIT 6.6 Long stock vs. long call + short put. A quick glance at these two strategies demonstrates that they are the same, but think about why. Consider the synthetic stock position if both options are held until expiration. The long call gives the trader the right to buy the stock at the strike price. The short put gives the trader the obligation to buy the stock at the same strike price. It doesn’t matter what the strike price is. As long as the strike is the same for the call and the put, the trader will have a long position in the underlying at the shared strike at expiration when exercise or assignment occurs. The options in this example are 50-strike options. At expiration, the trader can exercise the call to buy the underlying at $50 if the stock is above the strike. If the underlying is below the strike at expiration, he’ll get assigned on the put and buy the stock at $50. If the stock is bought, whether by exercise or assignment, the effective price of the potential stock purchase, however, is not necessarily $50. For example, if the trader bought one 50-strike call at 3.50 and sold one 50-strike put at 1.50, he will effectively purchase the underlying at $52 upon exercise or assignment. Why? The trader paid a net of $2 to get a long position in the stock synthetically (3.50 of call premium debited minus 1.50 of put premium credited). Whether the call or the put is ITM, the effective purchase price of the stock will always be the strike price plus or minus the cost of establishing the synthetic, in this case, $52. The question that begs to be asked is: would the trader rather buy the stock or pay $2 to have the same market exposure as long stock? Arbitrageurs in the market (with the help of the put-call parity) ensure that neither position—long stock or synthetic long stock—is better than the other. For example, assume a stock is trading at $51.54. With 71 days until expiration, 26.35 IV, a 5 percent interest rate, and no dividends, the 50-strike call is theoretically worth 3.50, and the 50-strike put is theoretically worth 1.50. Exhibit 6.7 charts the synthetic stock versus the actual stock when there are 71 days until expiration. EXHIBIT 6.7 Long stock and synthetic long stock with 71 days to expiration. Looking at this exhibit, it appears that being long the actual stock outperforms being long the stock synthetically. If the stock is purchased at $51.54, it need only rise a penny higher to profit (in the theoretical world where traders do not pay commissions on transactions). If the synthetic is purchased for $2, the stock needs to rise $0.46 to break even—an apparent disadvantage. This figure, however, does not include interest. The synthetic stock offers the same risk/reward as actually being long the stock. There is a benefit, from the perspective of interest, to paying only $2 for this exposure rather than $51.54. The interest benefit here is about $0.486. We can find this number by calculating the interest as we did earlier in the chapter. Interest, again, is computed as the strike price times the interest rate times the number of days to expiration divided by the number of days in a year. The formula is as follows: Inputting the numbers from this example: The $0.486 of interest is about equal to the $0.46 disparity between the diagrams of the stock and the synthetic stock with 71 days until expiration. The difference is due mainly to rounding and the early-exercise potential of the American put. In mathematical terms The synthetic long stock is approximately equal to the long stock position when considering the effect of interest. The two lines in Exhibit 6.7 —representing stock and synthetic stock—would converge with each passing day as the calculated interest decreases. This equation works as well for a synthetic short stock position; reversing the signs reveals the synthetic for short stock. Or, in this case, Shorting stock at $51.54 is about equal to selling the 50 call and buying the 50 put for a $2 credit based on the interest of 0.486 computed on the 50 strike. Again, the $0.016 disparity between the calculated interest and the actual difference between the synthetic value and the stock price is a function of rounding and early exercise. More on this in the “Conversions and Reversals” section. Synthetic Stock Strategies Ultimately, when we roll up our sleeves and get down to the nitty-gritty, options trading is less about having another alternative for trading the direction of the underlying than it is about trading the greeks. Different strategies allow traders to exploit different facets of option pricing. Some strategies allow traders to trade volatility. Some focus mainly on theta. Many of the strategies discussed in this section present ways for a trader to distill risk down mostly to interest rate exposure. Conversions and Reversals When calls and puts are combined to create synthetic stock, the main differences are the interest rate and dividends. This is important because the risks associated with interest and dividends can be isolated, and ultimately traded, when synthetic stock is combined with the underlying. There are two ways to combine synthetic stock with its underlying security: a conversion and a reversal. Conversion A conversion is a three-legged position in which a trader is long stock, short a call, and long a put. The options share the same month and strike price. By most metrics, this is a very flat position. A trader with a conversion is long the stock and, at the same time, synthetically short the same stock. Consider this from the perspective of delta. In a conversion, the trader is long 1.00 deltas (the long stock) and short very close to 1.00 deltas (the synthetic short stock). Conversions have net flat deltas. The following is a simple example of a typical conversion and the corresponding deltas of each component. Short one 35-strike call: −0.63 delta Long one 35-strike put: −0.37 delta Long 100 shares: 1.00 delta 0.00 delta The short call contributes a negative delta to the position, in this case, −0.63. The long put also contributes a negative delta, −0.37. The combined delta of the synthetic stock is −1.00 in this example, which is like being short 100 shares of stock. When the third leg of the spread is added, the long 100 shares, it counterbalances the synthetic. The total delta for the conversion is zero. Most of the conversion’s other greeks are pretty flat as well. Gamma, theta, and vega are similar for the call and the put in the conversion, because they have the same expiration month and strike price. Because the trader is selling one option and buying another—a call and a put, respectively—with the same month and strike, the greeks come very close to offsetting each other. For all intents and purposes, the trader is out of the primary risks of the position as measured by greeks when a position is converted. Let’s look at a more detailed example. A trader executes the following trade (for the purposes of this example, we assume the stock pays no dividend and the trade is executed at fair value): Sell one 71-day 50 call at 3.50 Buy one 71-day 50 put at 1.50 Buy 100 shares at $51.54 The trader buys the stock at $51.54 and synthetically sells the stock at $52. The synthetic price is computed as −3.50 + 1.50 − 50. Therefore, the stock is sold synthetically at $0.46 over the actual stock price. Exhibit 6.8 shows the analytics for the conversion. EXHIBIT 6.8 Conversion greeks. This position has very subtle sensitivity to the greeks. The net delta for the spread has a very slightly negative bias. The bias is so small it is negligible to most traders, except professionals trading very large positions. Why does this negative delta bias exist? Mathematically, the synthetic’s delta can be higher with American options than with their European counterparts because of the possibility of early exercise of the put. This anomaly becomes more tangible when we consider the unique directional risk associated with this trade. In this example, the stock is synthetically sold at $0.46 over the price at which the stock is bought. If the stock declines significantly in value before expiration, the put will, at some point, trade at parity while the call loses all its time value. In this scenario, the value of the synthetic stock will be short at effectively the same price as the actual stock price. For example, if the stock declines to $35 per share then the numbers are as follows: or With American options, a put this far in-the-money with less than 71 days until expiry will be all intrinsic value. Interest, in this case, will not factor into the put’s value, because the put can be exercised. By exercising the put, both the long stock leg and the long put leg can be closed for even money, leaving only the theoretically worthless call. The stock-synthetic spread is sold at 0.46 and essentially bought at zero when the put is exercised. If the put is exercised before expiration, the profit potential is 0.46 minus the interest calculated between the trade date and the day the put is exercised. If, however, the conversion is held until expiration, the $0.46 is negated by the $0.486 of interest incurred from holding long stock over the entire 71-day period, hence the trader’s desire to see the stock decline before expiration, and thus the negative bias toward delta. This is, incidentally, why the synthetic price (0.46 over the stock price) does not exactly equal the calculated value of the interest (0.486). The trader can exercise the put early if the stock declines and capitalize on the disparity between the interest calculated when the conversion was traded and the actual interest calculation given the shorter time frame. The model values the synthetic at a little less than the interest value would indicate—in this case $0.46 instead of $0.486. The gamma of this trade is fairly negligible. The theta is slightly positive. Rho is the figure that deserves the most attention. Rho is the change in an option’s price given a change in the interest rate. The −0.090 rho of the conversion indicates that if the interest rate rises one percentage point, the position as a whole loses $0.09. Why? The financing of the position gets more expensive as the interest rate rises. The trader would have to pay more in interest to carry the long stock. In this example, if interest rises by one percentage point, the synthetic stock, which had an effective short price of $0.46 over the price of the long stock before the interest rate increase, will be $0.55 over the price of the long stock afterward. If, however, the interest rate declines by one percentage point, the trader profits $0.09, as the synthetic is repriced by the market to $0.37 over the stock price. The lower the interest rate, the less expensive it is to finance the long stock. This is proven mathematically by put-call parity. Negative rho indicates a bearish position on the interest rate; the trader wants it to go lower. Positive rho is a bullish interest rate position. But a one-percentage-point change in the interest rate in one day is a big and uncommon change. The question is: is rho relevant? That depends on the type of position and the type of trader. A 0.090 rho would lead to a 0.0225 profit-and-loss (P&(L)) change per one lot conversion on a 25-basis-point, or quarter percent, change. That’s just $2.25 per spread. This incremental profit or loss, however, can be relevant to professional traders like market makers. They trade very large positions with the aspiration of making small incremental profits on each trade. A market maker with a 5,000-lot conversion would stand to make or lose $11,250, given a quarter-percentage-point change in interest rate and a 0.090 rho. The Mind of a Market Maker Market makers are among the only traders who can trade conversions and reversals profitably, because of the size of their trades and the fact that they can buy the bid and sell the offer. Market makers often attempt to leg into and out of conversions (and reversals). Given the conversion in this example, a market maker may set out to sell calls and in turn buy stock to hedge the call’s delta risk (this will be covered in Chapters 12 and 17), then buy puts and the rest of the stock to create a balanced conversion: one call to one put to one hundred shares. The trader may try to put on the conversion in the previous example for a total of $0.50 over the price of the long stock instead of the $0.46 it’s worth. He would then try to leg out of the trade for less, say $0.45 over the stock, with the goal of locking in a $0.05 profit per spread on the whole trade. Reversal A reversal, or reverse conversion, is simply the opposite of the conversion: buy call, sell put, and sell (short) stock. A reversal can be executed to close a conversion, or it can be an opening transaction. Using the same stock and options as in the previous example, a trader could establish a reversal as follows: Buy one 71-day 50 call at 3.50 Sell one 71-day 50 put at 1.50 Sell 100 shares at 51.54 The trader establishes a short position in the stock at $51.54 and a long synthetic stock position effectively at $52.00. He buys the stock synthetically at $0.46 over the stock price, again assuming the trade can be executed at fair value. With the reversal, the trader has a bullish position on interest rates, which is indicated by a positive rho. In this example, the rho for this position is 0.090. If interest rates rise one percentage point, the synthetic stock (which the trader is long) gains nine cents in value relative to the stock. The short stock rebate on the short stock leg earns more interest at a higher interest rate. If rates fall one percentage point, the synthetic long stock loses $0.09. The trader earns less interest being short stock given a lower interest rate. With the reversal, the fact that the put can be exercised early is a risk. Since the trader is short the put and short stock, he hopes not to get assigned. If he does, he misses out on the interest he planned on collecting when he put on the reversal for $0.46 over. Pin Risk Conversions and reversals are relatively low-risk trades. Rho and early exercise are relevant to market makers and other arbitrageurs, but they are among the lowest-risk positions they are likely to trade. There is one indirect risk of conversions and reversals that can be of great concern to market makers around expiration: pin risk. Pin risk is the risk of not knowing for certain whether an option will be assigned. To understand this concept, let’s revisit the mind of a market maker. Recall that market makers have two primary functions: 1. Buy the bid or sell the offer. 2. Manage risk. When institutional or retail traders send option orders to an exchange (through a broker), market makers are usually the ones with whom they trade. Customers sell the bid; the market makers buy the bid. Customers buy the offer; the market makers sell the offer. The first and arguably easier function of market makers is accomplished whenever a marketable order is sent to the exchange. Managing risk can get a bit hairy. For example, once the market makers buy April 40 calls, their first instinct is to hedge by selling stock to become delta neutral. Market makers are almost always delta neutral, which mitigates the direction risk. The next step is to mitigate theta, gamma, and vega risk by selling options. The ideal options to sell are the same calls that were bought—that is, get out of the trade. The next best thing is to sell the April 40 puts and sell more stock. In this case, the market makers have established a reversal and thereby have very little risk. If they can lock in the reversal for a small profit, they have done their job. What happens if the market makers still have the reversal in inventory at expiration? If the stock is above the strike price—40, in this case—the puts expire, the market makers exercise the calls, and the short stock is consequently eliminated. The market makers are left with no position, which is good. They’re delta neutral. If the stock is below 40, the calls expire, the puts get assigned, and the short stock is consequently eliminated. Again, no position. But what if the stock is exactly at $40? Should the calls be exercised? Will the puts get assigned? If the puts are assigned, the traders are left with no short stock and should let the calls expire without exercising so as not to have a long delta position after expiration. If the puts are not assigned, they should exercise the calls to get delta flat. It’s also possible that only some of the puts will be assigned. Because they don’t know how many, if any, of the puts will be assigned, the market makers have pin risk. To avoid pin risk, market makers try to eliminate their position if they have conversions or reversals close to expiration. Boxes and Jelly Rolls There are two other uses of synthetic stock positions that form conventional strategies: boxes and rolls. Boxes When long synthetic stock is combined with short synthetic stock on the same underlying within the same expiration cycle but with a different strike price, the resulting position is known as a box. With a box, a trader is synthetically both long and short the stock. The two positions, for all intents and purposes, offset each other directionally. The risk of stock-price movement is almost entirely avoided. A study of the greeks shows that the delta is close to zero. Gamma, theta, vega, and rho are also negligible. Here’s an example of a 60–70 box for April options: Short 1 April 60 call Long 1 April 60 put Long 1 April 70 call Short 1 April 70 put In this example, the trader is synthetically short the 60-strike and, at the same time, synthetically long the 70-strike. Exhibit 6.9 shows the greeks. EXHIBIT 6.9 Box greeks. Aside from the risks associated with early exercise implications, this position is just about totally flat. The near-1.00 delta on the long synthetic stock struck at 60 is offset by the near-negative-1.00 delta of the short synthetic struck at 70. The tiny gammas and thetas of both combos are brought closer to zero when they are spread against each another. Vega is zero. And the bullish interest rate sensitivity of the long combo is nearly all offset by the bearish interest sensitivity of the short combo. The stock can move, time can pass, volatility and interest can change, and there will be very little effect on the trader’s P&(L). The question is: Why would someone trade a box? Market makers accumulate positions in the process of buying bids and selling offers. But they want to eliminate risk. Ideally, they try to be flat the strike —meaning have an equal number of calls and puts at each strike price, whether through a conversion or a reversal. Often, they have a conversion at one strike and a reversal at another. The stock positions for these cancel each other out and the trader is left with only the four option legs—that is, a box. They can eliminate pin risk on both strikes by trading the box as a single trade to close all four legs. Another reason for trading a box has to do with capital. Borrowing and Lending Money The first thing to consider is how this spread is priced. Let’s look at another example of a box, the October 50–60 box. Long 1 October 60 call Short 1 October 60 put Short 1 October 70 call Long 1 October 70 put A trader with this position is synthetically long the stock at $60 and short the stock at $70. That sounds like $10 in the bank. The question is: How much would a trader be willing to pay for the right to $10? And for how much would someone be willing to sell it? At face value, the obvious answer is that the equilibrium point is at $10, but there is one variable that must be factored in: time. In this example, assume that the October call has 90 days until expiration and the interest rate is 6 percent. A rational trader would not pay $10 today for the right to have $10 90 days from now. That would effectively be like loaning the $10 for 90 days and not receiving interest—A losing proposition! The trader on the other side of this box would be happy to enter into the spread for $10. He would have interest-free use of $10 for 90 days. That’s free money! Certainly, there is interest associated with the cost of carrying the $10. In this case, the interest would be $0.15. This $0.15 is discounted from the price of the $10 box. In fact, the combined net value of the options composing the box should be about 9.85—with differences due mainly to rounding and the early exercise possibility for American options. A trader buying this box—that is, buying the more ITM call and more ITM put—would expect to pay $0.15 below the difference between the strike prices. Fair value for this trade is $9.85. The seller of this box—the trader selling the meatier options and buying the cheaper ones—would concede up to $0.15 on the credit. Jelly Rolls A jelly roll, or simply a roll, is also a spread with four legs and a combination of two synthetic stock trades. In a box, the difference between the synthetics is the strike price; in a roll, it’s the contract month. Here’s an example: Long 1 April 50 call Short 1 April 50 put Short 1 May 50 call Long 1 May 50 put The options in this spread all share the same strike price, but they involve two different months—April and May. In this example, the trader is long synthetic stock in April and short synthetic stock in May. Like the conversion, reversal, and box, this is a mostly flat position. Delta, gamma, theta, vega, and even rho have only small effects on a jelly roll, but like the others, this spread serves a purpose. A trader with a conversion or reversal can roll the option legs of the position into a month with a later expiration. For example, a trader with an April 50 conversion in his inventory (short the 50 call, long the 50 put, long stock) can avoid pin risk as April expiration approaches by trading the roll from the above example. The long April 50 call and short April 50 put cancel out the current option portion of the conversion leaving only the stock. Selling the May 50 calls and buying the May 50 puts reestablishes the conversion a month farther out. Another reason for trading a roll has to do with interest. The roll in this example has positive exposure to rho in April and negative exposure to rho in May. Based on a trader’s expectations of future changes in interest rates, a position can be constructed to exploit opportunities in interest. Theoretical Value and the Interest Rate The main focus of the positions discussed in this chapter is fluctuations in the interest rate. But which interest rate? That of 30-year bonds? That of 10- or 5-year notes? Overnight rates? The federal funds rate? In the theoretical world, the answer to this question is not really that important. Professors simply point to the riskless rate and continue with their lessons. But when putting strategies like these into practice, choosing the right rate makes a big difference. To answer the question of which interest rate, we must consider exactly what the rates represent from the standpoint of an economist. Therefore, we must understand how an economist makes arguments—by making assumptions. Take the story of the priest, the physicist, and the economist stranded on a desert island with nothing to eat except a can of beans. The problem is, the can is sealed. In order to survive, they must figure out how to open the can. The priest decides he will pray for the can to be opened by means of a miracle. He prays for hours, but, alas, the can remains sealed tight. The physicist devises a complex system of wheels and pulleys to pop the top off the can. This crude machine unfortunately fails as well. After watching the lack of success of his fellow strandees, the economist announces that he has the solution: “Assume we have a can opener.” In the spirit of economists’ logic, let’s imagine for a moment a theoretical economic microcosm in which a trader has two trading accounts at the same firm. The assumptions here are that a trader can borrow 100 percent of a stock’s value to finance the purchase of the security and that there are no legal, moral, or other limitations on trading. In one account the trader is long 100 shares, fully leveraged. In the other, the trader is short 100 shares of the same stock, in which case the trader earns a short-stock rebate. In the long run, what is the net result of this trade? Most likely, this trade is a losing proposition for the trader, because the interest rate at which the trader borrows capital is likely to be higher than the interest rate earned on the short-stock proceeds. In this example, interest is the main consideration. But interest matters in the real world, too. Professional traders earn interest on proceeds from short stock and pay interest on funds borrowed. Interest rates may vary slightly from firm to firm and trader to trader. Interest rates are personal. The interest rate a trader should use when pricing options is specific to his or her situation. A trader with no position in a particular stock who is interested in trading a conversion should consider that he will be buying the stock. This implies borrowing funds to open the long stock position. The trader should price his options according to the rate he will pay to borrow funds. Conversely, a trader trading a reversal should consider the fact that he is shorting the stock and will receive interest at the rate of the short-stock rebate. This trader should price his options at the short-stock rate. A Call Is a Put The idea that “a put is a call, a call is a put” is an important one, indeed. It lays the foundation for more advanced spreading strategies. The concepts in this chapter in one way or another enter into every spread strategy that will be discussed in this book from here on out. Note 1 . Note, for simplicity, simple interest is used in the computation. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00016.html SCORE: 16.00 ================================================================================ CHAPTER 7 Rho Interest is one of the six inputs of an option-pricing model for American options. Although interest rates can remain constant for long periods, when interest rates do change, call and put values can be positively or negatively affected. Some options are more sensitive to changes in the interest rate than others. To the unaware trader, interest-rate changes can lead to unexpected profits or losses. But interest rates don’t have to be a wild-card risk. They’re one that experienced traders watch closely to avoid unnecessary risk and increase profitability. To monitor the effect of changes in the interest rate, it is important to understand the quiet greek—rho. Rho and Interest Rates Rho is a measurement of the sensitivity of an option’s value to a change in the interest rate. To understand how and why the interest rate is important to the value of an option, recall the formula for put-call parity stated in Chapter 6. Call + Strike − Interest = Put + Stock 1 From this formula, it’s clear that as the interest rate rises, put prices must fall and call prices must rise to keep put-call parity balanced. With a little algebra, the equation can be restated to better illustrate this concept: and If interest rates fall, and Rho helps quantify this relationship. Calls have positive rho, and puts have negative rho. For example, a call with a rho of +0.08 will gain $0.08 with each one-percentage-point rise in interest rates and fall $0.08 with each one-percentage-point fall in interest rates. A put with a rho of −0.08 will lose $0.08 with each one-point rise and gain $0.08 in value with a one-point fall. The effect of changes in the interest variable of put-call parity on call and put values is contingent on three factors: the strike price, the interest rate, and the number of days until expiration. Interest = Strike×Interest Rate×(Days to Expiration/365) 2 Interest, for our purposes, is a function of the strike price. The higher the strike price, the greater the interest and, consequently the more changes in the interest rate will affect the option. The higher the interest rate is, the higher the interest variable will be. Likewise, the more time to expiration, the greater the effect of interest. Rho measures an option’s sensitivity to the end results of these three influences. To understand how changes in interest affect option prices, consider a typical at-the-money (ATM) conversion on a non-dividend-paying stock. Short 1 May 50 call at 1.92 Long 1 May 50 put at 1.63 Long 100 shares at $50 With 43 days until expiration at a 5 percent interest rate, the interest on the 50 strike will be about $0.29. Put-call parity ensures that this $0.29 shows up in option prices. After rearranging the equation, we get In this example, both options are exactly ATM. There is no intrinsic value. Therefore, the difference between the extrinsic values of the call and the put must equal interest. If one option were in-the-money (ITM), the intrinsic value on the left side of the equation would be offset by the Stock − Strike on the right side. Still, it would be the difference in the time value of the call and put that equals the interest variable. This is shown by the fact that the synthetic stock portion of the conversion is short at $50.29 (call − put + strike). This is $0.29 above the stock price. The synthetic stock equals the Stock + Interest, or Certainly, if the interest rate were higher, the interest on the synthetic stock would be a higher number. At a 6 percent interest rate, the effective short price of the synthetic stock would be about $50.35. The call would be valued at about 1.95, and the put would be 1.60—a net of $0.35. A one-percentage-point rise in the interest rate causes the synthetic stock position to be revalued by $0.06—a $0.03 gain in the call value and a $0.03 decline in the put. Therefore, by definition, the call has a +0.03 rho and the put has a −0.03 rho. Rho and Time The time component of interest has a big impact on the magnitude of an option’s rho, because the greater the number of days until expiration, the greater the interest. Long-term options will be more sensitive to changes in the interest rate and, therefore, have a higher rho. Take a stock trading at about $120 per share. The July, October, and January ATM calls have the following rhos with the interest rate at 5.5 percent. Option Rho July (38-day) 120 calls +0.068 October (130-day) 120 calls +0.226 January (221-day) 120 calls +0.385 If interest rates rise 25 basis points, or a quarter of a percentage point, the July calls with only 38 days until expiration will gain very little: only $0.017 (0.068 × 0.25). The October 120 calls with 130 days until expiration gain more: $0.057 (0.226 × 0.25). The January calls that have 221 days until they expire make $0.096 theoretically (0.385 × 0.25). If all else is held constant, the more time to expiration, the higher the option’s rho, and therefore, the more interest will affect the option’s value. Considering Rho When Planning Trades Just having an opinion on a stock is only half the battle in options trading. Choosing the best way to trade a forecast can make all the difference to the success of a trade. Options give traders choices. And one of the choices a trader has is the month in which to trade. When trading LEAPS—Long-Term Equity AnticiPation Securities—delta, gamma, theta, and vega are important, as always, but rho is also a valuable part of the strategy. LEAPS Options buyers have time working against them. With each passing day, theta erodes the value of their assets. Buying a long-term option, or a LEAPS, helps combat erosion because long-term options can decay at a slower rate. In environments where there is interest rate uncertainty, however, LEAPS traders have to think about more than the rate of decay. Consider two traders: Jason and Susanne. Both are bullish on XYZ Corp. (XYZ), which is trading at $59.95 per share. Jason decides to buy a May 60 call at 1.60, and Susanne buys a LEAPS 60 call at 7.60. In this example, May options have 44 days until expiration, and the LEAPS have 639 days. Both of these trades are bullish, but the traders most likely had slightly different ideas about time, volatility, and interest rates when they decided which option to buy. Exhibit 7.1 compares XYZ short-term at-the-money calls with XYZ LEAPS ATM calls. EXHIBIT 7.1 XYZ short-term call vs. LEAPS call. To begin with, it appears that Susanne was allowing quite a bit of time for her forecast to be realized—almost two years. Jason, however, was looking for short-term price appreciation. Concerns about time decay may have been a motivation for Susanne to choose a long-term option—her theta of 0.01 is half Jason’s, which is 0.02. With only 44 days until expiration, the theta of Jason’s May call will begin to rise sharply as expiration draws near. But the trade-off of lower time decay is lower gamma. At the current stock price, Susanne has a higher delta. If the XYZ stock price rises $2, the gamma of the May call will cause Jason’s delta to creep higher than Susanne’s. At $62, the delta for the May 60s would be about 0.78, whereas the LEAPS 60 call delta is about 0.77. This disparity continues as XYZ moves higher. Perhaps Susanne had implied volatility (IV) on her mind as well as time decay. These long-term ATM LEAPS options have vegas more than three times the corresponding May’s. If IV for both the May and the LEAPS is at a yearly low, LEAPS might be a better buy. A one- or two-point rise in volatility if IV reverts to its normal level will benefit the LEAPS call much more than the May. Theta, delta, gamma, and vega are typical considerations with most trades. Because this option is long term, in addition to these typical considerations, Susanne needs to take a good hard look at rho. The LEAPS rho is significantly higher than that of its short-term counterpart. A one-percentage-point change in the interest rate will change Susanne’s P&(L) by $0.64—that’s about 8.5 percent of the value of her option—and she has nearly two years of exposure to interest rate fluctuations. Certainly, when the Federal Reserve Board has great concerns about growth or inflation, rates can rise or fall by more than one percentage point in one year’s time. It is important to understand that, like the other greeks, rho is a snapshot at a particular price, volatility level, interest rate, and moment in time. If interest rates were to fall by one percentage point today, it would cause Susanne’s call to decline in value by $0.64. If that rate drop occurred over the life of the option, it would have a much smaller effect. Why? Rate changes closer to expiration have less of an effect on option values. Assume that on the trade date, when the LEAPS has 639 days until expiration, interest rates fall by 25 basis points. The effect will be a decline in the value of the call of 0.16—one-fourth of the 0.638 rho. If the next rate cut occurs six months later, the rho of the LEAPS will be smaller, because it will have less time until expiration. In this case, after six months, the rho will be only 0.46. Another 25-basis-point drop will hurt the call by $0.115. After another six months, the option will have a 0.26 rho. Another quarter-point cut costs Susanne only $0.065. Any subsequent rate cuts in ensuing months will have almost no effect on the now short-term option value. Pricing in Interest Rate Moves In the same way that volatility can get priced in to an option’s value, so can the interest rate. When interest rates are expected to rise or fall, those expectations can be reflected in the prices of options. Say current interest rates are at 8 percent, but the Fed has announced that the economy is growing at too fast of a pace and that it may raise interest rates at the next Federal Open Market Committee meeting. Analysts expect more rate hikes to follow. The options with expiration dates falling after the date of the expected rate hikes will have higher interest rates priced in. In this situation, the higher interest rates in the longer-dated options will be evident when entering parameters into the model. Take options on Already Been Chewed Bubblegum Corp. (ABC). A trader, Kyle, enters parameters into the model for ABC options and notices that the prices don’t line up. To get the theoretical values of the ATM calls for all the expiration months to sit in the middle of the actual market values, Kyle may have to tinker with the interest rate inputs. Assume the following markets for the ATM 70-strike calls in ABC options: Calls Puts Aug 70 calls 1.75–1.85 1.30–1.40 Sep 70 calls 2.65–2.75 1.75–1.85 Dec 70 calls 4.70–4.90 2.35–2.45 Mar 70 calls 6.50–6.70 2.65–2.75 ABC is at $70 a share, has a 20 percent IV in all months, and pays no dividend. August expiration is one month away. Entering the known inputs for strike price, stock price, time to expiration, volatility, and dividend and using an 8 percent interest rate yields the following theoretical values for ABC options: The theoretical values, in bold type, are those that don’t line up in the middle of the call and put markets. These values are wrong. The call theoretical values are too low, and the put theoretical values are too high. They are the product of an interest rate that is too low being applied to the model. To generate values that are indicative of market prices, Kyle must change the interest input to the pricing model to reflect the market’s expectations of future interest rate changes. Using new values for the interest rate yields the following new values: After recalculating, the theoretical values line up in the middle of the call and put markets. Using higher interest rates for the longer expirations raises the call values and lowers the put values for these months. These interest rates were inferred from, or backed out of, the option-market prices by use of the option-pricing model. In practice, it may take some trial and error to find the correct interest values to use. In times of interest rate uncertainty, rho can be an important factor in determining which strategy to select. When rates are generally expected to continue to rise or fall over time, they are normally priced in to the options, as shown in the previous example. When there is no consensus among analysts and traders, the rates that are priced in may change as economic data are made available. This can cause a revision of option values. In long-term options that have higher rhos, this is a bona fide risk. Short-term options are a safer play in this environment. But as all traders know, risk also implies opportunity. Trading Rho While it’s possible to trade rho, most traders forgo this niche for more dynamic strategies with greater profitability. The effects of rho are often overshadowed by the more profound effects of the other greeks. The opportunity to profit from rho is outweighed by other risks. For most traders, rho is hardly ever even looked at. Because LEAPS have higher rho values than corresponding short-term options, it makes sense that these instruments would be appropriate for interest-rate plays. But even with LEAPS, rho exposure usually pales in comparison with that of delta, theta, and vega. It is not uncommon for the rho of a long-term option to be 5 to 8 percent of the option’s value. For example, Exhibit 7.2 shows a two-year LEAPS on a $70 stock with the following pricing-model inputs and outputs: EXHIBIT 7.2 Long 70-strike LEAPS call. The rho is +0.793, or about 5.8 percent of the call value. That means a 25-basis-point rise in rates contributes to only a 20-cent profit on the call. That’s only about 1.5 percent of the call’s value. On one hand, 1.5 percent is not a very big profit on a trade. On the other hand, if there are more rate rises at following Fed meetings, the trader can expect further gains on rho. Even if the trader is compelled to wait until the next Fed meeting to make another $0.20—or less, as rho will get smaller as time passes—from a second 25-basis-point rate increase, other influences will diminish rho’s significance. If over the six-week period between Fed meetings, the underlying declines by just $0.60, the $0.40 that the trader hoped to make on rho is wiped out by delta loss. With the share price $0.60 lower, the 0.760 delta costs the trade about $0.46. Furthermore, the passing of six weeks (42 days) will lead to a loss of about $0.55 from time decay because of the −0.013 theta. There is also the risk from the fat vegas associated with LEAPS. A 1.5 percent drop in implied volatility completely negates any hopes of rho profits. Aside from the possibility that delta, theta, and vega may get in the way of profits, the bid-ask spread with these long-term options tends to be wider than with their short-term counterparts. If the bid-ask spread is more than $0.40 wide, which is often the case with LEAPS, rho profits are canceled out by this cost of doing business. Buying the offer and selling the bid negative scalps away potential profits. With LEAPS, rho is always a concern. It will contribute to prosperity or peril and needs to be part of the trade plan from forecast to implementation. Buying or selling a LEAPS call or put, however, is not a practical way to speculate on interest rates. To take a position on interest rates in the options market, risk needs to be distilled down to rho. The other greeks need to be spread off. This is accomplished only through the conversions, reversals, and jelly rolls described in Chapter 6. However, the bid-ask can still be a hurdle to trading these strategies for non–market makers. Generally, rho is a greek that for most traders is important to understand but not practical to trade. Notes 1 . Please note, for simplification, dividends are not included. 2 . Note, for simplicity, simple interest is used in the calculation. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00017.html SCORE: 16.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html SCORE: 101.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html SCORE: 161.00 ================================================================================ CHAPTER 10 Wing Spreads Condors and Butterflies The “wing spread” family is a set of option strategies that is very popular, particularly among experienced traders. These strategies make it possible for speculators to accomplish something they could not possibly do by just trading stocks: They provide a means to profit from a truly neutral market in a security. Stocks that don’t move one iota can earn profits month after month for income-generating traders who trade these strategies. These types of spreads have a lot of moving parts and can be intimidating to newcomers. At their heart, though, they are rather straightforward break-even analysis trades that require little complex math to maintain. A simple at-expiration diagram reveals in black and white the range in which the underlying stock must remain in order to have a profitable position. However, applying the greeks and some of the mathematics discussed in previous chapters can help a trader understand these strategies on a deeper level and maximize the chance of success. This chapter will discuss condors and butterflies and how to put them into action most effectively. Taking Flight There are four primary wing spreads: the condor, the iron condor, the butterfly, and the iron butterfly. Each of these spreads involves trading multiple options with three or four strikes prices. We can take these spreads at face value, we can consider each option as an individual component of the spread, or we can view the spreads as being made up of two vertical spreads. Condor A condor is a four-legged option strategy that enables a trader to capitalize on volatility—increased or decreased. Traders can trade long or short iron condors. Long Condor Long one call (put) with strike A; short one call (put) with a higher strike, B; short one call (put) at strike C, which is higher than B; and long one call (put) at strike D, which is higher than C. The distance between strike price A and B is equal to the distance between strike C and strike D. The options are all on the same security, in the same expiration cycle, and either all calls or all puts. Long Condor Example Buy 1 XYZ November 70 call (A) Sell 1 XYZ November 75 call (B) Sell 1 XYZ November 90 call (C) Buy 1 XYZ November 95 call (D) Short Condor Short one call (put) with strike A; long one call (put) with a higher strike, B; long one call (put) with a strike, C, that is higher than B; and short one call (put) with a strike, D, that is higher than C. The options must be on the same security, in the same expiration cycle, and either all calls or all puts. The differences in strike price between the vertical spread of strike prices A and B and the strike prices of the vertical spread of strikes C and D are equal. Short Condor Example Sell 1 XYZ November 70 call (A) Buy 1 XYZ November 75 call (B) Buy 1 XYZ November 90 call (C) Sell 1 XYZ November 95 call (D) Iron Condor An iron condor is similar to a condor, but with a mix of both calls and puts. Essentially, the condor and iron condor are synthetically the same. Short Iron Condor Long one put with strike A; short one put with a higher strike, B; short one call with an even higher strike, C; and long one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put credit spread has the same distance between the strike prices as the call credit spread. Short Iron Condor Example Buy 1 XYZ November 70 put (A) Sell 1 XYZ November 75 put (B) Sell 1 XYZ November 90 call (C) Buy 1 XYZ November 95 call (D) Long Iron Condor Short one put with strike A; long one put with a higher strike, B; long one call with an even higher strike, C; and short one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put debit spread (strikes A and B) has the same distance between the strike prices as the call debit spread (strikes C and D). Long Iron Condor Example Sell 1 XYZ November 70 put (A) Buy 1 XYZ November 75 put (B) Buy 1 XYZ November 90 call (C) Sell 1 XYZ November 95 call (D) Butterflies Butterflies are wing spreads similar to condors, but there are only three strikes involved in the trade—not four. Long Butterfly Long one call (put) with strike A; short two calls (puts) with a higher strike, B; and long one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The difference in price between strikes A and B equals that between strikes B and C. Long Butterfly Example Buy 1 XYZ December 50 call (A) Sell 2 XYZ December 60 call (B) Buy 1 XYZ December 70 call (C) Short Butterfly Short one call (put) with strike A; long two calls (puts) with a higher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike A and strike B has the same distance between the strike prices of the vertical spread made up of the options with strike B and strike C. Short Butterfly Example Sell 1 XYZ December 50 call Buy 2 XYZ December 60 call Sell 1 XYZ December 70 call Iron Butterflies Much like the relationship of the condor to the iron condor, a butterfly has its synthetic equal as well: the iron butterfly. Short Iron Butterfly Long one put with strike A; short one put with a higher strike, B; short one call with strike B; long one call with a strike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal. Short Iron Butterfly Example Buy 1 XYZ December 50 put (A) Sell 1 XYZ December 60 put (B) Sell 1 XYZ December 60 call (B) Buy 1 XYZ December 70 call (C) Long Iron Butterfly Short one put with strike A; long one put with a higher strike, B; long one call with strike B; short one call with a strike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal. The put debit spread has the same distance between the strike prices as the call debit spread. Long Iron Butterfly Example Sell 1 XYZ December 50 put Buy 1 XYZ December 60 put Buy 1 XYZ December 60 call Sell 1 XYZ December 70 call These spreads were defined in terms of both long and short for each strategy. Whether the spread is classified as long or short depends on whether it was established at a credit or a debit. Debit condors or butterflies are considered long spreads. And credit condors or butterflies are considered short spreads. The words long and short mean little, though in terms of the spread as a whole. The important thing is which strikes have long options and which have short options. A call debit spread is synthetically equal to a put credit spread on the same security, with the same expiration month and strike prices. That means a long condor is synthetically equal to a short iron condor, and a long butterfly is synthetically equal to a short iron butterfly, when the same strikes are used. Whichever position is constructed, the best-case scenario is to have debit spreads expire with both options in-the-money (ITM) and credit spreads expire with both options out-of-the-money (OTM). Many retail traders prefer trading these spreads for the purpose of generating income. In this case, a trader would sell the guts, or middle strikes, and buy the wings, or outer strikes. When a trader is short the guts, low realized volatility is usually the objective. For long butterflies and short iron butterflies, the stock needs to be right at the middle strike for the maximum payout. For long condors and short iron condors, the stock needs to be between the short strikes at expiration for maximum payout. In both instances, the wings are bought to limit potential losses of the otherwise naked options. Long Butterfly Example A trader, Kathleen, has been studying United Parcel Service (UPS), which is trading at around $70.65. She believes UPS will trade sideways until July expiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She executes the following legs: Kathleen looks at her trade as two vertical spreads, the 65–70 bull (debit) call spread and the 70–75 bear (credit) call spread. Intuitively, she would want UPS to be at or above $70 at expiration for her bull call spread to have maximum value. But she has the seemingly conflicting goal of also wanting UPS to be at or below $70 to get the most from her 70–75 bear call spread. The ideal price for the stock to be trading at expiration in this example is right at $70 per share—the best of both worlds. The at-expiration diagram, Exhibit 10.1 , shows the profit or loss of all possible outcomes at expiration. EXHIBIT 10.1 UPS 65–70–75 butterfly. If the price of UPS shares declines below $65 at expiration, all these calls will expire. The entire 2.00 spent on the trade will be lost. If UPS is above $65 at expiration, the 65 call will be ITM and will be exercised. The call will profit like a long position in 100 shares of the underlying. The maximum profit is reached if UPS is at $70 at expiration. Kathleen makes a 5.00 profit from $65 to $70 on her 65 calls. But because she paid 2.00 initially for the spread, her net profit at $70 is just 3.00. If UPS is above $70 a share at expiration in this example, the two 70 calls will be assigned. The assignment of one call will offset the long stock acquired by the 65 calls being exercised. Assignment of the other call will create a short position in the underlying. That short position loses as UPS moves higher up to $75 a share, eating away at the 3.00 profit. If UPS is above $75 at expiration, the 75 call can be exercised to buy back the short stock position that resulted from the 70’s being assigned. The loss on the short stock between $70 and $75 will cost Kathleen 5.00, stripping her of her 3.00 profit and giving her a net loss of 2.00 to boot. End result? Above $75 at expiration, she has no position in the underlying and loses 2.00. A butterfly is a break-even analysis trade . This name refers to the idea that the most important considerations in this strategy are the breakeven points. The at-expiration diagram, Exhibit 10.2 , shows the break-even prices for this trade. EXHIBIT 10.2 UPS 65–70–75 butterfly breakevens. If the position is held until expiration and UPS is between $65 and $70 at that time, the 65 calls are exercised, resulting in long stock. The effective purchase price of that stock is $67. That’s the strike price plus the cost of the spread; that’s the lower break-even price. The other break-even is at $73. The net short position of 100 shares resulting from assignment of the 70 call loses more as the stock rises between $70 and $75. The entire 3.00 profit realized at the $70 share price is eroded when the stock reaches $73. Above $73, the trade produces a loss. Kathleen’s trading objective is to profit from UPS trading between $67 and $73 at expiration. The best-case scenario is that it declines only slightly from its price of $70.65 when the trade is established, to $70 per share. Alternatives Kathleen had other alternative positions she could have traded to meet her goals. An iron butterfly with the same strike prices would have shown about the same risk/reward picture, because the two positions are synthetically equivalent. But there may, in some cases, be a slight advantage to trading the iron butterfly over the long butterfly. The iron butterfly uses OTM put options instead of ITM calls, meaning the bid-ask spreads may be tighter. This means giving up less edge to the liquidity providers. She could have also bought a condor or sold an iron condor. With condor-family spreads, there is a lower maximum profit potential but a wider range in which that maximum payout takes place. For example, Kathleen could have executed the following legs to establish an iron condor: Essentially, Kathleen would be selling two credit spreads: the July 60–65 put spread for 0.30 and the July 75–80 call spread for 0.35. Exhibit 10.3 shows the payout at expiration of the UPS July 60–65–75–80 iron condor. EXHIBIT 10.3 UPS 60–65–75–80 iron condor. Although the forecast and trading objectives may be similar to those for the butterfly, the payout diagram reveals some important differences. First, the maximum loss is significantly higher with a condor or iron condor. In this case, the maximum loss is 4.35. This unfortunate situation would occur if UPS were to drop to below $60 or rise above $80 by expiration. Below $60, the call spread expires, netting 0.35. But the put spread is ITM. Kathleen would lose a net of 4.70 on the put spread. The gain on the call spread combined with the loss on the put spread makes the trade a loser of 4.35 if the stock is below $60 at expiration. Above $80, the put spread is worthless, earning 0.30, but the call spread is a loser by 4.65. The gain on the put spread plus the loss on the call spread is a net loser of 4.35. Between $65 and $75, all options expire and the 0.65 credit is all profit. So far, this looks like a pretty lousy alternative to the butterfly. You can lose 4.35 but only make 0.65! Could there be any good reason for making this trade? Maybe. The difference is wiggle room. The breakevens are 2.65 wider in each direction with the iron condor. Exhibit 10.4 shows these prices on the graph. EXHIBIT 10.4 UPS 60–65–75–80 iron condor breakevens. The lower threshold for profit occurs at $64.35 and the upper at $75.65. With condor/iron condors, there can be a greater chance of producing a winning trade because the range is wider than that of the butterfly. This benefit, however, has a trade-off of lower potential profit. There is always a parallel relationship of risk and reward. When risk increases so does reward, and vice versa. This way of thinking should now be ingrained in your DNA. The risk of failure is less, so the payout is less. Because the odds of winning are higher, a trader will accept lower payouts on the trade. 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. Greeks and Wing Spreads Much of this chapter has been spent on how wing spreads perform if held until expiration, and little has been said of option greeks and their role in wing spreads. Greeks do come into play with butterflies and condors but not necessarily the same way they do with other types of option trades. The vegas on these types of spreads are smaller than they are on many other types of strategies. For a typical nonprofessional trader, it’s hard to trade implied volatility with condors or butterflies. The collective commissions on the four legs, as well as margin and capital considerations, put these out of reach for active trading. Professional traders and retail traders subject to portfolio margining are better equipped for volatility trading with these spreads. The true strength of wing spreads, however, is in looking at them as break-even analysis trades much like vertical spreads. The trade is a winner if it is on the correct side of the break-even price. Wing spreads, however, are a combination of two vertical spreads, so there are two break-even prices. One of the verticals is guaranteed to be a winner. The stock can be either higher or lower at expiration—not both. In some cases, both verticals can be winners. Consider an iron condor. Instead of reaping one premium from selling one OTM call credit spread, iron condor sellers double dip by additionally selling an OTM put credit spread. They collect a double credit, but only one of the credit spreads can be a loser at expiration. The trader, however, does have to worry about both directions independently. There are two ways for greeks and volatility analysis to help traders trade wing spreads. One of them involves using delta and theta as tools to trade a directional spread. The other uses implied volatility in strike selection decisions. Directional Butterflies Trading a butterfly can be an excellent way to establish a low-cost, relatively low-risk directional trade when a trader has a specific price target in mind. For example, a trader, Ross, has been studying Walgreen Co. (WAG) and believes it will rise from its current level of $33.50 to $36 per share over the next month. Ross buys a butterfly consisting of all OTM January calls with 31 days until expiration. He executes the following legs: As a directional trade alternative, Ross could have bought just the January 35 call for 1.15. As a cheaper alternative, he could have also bought the 35–36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only a dime. The benefit of lower cost, however, comes with trade-offs. Exhibit 10.5 compares the bull call spread with a bullish butterfly. EXHIBIT 10.5 Bull call spread vs. bull butterfly (Walgreen Co. at $33.50). The butterfly has lower nominal risk—only 0.10 compared with 0.35 for the call spread. The maximum reward is higher in nominal terms, too—0.90 versus 0.65. The trade-off is what is given up. With both strategies, the goal is to have Walgreen Co. at $36 around expiration. But the bull call spread has more room for error to the upside. If the stock trades a lot higher than expected, the butterfly can end up being a losing trade. Given Ross’s expectations in this example, this might be a risk he is willing to take. He doesn’t expect Walgreen Co. to close right at $36 on the expiration date. It could happen, but it’s unlikely. However, he’d have to be wildly wrong to have the trade be a loser on the upside. It would be a much larger move than expected for the stock to rise significantly above $36. If Ross strongly believes Walgreen Co. can be around $36 at expiration, the cost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As a general rule, directional butterflies work well in trending, low-volatility stocks. When Ross monitors his butterfly, he will want to see the greeks for this position as well. Exhibit 10.6 shows the trade’s analytics with Walgreen Co. at $33.50. EXHIBIT 10.6 Walgreen Co. 35–36–37 butterfly greeks (stock at $33.50, 31 days to expiration). Delta +0.008 Gamma −0.004 Theta +0.001 Vega −0.001 When the trade is first put on, the delta is small—only +0.008. Gamma is slightly negative and theta is very slightly positive. This is important information if Walgreen Co.’s ascent happens sooner than Ross planned. The trade will show just a small profit if the stock jumps to $36 per share right away. Ross’s theoretical gain will be almost unnoticeable. At $36 per share, the position will have its highest theta, which will increase as expiration approaches. Ross will have to wait for time to pass to see the trade reach its full potential. This example shows the interrelation between delta and theta. We know from an at-expiration analysis that if Walgreen Co. moves from $33.50 to $36, the butterfly’s profit will be 0.90 (the spread of $1 minus the 0.10 initial debit). If we distribute the 0.90 profit over the 2.50 move from $33.50 to $36, the butterfly gains about 0.36 per dollar move in Walgreen Co. (0.90/(36 − 33.50). This implies a delta of about 0.36. But the delta, with 31 days until expiration and Walgreen Co. at $33.50, is only 0.008, and because of negative gamma this delta will get even smaller as Walgreen Co. rises. Butterflies, like the vertical spreads of which they are composed, can profit from direction but are never purely directional trades. Time is always a factor. It is theta, working in tandem with delta, that contributes to profit or peril. A bearish butterfly can be constructed as well. One would execute the trade with all OTM puts or all ITM calls. The concept is the same: sell the guts at the strike at which the stock is expected to be trading at expiration, and buy the wings for protection. Constructing Trades to Maximize Profit Many traders who focus on trading iron condors trade exchange-traded funds (ETFs) or indexes. Why? Diversification. Because indexes are made up of many stocks, they usually don’t have big gaps caused by surprise earnings announcements, takeovers, or other company-specific events. But it’s not just selecting the right underlying to trade that is the challenge. A trader also needs to pick the right strike prices. Finding the right strike prices to trade can be something of an art, although science can help, as well. Three Looks at the Condor Strike selection is essential for a successful condor. If strikes are too close together or two far apart, the trade can become much less attractive. Strikes Too Close The QQQs are options on the ETFs that track the Nasdaq 100 (QQQ). They have strikes in $1 increments, giving traders a lot to choose from. With QQQ trading at around $55.95, consider the 54–55–57–58 iron condor. In this example, with 31 days until expiration, the following legs can be executed: In this trade, the maximum profit is 0.63. The maximum risk is 0.37. This isn’t a bad profit-to-loss ratio. The break-even price on the downside is $54.37 and on the upside is $57.63. That’s a $3.26 range—a tight space for a mover like the QQQ to occupy in a month. The ETF can drop about only 2.8 percent or rise 3 percent before the trade becomes a loser. No one needs any fancy math to show that this is likely a losing proposition in the long run. While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit. Strikes Too Far Strikes too far apart can make for impractical trades as well. Exhibit 10.7 shows an options chain for the Dow Jones Industrial Average Index (DJX). These prices are from around 2007 when implied volatility (IV) was historically low, making the OTM options fairly low priced. In this example, DJX is around $135.20 and there are 51 days until expiration. EXHIBIT 10.7 Options chain for DJIA. If the goal is to choose strikes that are far enough apart to be unlikely to come into play, a trader might be tempted to trade the 120–123–142–145 iron condor. With this wingspan, there is certainly a good chance of staying between those strikes—you could drive a proverbial truck through that range. This would be a great trade if it weren’t for the prices one would have to accept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts are 0.25 bid. This means that the put spread would be sold at zero! The maximum risk is 3.00, and the maximum gain is zero. Not a really good risk/reward. The 142–145 call spread isn’t much better: it can be sold for a dime. At the time, again a low-volatility period, many traders probably felt it was unlikely that the DJX will rise 5 percent in a 51-day period. Some traders may have considered trading a similarly priced iron condor (though of course they’d have to require some small credit for the risk). A little over a year later the DJX was trading around 50 percent lower. Traders must always be vigilant of the possibility of volatility, even unexpected volatility and structure their risk/reward accordingly. Most traders would say the risk/reward of this trade isn’t worth it. Strikes too far apart have a greater chance of success, but the payoff just isn’t there. Strikes with High Probabilities of Success So how does a trader find the happy medium of strikes close enough together to provide rich premiums but far enough apart to have a good chance of success? Certainly, there is something to be said for looking at the prices at which a trade can be done and having a subjective feel for whether the underlying is likely to move outside the range of the break-even prices. A little math, however, can help quantify this likelihood and aid in the decision-making process. Recall that IV is read by many traders to be the market’s consensus estimate of future realized volatility in terms of annualized standard deviation. While that is a mouthful to say—or in this case, rather, an eyeful to read—when broken down it is not quite as intimidating as it sounds. Consider a simplified example in which an underlying security is trading at $100 a share and the implied volatility of the at-the-money (ATM) options is 10 percent. That means, from a statistical perspective, that if the expected return for the stock is unchanged, the one-year standard deviations are at $90 and $110. 1 In this case, there is about a 68 percent chance of the stock trading between $90 and $110 one year from now. IV then is useful information to a trader who wants to quantify the chances of an iron condor’s expiring profitable, but there are a few adjustments that need to be made. First, because with an iron condor the idea is to profit from net short option premium, it usually makes more sense to sell shorter-term options to profit from higher rates of time decay. This entails trading condors composed of one- or two-month options. The IV needs to be deannualized and converted to represent the standard deviation of the underlying at expiration. The first step is to compute the one-day standard deviation. This is found by dividing the implied volatility by the square root of the number of trading days in a year, then multiplying by the square root of the number of trading days until expiration. The result is the standard deviation (σ) at the time of expiration stated as a percent. Next, multiply that percentage by the price of the underlying to get the standard deviation in absolute terms. The formula 2 for calculating the shorter-term standard deviation is as follows: This value will be added to or subtracted from the price of the underlying to get the price points at which the approximate standard deviations fall. Consider an example using options on the Standard & Poor’s 500 Index (SPX). With 50 days until expiration, the SPX is at 1241 and the implied volatility is 23.2 percent. To find strike prices that are one standard deviation away from the current index price, we need to enter the values into the equation. We first need to know how many actual trading days are in the 50-day period. There are 35 business days during this particular 50-day period (there is one holiday and seven weekend days). We now have all the data we need to calculate which strikes to sell. The lower standard deviation is 1134.55 (1241 − 106.45) and the upper is 1347.45 (1241 + 106.45). This means there would be about a 68 percent chance of SPX ending up between 1134.55 and 1347.45 at expiration. In this example, to have about a two-thirds chance of success, one would sell the 1135 puts and the 1350 calls as part of the iron condor. Being Selective There is about a two-thirds chance of the underlying staying between the upper and lower standard deviation points and about a one-third chance it won’t. Reasonably good odds. But the maximum loss of an iron condor will be more than the maximum profit potential. In fact, the max-profit-to-max-loss ratio is usually less than 1 to 3. For every $1 that can be made, often $4 or $5 will be at risk. The pricing model determines fair value of an option based on the implied volatility set by the market. Again, many traders consider IV to be the market’s consensus estimate of future realized volatility. Assuming the market is generally right and options are efficiently priced, in the long run, future stock volatility should be about the same as the implied volatility from options prices. That means that if all of your options trades are executed at fair value, you are likely to break even in the long run. The caveat is that whether the options market is efficient or not, retail or institutional traders cannot generally execute trades at fair value. They have to sell the bid (sell below theoretical value) and buy the offer (buy above theoretical value). This gives the trade a statistical disadvantage, called giving up the edge, from an expected return perspective. Even though you are more likely to win than to lose with each individual trade when strikes are sold at the one-standard-deviation point, the edge given up to the market in conjunction with the higher price tag on losers makes the trade a statistical loser in the long run. While this means for certain that the non-market-making trader is at a constant disadvantage, trading condors and butterflies is no different from any other strategy. Giving up the edge is the plight of retail and institutional traders. To profit in the long run, a trader needs to beat the market, which requires careful planning, selectivity, and risk management. Savvy traders trade iron condors with strikes one standard deviation away from the current stock price only when they think there is more than a two-thirds chance of market neutrality. In other words, if you think the market will be less volatile than the prices in the options market imply, sell the iron condor or trade another such premium-selling strategy. As discussed above, this opinion should reflect sound judgment based on some combination of technical analysis, fundamental analysis, volatility analysis, feel, and subjectivity. A Safe Landing for an Iron Condor Although traders can’t control what the market does, they can control how they react to the market. Assume a trader has done due diligence in studying a stock and feels it is a qualified candidate for a neutral strategy. With the stock at $90, a 16.5 percent implied volatility, and 41 days until expiration, the standard deviation is about 5. The trader sells the following iron condor: With the stock at $90, directly between the two short strikes, the trade is direction neutral. The maximum profit is equal to the total premium taken in, which in this case is $800. The maximum loss is $4,200. There is about a two-thirds chance of retaining the $800 at expiration. After one week, the overall market begins trending higher on unexpected bullish economic news. This stock follows suit and is now trading at $93, and concern is mounting that the rally will continue. The value of the spread now is about 1.10 per contract (we ignore slippage from trading on the bid-ask spreads of the four legs of the spread). This means the trade has lost $300 because it would cost $1,100 to buy back what the trader sold for a total of $800. One strategy for managing this trade looking forward is inaction. The philosophy is that sometimes these trades just don’t work out and you take your lumps. The philosophy is that the winners should outweigh the losers over the long term. For some of the more talented and successful traders with a proven track record, this may be a viable strategy, but there are more active options as well. A trader can either close the spread or adjust it. The two sets of data that must be considered in this decision are the prices of the individual options and the greeks for the trade. Exhibit 10.8 shows the new data with the stock at $93. EXHIBIT 10.8 Greeks for iron condor with stock at $93. The trade is no longer neutral, as it was when the underlying was at $90. It now has a delta of −2.54, which is like being short 254 shares of the underlying. Although the more time that passes the better—as indicated by the +0.230 theta—delta is of the utmost concern. The trader has now found himself short a market that he thinks may rally. Closing the entire position is one alternative. To be sure, if you don’t have an opinion on the underlying, you shouldn’t have a position. It’s like making a bet on a sporting event when you don’t really know who you think will win. The spread can also be dismantled piecemeal. First, the 85 puts are valued at $0.07 each. Buying these back is a no-brainer. In the event the stock does retrace, why have the positive delta of that leg working against you when you can eliminate the risk inexpensively now? The 80 puts are worthless, offered at 0.05, presumably. There is no point in trying to sell these. If the market does turn around, they may benefit, resulting in an unexpected profit. The 80 and 85 puts are the least of his worries, though. The concern is a continuing rally. Clearly, the greater risk is in the 95–100 call spread. Closing the call spread for a loss eliminates the possibility of future losses and may be a wise choice, especially if there is great uncertainty. Taking a small loss now of only around $300 is a better trade than risking a total loss of $4,200 when you think there is a strong chance of that total loss occurring. But if the trader is not merely concerned that the stock will rally but truly believes that there is a good chance it will, the most logical action is to position himself for that expected move. Although there are many ways to accomplish this, the simplest way is to buy to close the 95 calls to eliminate the position at that strike. This eliminates the short delta from the 95 calls, leading to a now-positive delta for the position as a whole. The new position after adjusting by buying the 85 puts and the 95 calls is shown in Exhibit 10.9 . EXHIBIT 10.9 Iron condor adjusted to strangle. The result is a long strangle: a long call and a long put of the same month with two different strikes. Strangles will be discussed in subsequent chapters. The 80 puts are far enough out-of-the-money to be fairly irrelevant. Effectively, the position is long ten 100-strike calls. This serves the purpose of changing the negative 2.54 delta into a positive 0.96 delta. The trader now has a bullish position in the stock that he thinks will rally—a much smarter position, given that forecast. 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. In this example, February is 59 days from expiration. Exhibit 10.10 shows the analytics for this trade with CRM at $104.32. EXHIBIT 10.10 Salesforce.com condor ( Salesforce.com at $104.32). As expected with the underlying centered between the two middle strikes, delta and gamma are about flat. As Salesforce.com moves higher or lower, though, gamma and, consequently, delta will change. As the stock moves closer to either of the long strikes, gamma will become more positive, causing the delta to change favorably for Joe. Theta, however, is working against him with Salesforce.com at $104.32, costing $150 a day. In this instance, movement is good. Joe benefits from increased realized volatility. The best-case scenario would be if Salesforce.com moves through either of the long strikes to, or through, either of the short strikes. The prime objective in this example, though, is to profit from a rise in IV. The position has a positive vega. The position makes or loses $400 with every point change in implied volatility. Because of the proportion of theta risk to vega risk, this should be a short-term play. If Joe were looking for a small rise in IV, say five points, the move would have to happen within 13 calendar days, given the vega and theta figures. The vega gain on a rise of five vol points would be $2,000, and the theta loss over 13 calendar days would be $1,950. If there were stock movement associated with the IV increase, that delta/gamma gain would offset some of the havoc that theta wreaked on the option premiums. However, if Joe traded a strategy like a condor as a vol play, he would likely expect a bigger volatility move than the five points discussed here as well as expecting increased realized volatility. A condor bullish vol play works when you expect something to change a stock’s price action in the short term. Examples would be rumors of a new product’s being unveiled, a product recall, a management change, or some other shake-up that leads to greater uncertainty about the company’s future—good or bad. The goal is to profit from a rise in IV, so the trade needs to be put on before the announcement occurs. The motto in option-volatility trading is “Buy the rumor; sell the news.” Usually, by the time the news is out, the increase in IV is already priced into option premiums. As uncertainty decreases, IV decreases as well. Notes 1 . It is important to note that in the real world, interest and expectations for future stock-price movement come into play. For simplicity’s sake, they’ve been excluded here. 2 . This is an approximate formula for estimating standard deviation. Although it is mathematically only an approximation, it is the convention used by many option traders. It is a traders’ short cut. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html SCORE: 118.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00023.html SCORE: 29.00 ================================================================================ CHAPTER 12 Delta-Neutral Trading Trading Implied Volatility Many of the strategies covered so far have been option-selling strategies. Some had a directional bias; some did not. Most of the strategies did have a primary focus on realized volatility—especially selling it. These short volatility strategies require time. The reward of low stock volatility is theta. In general, most of the strategies previously covered were theta trades in which negative gamma was an unpleasant inconvenience to be dealt with. Moving forward, much of the remainder of this book will involve more in-depth discussions of trading both realized and implied volatility (IV), with a focus on the harmonious, and sometimes disharmonious, relationship between the two types. Much attention will be given to how IV trades in the option market, describing situations in which volatility moves are likely to occur and how to trade them. Direction Neutral versus Direction Indifferent In the world of nonlinear trading, there are two possible nondirectional views of the underlying asset: direction neutral and direction indifferent. Direction neutral means the trader believes the stock will not trend either higher or lower. The trader is neutral in his or her assessment of the future direction of the asset. Short iron condors, long time spreads, and out-of-the-money (OTM) credit spreads are examples of direction-neutral strategies. These strategies generally have deltas close to zero. Because of negative gamma, movement is the bane of the direction-neutral trade. Direction indifferent means the trader may desire movement in the underlying but is indifferent as to whether that movement is up or down. Some direction-indifferent trades are almost completely insulated from directional movement, with a focus on interest or dividends instead. Examples of these types of trades are conversions, reversals, and boxes, which are described in Chapter 6, as well as dividend plays, which are described in Chapter 8. Other direction-indifferent strategies are long option strategies that have positive gamma. In these trades, the focus is on movement, but the direction of that movement is irrelevant. These are plays that are bullish on realized volatility. Yet other direction-indifferent strategies are volatility plays from the perspective of IV. These are trades in which the trader’s intent is to take a bullish or bearish position in IV. Delta Neutral To be truly direction neutral or direction indifferent means to have a delta equal to zero. In other words, there are no immediate gains if the underlying moves incrementally higher or lower. This zero-delta method of trading is called delta-neutral trading . A delta-neutral position can be created from any option position simply by trading stock to flatten out the delta. A very basic example of a delta-neutral trade is a long at-the-money (ATM) call with short stock. Consider a trade in which we buy 20 ATM calls that have a 50 delta and sell stock on a delta-neutral ratio. Buy 20 50-delta calls (long 1,000 deltas) Short 1,000 shares (short 1,000 deltas) In this position, we are long 1,000 deltas from the calls (20 × 50) and short 1,000 deltas from the short sale of stock. The net delta of the position is zero. Therefore, the immediate directional exposure has been eliminated from the trade. But intuitively, there are other opportunities for profit or loss with this trade. The addition of short stock to the calls will affect only the delta, not the other greeks. The long calls have positive gamma, negative theta, and positive vega. Exhibit 12.1 is a simplified representation of the greeks for this trade. EXHIBIT 12.1 20-lot delta-neutral long call. With delta not an immediate concern, the focus here is on gamma, theta, and vega. The +1.15 vega indicates that each one-point change in IV makes or loses $115 for this trade. Yet there is more to the volatility story. Each day that passes costs the trader $50 in time decay. Holding the position for an extended period of time can produce a loser even if IV rises. Gamma is potentially connected to the success of this trade, too. If the underlying moves in either direction, profit from deltas created by positive gamma may offset the losses from theta. In fact, a big enough move in either direction can produce a profitable trade, regardless of what happens to IV. Imagine, for a moment, that this trade is held until expiration. If the stock is below the strike price at this point, the calls expire. The resulting position is short 1,000 shares of stock. If the stock is above the strike price at expiration, the calls can be exercised, creating 2,000 shares of long stock. Because the trade is already short 1,000 shares, the resulting net position is long 1,000 shares (2,000 − 1,000). Clearly, the more the underlying stock moves in either direction the greater the profit potential. The underlying has to move far enough above or below the strike price to allow the beneficial gains from buying or selling stock to cover the option premium lost from time decay. If the trade is held until expiration, the underlying needs to move far enough to cover the entire premium spent on the calls. The solid lines forming a V in Exhibit 12.2 conceptually illustrate the profit or loss for this delta-neutral long call at expiration. EXHIBIT 12.2 Profit-and-loss diagram for delta-neutral long-call trade. Because of gamma, some deltas will be created by movement of the underlying before expiration. Gamma may lead to this being a profitable trade in the short term, depending on time and what happens with IV. The dotted line illustrates the profit or loss of this trade at the point in time when the trade is established. Because the options may still have time value at this point—depending on how far from the strike price the stock is trading—the value of the position, as a whole, is higher than it will be if the calls are trading at parity at expiration. Regardless, the plan is for the stock to make a move in either direction. The bigger the move and the faster it happens, the better. Why Trade Delta Neutral? A few years ago, I was teaching a class on option trading. Before the seminar began, I was talking with one of the students in attendance. I asked him what he hoped to learn in the class. He said that he was really interested in learning how to trade delta neutral. When I asked him why he was interested in that specific area of trading, he replied, “I hear that’s where all the big money is made!” This observation, right or wrong, probably stems from the fact that in the past most of the trading in this esoteric discipline has been executed by professional traders. There are two primary reasons why the pros have dominated this strategy: high commissions and high margin requirements for retail traders. Recently, these two reasons have all but evaporated. First, the ultracompetitive world of online brokers has driven commissions for retail traders down to, in some cases, what some market makers pay. Second, the oppressive margin requirements that retail option traders were subjected to until 2007 have given way to portfolio margining. Portfolio Margining Customer portfolio margining is a method of calculating customer margin in which the margin requirement is based on the “up and down risk” of the portfolio. Before the advent of portfolio margining, retail traders were subject to strategy-based margining, also called Reg. T margining, which in many cases required a significantly higher amount of capital to carry a position than portfolio margining does. With portfolio margining, highly correlated securities can be offset against each other for purposes of calculating margin. For example, SPX options and SPY options—both option classes based on the Standard & Poor’s 500 Index—can be considered together in the margin calculation. A bearish position in one and a bullish position in the other may partially offset the overall risk of the portfolio and therefore can help to reduce the overall margin requirement. With portfolio margining, many strategies are margined in such a way that, from the point of view of this author, they are subject to a much more logical means of risk assessment. Strategy-based margining required traders of some strategies, like a protective put, to deposit significantly more capital than one could possibly lose by holding the position. The old rules require a minimum margin of 50 percent of the stock’s value and up to 100 percent of the put premium. A portfolio-margined protective put may require only a fraction of what it would with strategy-based margining. Even though Reg. T margining is antiquated and sometimes unreasonable, many traders must still abide by these constraints. Not all traders meet the eligibility requirements to qualify for portfolio-based margining. There is a minimum account balance for retail traders to be eligible for this treatment. A broker may also require other criteria to be met for the trader to benefit from this special margining. Ultimately, portfolio margining allows retail traders to be margined similarly to professional traders. There are some traders, both professional and otherwise, who indeed have made “big money,” as the student in my class said, trading delta neutral. But, to be sure, there are successful and unsuccessful traders in many areas of trading. The real motivation for trading delta neutral is to take a position in volatility, both implied and realized. Trading Implied Volatility With a typical option, the sensitivity of delta overshadows that of vega. To try and profit from a rise or fall in IV, one has to trade delta neutral to eliminate immediate directional sensitivity. There are many strategies that can be traded as delta-neutral IV strategies simply by adding stock. Throughout this chapter, I will continue using a single option leg with stock, since it provides a simple yet practical example. It’s important to note that delta-neutral trading does not refer to a specific strategy; it refers to the fact that the trader is indifferent to direction. Direction isn’t being traded, volatility is. Volatility trading is fundamentally different from other types of trading. While stocks can rise to infinity or decline to zero, volatility can’t. Implied volatility, in some situations, can rise to lofty levels of 100, 200, or even higher. But in the long-run, these high levels are not sustainable for most stocks. Furthermore, an IV of zero means that the options have no extrinsic value at all. Now that we have established that the thresholds of volatility are not as high as infinity and not as low as zero, where exactly are they? The limits to how high or low IV can go are not lines in the sand. They are more like tides that ebb and flow, but normally come up only so far onto the beach. The volatility of an individual stock tends to trade within a range that can be unique to that particular stock. This can be observed by studying a chart of recent volatility. When IV deviates from the range, it is typical for it to return to the range. This is called reversion to the mean , which was discussed in Chapter 3. IV can get stretched in either direction like a rubber band but then tends to snap back to its original shape. There are many examples of situations where reversion to the mean enters into trading. In some, volatility temporarily dips below the typical range, and in some, it rises beyond the recent range. One of the most common examples is the rush and the crush. The Rush and the Crush In this situation, volatility rises before and falls after a widely anticipated news announcement, of earnings, for instance, or of a Food and Drug Administration (FDA) approval. In this situation, option buyers rush in and bid up IV. The more uncertainty—the more demand for insurance—the higher vol rises. When the event finally occurs and the move takes place or doesn’t, volatility gets crushed. The crush occurs when volatility falls very sharply—sometimes 10 points, 20 points, or more—in minutes. Traders with large vega positions appreciate the appropriateness of the term crush all too well. Volatility traders also affectionately refer to this sudden drop in IV by saying that volatility has gotten “whacked.” In order to have a feel for whether implied volatility is high or low for a particular stock, you need to know where it’s been. It’s helpful to have an idea of where realized volatility is and has been, too. To be sure, one analysis cannot be entirely separate from the other. Studying both implied and realized volatility and how they relate is essential to seeing the big picture. The Inertia of Volatility Sir Isaac Newton said that an object in motion tends to stay in motion unless acted upon by another force. Volatility acts much the same way. Most stocks tend to trade with a certain measurable amount of daily price fluctuations. This can be observed by looking at the stock’s realized volatility. If there is no outside force—some pivotal event that fundamentally changes how the stock is likely to behave—one would expect the stock to continue trading with the same level of daily price movement. This means IV (the market’s expectation of future stock volatility) should be the same as realized volatility (the calculated past stock volatility). But just as in physics, it seems there is always some friction affecting the course of what is in motion. Corporate earnings, Federal Reserve Board reports, apathy, lulls in the market, armed conflicts, holidays, rumors, and takeovers, among other market happenings all provide a catalyst for volatility changes. Divergences of realized and implied volatility, then, are commonplace. These divergences can create tradable conditions, some of which are more easily exploited than others. To find these opportunities, a trader must conduct a study of volatility. Volatility charts can help a trader visualize the big picture. This historical information offers a comparison of what is happening now in volatility with what has happened in the past. The following examples use a volatility chart to show how two different traders might have traded the rush and crush of an earnings report. Volatility Selling Susie Seller, a volatility trader, studies semiconductor stocks. Exhibit 12.3 shows the volatilities of a $50 chip stock. The circled area shows what happened before and after second-quarter earnings were reported in July. The black line is the IV, and the gray is the 30-day historical. EXHIBIT 12.3 Chip stock volatility before and after earnings reports. Source : Chart courtesy of iVolatility.com In mid-July, Susie did some digging to learn that earnings were to be announced on July 24, after the close. She was careful to observe the classic rush and crush that occurred to varying degrees around the last three earnings announcements, in October, January, and April. In each case, IV firmed up before earnings only to get crushed after the report. In mid-to-late July, she watched as IV climbed to the mid-30s (the rush) just before earnings. As the stock lay in wait for the report, trading came to a proverbial screeching halt, sending realized volatility lower, to about 13 percent. Susie waited for the end of the day just before the report to make her move. Before the closing bell, the stock was at $50. Susie sold 20 one-month 50-strike calls at 2.10 (a 35 volatility) and bought 1,100 shares of the underlying stock at $50 to become delta neutral. Exhibit 12.4 shows Susie’s position. EXHIBIT 12.4 Delta-neutral short ATM call, long stock position. Her delta was just about flat. The delta for the 50 calls was 0.54 per contract. Selling a 20-lot creates 10.80 short deltas for her overall position. After buying 1,100 shares, she was left long 0.20 deltas, about the equivalence of being long 20 shares. Where did her risk lie? Her biggest concern was negative gamma. Without even seeing a chart of the stock’s price, we can see from the volatility chart that this stock can have big moves on earnings. In October, earnings caused a more than 10-point jump in realized volatility, to its highest level during the year shown. Whether the stock rose or fell is irrelevant. Either event means risk for a premium seller. The positive theta looks good on the surface, but in fact, theta provided Susie with no significant benefit. Her plan was “in and out and nobody gets hurt.” She got into the trade right before the earnings announcement and out as soon as implied volatility dropped off. Ideally, she’d like to hold these types of trades for less than a day. The true prize is vega. Susie was looking for about a 10-point drop in IV, which this option class had following the October and January earnings reports. April had a big drop in IV, as well, of about eight or nine points. Ultimately, what Susie is looking for is reversion to the mean. She gauges the normal level of volatility by observing where it is before and after the surges caused by earnings. From early November to mid- to late- December, the stock’s IV bounced around the 25 percent level. In the month of February, the IV was around 25. After the drop-off following April earnings and through much of May, the IV was closer to 20 percent. In June, IV was just above 25. Susie surmised from this chart that when no earnings event is pending, this stock’s options typically trade at about a 25 percent IV. Therefore, anticipating a 10-point decline from 35 was reasonable, given the information available. If Susie gets it right, she stands to make $1,150 from vega (10 points × 1.15 vegas × 100). As we can see from the right side of the volatility chart in Exhibit 12.3 , Susie did get it right. IV collapsed the next morning by just more than ten points. But she didn’t make $1,150; she made less. Why? Realized volatility (gamma). The jump in realized volatility shown on the graph is a function of the fact that the stock rallied $2 the day after earnings. Negative gamma contributed to negative deltas in the face of a rallying market. This negative delta affected some of Susie’s potential vega profits. So what was Susie’s profit? On this trade she made $800. The next morning at the open, she bought back the 50-strike calls at 2.80 (25 IV) and sold the stock at $52. To compute her actual profit, she compared the prices of the spread when entering the trade with the prices of the spread when exiting. Exhibit 12.5 shows the breakdown of the trade. EXHIBIT 12.5 Profit breakdown of delta-neutral trade. After closing the trade, Susie knew for sure what she made or lost. But there are many times when a trader will hold a delta-neutral position for an extended period of time. If Susie hadn’t closed her trade, she would have looked at her marks to see her P&(L) at that point in time. Marks are the prices at which the securities are trading in the actual market, either in real time or at end of day. With most online brokers’ trading platforms or options-trading software, real-time prices are updated dynamically and always at their fingertips. The profit or loss is, then, calculated automatically by comparing the actual prices of the opening transaction with the current marks. What Susie will want to know is why she made $800. Why not more? Why not less, for that matter? When trading delta neutral, especially with more complex trades involving multiple legs, a manual computation of each leg of the spread can be tedious. And to be sure, just looking at the profit or loss on each leg doesn’t provide an explanation. Susie can see where her profits or losses came from by considering the profit or loss for each influence contributing to the option’s value. Exhibit 12.6 shows the breakdown. EXHIBIT 12.6 Profit breakdown by greek. Delta Susie started out long 0.20 deltas. A $2 rise in the stock price yielded a $40 profit attributable to that initial delta. Gamma As the stock rose, the negative delta of the position increased as a result of negative gamma. The delta of the stock remained the same, but the negative delta of the 50 call grew by the amount of the gamma. Deriving an exact P&(L) attributable to gamma is difficult because gamma is a dynamic metric: as the stock price changes, so can the gamma. This calculation assumes that gamma remains constant. Therefore, the gamma calculation here provides only an estimate. The initial position gamma of −1.6 means the delta decreases by 3.2 with a $2 rise in the stock (–1.60 times the $2 rise in the stock price). Susie, then, would multiply −3.2 by $2 to find the loss on −3.2 deltas over a $2 rise. But she wasn’t short 3.2 deltas for the whole $2. She started out with zero deltas attributable to gamma and ended up being 3.2 shorter from gamma over that $2 move. Therefore, if she assumes her negative delta from gamma grew steadily from 0 to −3.2, she can estimate her average delta loss over that move by dividing by 2. Theta Susie held this trade one day. Her total theta contributed 0.75 or $75 to her position. Vega Vega is where Susie made her money on this trade. She was able to buy her call back 10 IV points lower. The initial position vega was −1.15. Multiplying −1.15 by the negative 10-point crush of volatility yields a vega profit of $1,150. Conclusions Studying her position’s P&(L) by observing what happened in her greeks provides Susie with an alternate—and in some ways, better—method to evaluate her trade. The focus of this delta-neutral trade is less on the price at which Susie can buy the calls back to close the position than on the volatility level at which she can buy them back, weighed against the P&(L) from her other risks. Analyzing her position this way gives her much more information than just comparing opening and closing prices. Not only does she get a good estimate of how much she made or lost, but she can understand why as well. The Imprecision of Estimation It is important to notice that the P&(L) found by adding up the P&(L)’s from the greeks is slightly different from the actual P&(L). There are a couple of reasons for this. First, the change in delta resulting from gamma is only an estimate, because gamma changes as the stock price changes. For small moves in the underlying, the gamma change is less significant, but for larger moves, the rate of change of the gamma can be bigger, and it can be nonlinear. For example, as an option moves from being at-the-money (ATM) to being out-of-the-money (OTM), its gamma decreases. But as the option becomes more OTM, its gamma decreases at a slower rate. Another reason that the P&(L) from the greeks is different from the actual P&(L) is that the greeks are derived from the option-pricing model and are therefore theoretical values and do not include slippage. Furthermore, the volatility input in this example is rounded a bit for simplicity. For example, a volatility of 25 actually yielded a theoretical value of 2.796, while the call was bought at 2.80. Because some options trade at minimum price increments of a nickel, and none trade in fractions of a penny, IV is often rounded. Caveat Venditor Reversion to the mean holds the promise of profit in this trade, but Susie also knows that this strategy does not come without risks of loss. The mean to which volatility is expected to revert is not a constant. This benchmark can and does change. In this example, if the company had an unexpectedly terrible quarter, the stock could plunge sharply. In some cases, this would cause IV to find a new, higher level at which to reside. If that had happened here, the trade could have been a big loser. Gamma and vega could both have wreaked havoc. In trading, there is no sure thing, no matter what the chart looks like. Remember, every ship on the bottom of the ocean has a chart! Volatility Buying This same earnings event could have been played entirely differently. A different trader, Bobby Buyer, studied the same volatility chart as Susie. It is shown again here as Exhibit 12.7 . Bobby also thought there would be a rush and crush of IV, but he decided to take a different approach. EXHIBIT 12.7 Chip stock volatility before and after earnings reports. Source : Chart courtesy of iVolatility.com About an hour before the close of business on July 21, just three days before earnings announcements, Bobby saw that he could buy volatility at 30 percent. In Bobby’s opinion, volatility seemed cheap with earnings so close. He believed that IV could rise at least five points over the next three days. Note that we have the benefit of 20/20 hindsight in the example. Near the end of the trading day, the stock was at $49.70. Bobby bought 20 33-day 50-strike calls at 1.75 (30 volatility) and sold short 1,000 shares of the underlying stock at $49.70 to become delta neutral. Exhibit 12.8 shows Bobby’s position. EXHIBIT 12.8 Delta-neutral long call, short stock position. With the stock at $49.70, the calls had +0.51 delta per contract, or +10.2 for the 20-lot. The short sale of 1,000 shares got Bobby as close to delta-neutral as possible without trading an odd lot in the stock. The net position delta was +0.20, or about the equivalent of being long 20 shares of stock. Bobby’s objective in this case is to profit from an increase in implied volatility leading up to earnings. While Susie was looking for reversion to the mean, Bobby hoped for a further divergence. For Bobby, positive gamma looked like a good thing on the surface. However, his plan was to close the position just before earnings were released—before the vol crush and before the potential stock-price move. With realized volatility already starting to drop off at the time the trade was put on, gamma offered little promise of gain. As fate would have it, IV did indeed increase. At the end of the day before the July earnings report, IV was trading at 35 percent. Bobby closed his trade by selling his 20-lot of the 50 calls at 2.10 and buying his 1,000 shares of stock back at $50. Exhibit 12.9 shows the P&(L) for each leg of the spread. EXHIBIT 12.9 Profit breakdown. The calls earned Bobby a total of $700, while the stock lost $300. Of course, with this type of trade, it is not relevant which leg was a winner and which a loser. All that matters is the bottom line. The net P&(L) on the trade was a gain of $400. The gain in this case was mostly a product of IV’s rising. Exhibit 12.10 shows the P&(L) per greek. EXHIBIT 12.10 Profit breakdown by greek. Delta The position began long 0.20 deltas. The 0.30-point rise earned Bobby a 0.06 point gain in delta per contract. Gamma Bobby had an initial gamma of +1.8. We will use 1.8 for estimating the P&(L) in this example, assuming gamma remained constant. A 0.30 rise in the stock price multiplied by the 1.8 gamma means that with the stock at $50, Bobby was long an additional 0.54 deltas. We can estimate that over the course of the 0.30 rise in the stock price, Bobby was long an average of 0.27 (0.54 ÷ 2). His P&(L) due to gamma, therefore, is a gain of about 0.08 (0.27 × 0.30). Theta Bobby held this trade for three days. His total theta cost him 1.92 or $192. Vega The biggest contribution to Bobby’s profit on this trade was made by the spike in IV. He bought 30 volatility and sold 35 volatility. His 1.20 position vega earned him 6.00, or $600. Conclusions The $422 profit is not exact, but the greeks provide a good estimate of the hows and the whys behind it. Whether they are used for forecasting profits or for doing a postmortem evaluation of a trade, consulting the greeks offers information unavailable by just looking at the transaction prices. By thinking about all these individual pricing components, a trader can make better decisions. For example, about two weeks earlier, Bobby could have bought an IV level closer to 26 percent. Being conscious of his theta, however, he decided to wait. The $64-a-day theta would have cost him $896 over 14 days. That’s much more that the $480 he could have made by buying volatility four points lower with his 1.20 vega. Risks of the Trade Like Susie’s trade, Bobby’s play was not without risk. Certainly theta was a concern, but in addition to that was the possibility that IV might not have played out as he planned. First, IV might not have risen enough to cover three days’ worth of theta. It needed to rise, in this case, about 1.6 volatility points for the 1.20 vega to cover the 1.92 theta loss. It might even have dropped. An earlier-than-expected announcement that the earnings numbers were right on target could have spoiled Bobby’s trade. Or the market simply might not have reacted as expected; volatility might not have risen at all, or might have fallen. Remember, IV is a function of the market. It does not always react as one thinks it should. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00024.html SCORE: 8.00 ================================================================================ CHAPTER 13 Delta-Neutral Trading Trading Realized Volatility So far, we’ve discussed many option strategies in which realized volatility is an important component of the trade. And while the management of these positions has been the focus of much of the discussion, the ultimate gain or loss for many of these strategies has been from movement in a single direction. For example, with a long call, the higher the stock rallies the better. But increases or decreases in realized volatility do not necessarily have an exclusive relationship with direction. Recall that realized volatility is the annualized standard deviation of daily price movements. Take two similarly priced stocks that have had a net price change of zero over a one-month period. Stock A had small daily price changes during that period, rising $0.10 one day and falling $0.10 the next. Stock B went up or down by $5 each day for a month. In this rather extreme example, Stock B was much more volatile than Stock A, regardless of the fact that the net price change for the period for both stocks was zero. A stock’s volatility—either high or low volatility—can be capitalized on by trading options delta neutral. Simply put, traders buy options delta neutral when they believe a stock will have more movement and sell options delta neutral when they believe a stock will move less. Delta-neutral option sellers profit from low volatility through theta. Every day that passes in which the loss from delta/gamma movement is less than the gain from theta is a winning day. Traders can adjust their deltas by hedging. Delta-neutral option buyers exploit volatility opportunities through a trading technique called gamma scalping. Gamma Scalping Intraday trading is seldom entirely in one direction. A stock may close higher or lower, even sharply higher or lower, on the day, but during the day there is usually not a steady incremental rise or fall in the stock price. A typical intraday stock chart has peaks and troughs all day long. Delta-neutral traders who have gamma don’t remain delta neutral as the underlying price changes, which inevitably it will. Delta-neutral trading is kind of a misnomer. In fact, it is gamma trading in which delta-neutral traders engage. For long-gamma traders, the position delta gets more positive as the underlying moves higher and more negative as the underlying moves lower. An upward move in the underlying increases positive deltas, resulting in exponentially increasing profits. But if the underlying price begins to retrace downward, the gain from deltas can be erased as quickly as it was racked up. To lock in delta gains, a trader can adjust the position to delta neutral again by selling short stock to cover long deltas. If the stock price declines after this adjustment, losses are curtailed thanks to the short stock. In fact, the delta will become negative as the underlying price falls, leading to growing profits. To lock in profits again, the trader buys stock to cover short deltas to once again become delta neutral. The net effect is a stock scalp. Positive gamma causes the delta-neutral trader to sell stock when the price rises and buy when the stock falls. This adds up to a true, realized profit. So positive gamma is a money-making machine, right? Not so fast. As in any business, the profits must be great enough to cover expenses. Theta is the daily cost of running this gamma-scalping business. For example, a trader, Harry, notices that the intraday price swings in a particular stock have been increasing. He takes a bullish position in realized volatility by buying 20 off the 40-strike calls, which have a 50 delta, and selling stock on a delta-neutral ratio. Buy 20 40-strike calls (50 delta) (long 1,000 deltas) Short 1,000 shares at $40 (short 1,000 deltas) The immediate delta of this trade is flat, but as the stock moves up or down, that will change, presenting gamma-scalping opportunities. Gamma scalping is the objective here. The position greeks in Exhibit 13.1 show the relationship of the two forces involved in this trade: gamma and theta. EXHIBIT 13.1 Greeks for 20-lot delta-neutral long call. The relationship of gamma to theta in this sort of trade is paramount to its success. Gamma-scalping plays are not buy-and-hold strategies. This is active trading. These spreads need to be monitored intraday to take advantage of small moves in the underlying security. Harry will sell stock when the underlying rises and buy it when the underlying falls, taking a profit with each stock trade. The goal for each day that passes is to profit enough from positive gamma to cover the day’s theta. But that’s not always as easy as it sounds. Let’s study what happens the first seven days after this hypothetical trade is executed. For the purposes of this example, we assume that gamma remains constant and that the trader is content trading odd lots of stock. Day One The first day proves to be fairly volatile. The stock rallies from $40 to $42 early in the day. This creates a positive position delta of 5.60, or the equivalent of being long about 560 shares. At $42, Harry covers the position delta by selling 560 shares of the underlying stock to become delta neutral again. Later in the day, the market reverses, and the stock drops back down to $40 a share. At this point, the position is short 5.60 deltas. Harry again adjusts the position, buying 560 shares to get flat. The stock then closes right at $40. The net result of these two stock transactions is a gain of $1,070. How? The gamma scalp minus the theta, as shown below. The volatility of day one led to it being a profitable day. Harry scalped 560 shares for a $2 profit, resulting from volatility in the stock. If the stock hadn’t moved as much, the delta would have been smaller, and the dollar amount scalped would have been smaller, leading to an exponentially smaller profit. If there had been more volatility, profits would have been exponentially larger. It would have led to a bigger bite being taken out of the market. Day Two The next day, the market is a bit quieter. There is a $0.40 drop in the price of the stock, at which point the position delta is short 1.12. Harry buys 112 shares at $39.60 to get delta neutral. Following Harry’s purchase, the stock slowly drifts back up and is trading at $40 near the close. Harry decides to cover his deltas and sell 112 shares at $40. It is common to cover all deltas at the end of the day to get back to being delta neutral. Remember, the goal of gamma scalping is to trade volatility, not direction. Starting the next trading day with a delta, either positive or negative, means an often unwanted directional bias and unwanted directional risk. Tidying up deltas at the end of the day to get neutral is called going home flat. Today was not a banner day. Harry did not quite have the opportunity to cover the decay. Day Three On this day, the market trends. First, the stock rises $0.50, at which point Harry sells 140 shares of stock at $40.50 to lock in gains from his delta and to get flat. However, the market continues to rally. At $41 a share, Harry is long another 1.40 deltas and so sells another 140 shares. The rally continues, and at $41.50 he sells another 140 shares to cover the delta. Finally, at the end of the day, the stock closes at $42 a share. Harry sells a final 140 shares to get flat. There was not any literal scalping of stock today. It was all selling. Nonetheless, gamma trading led to a profitable day. As the stock rose from $40 to $40.50, 140 deltas were created from positive gamma. Because the delta was zero at $40 and 140 at $40.50, the estimated average delta is found by dividing 140 in half. This estimated average delta multiplied by the $0.50 gain on the stock equals a $35 profit. The delta was zero after the adjustment made at $40.50, when 140 shares were sold. When the stock reached $41, another $35 was reaped from the average delta of 70 over the $0.50 move. This process was repeated every time the stock rose $0.50 and the delta was covered. Day Four Day four offers a pleasant surprise for Harry. That morning, the stock opens $4 lower. He promptly covers his short delta of 11.2 by buying 1,120 shares of the stock at $38 a share. The stock barely moves the rest of the day and closes at $38. An exponentially larger profit was made because there was $4 worth of gains on the growing delta when the stock gapped open. The whole position delta was covered $4 lower, so both the delta and the dollar amount gained on that delta had a chance to grow. Again, Harry can estimate the average delta over the $4 move to be half of 11.20. Multiplying that by the $4 stock advance gives him his gamma profit of $2,240. After accounting for theta, the net profit is $2,190. Days Five and Six Days five and six are the weekend; the market is closed. Day Seven This is a quiet day after the volatility of the past week. Today, the stock slowly drifts up $0.25 by the end of the day. Harry sells 70 shares of stock at $38.25 to cover long deltas. This day was a loser for Harry, as profits from gamma were not enough to cover his theta. Art and Science Although this was a very simplified example, it was typical of how a profitable week of gamma scalping plays out. This stock had a pretty volatile week, and overall the week was a winner: there were four losing days and three winners. The number of losing days includes the weekends. Weekends and holidays are big hurdles for long-gamma traders because of the theta loss. The biggest contribution to this being a winning week was made by the gap open on day four. Part of the reason was the sheer magnitude of the move, and part was the fact that the deltas weren’t covered too soon, as they had been on day three. In a perfect world, a long-gamma trader will always buy the low of the day and sell the high of the day when covering deltas. This, unfortunately, seldom happens. Long-gamma traders are very often wrong when trading stock to cover deltas. Being wrong can be okay on occasion. In fact, it can even be rewarding. Day three was profitable despite the fact that 140 shares were sold at $40.50, $41, and $41.50. The stock closed at $42; the first three stock trades were losers. Harry sold stock at a lower price than the close. But the position still made money because of his positive gamma. To be sure, Harry would like to have sold all 560 shares at $42 at the end of the day. The day’s profits would have been significantly higher. The problem is that no one knows where the stock will move next. On day three, if the stock had topped out at $40.50 and Harry did not sell stock because he thought it would continue higher, he would have missed an opportunity. Gamma scalping is not an exact science. The art is to pick spots that capture the biggest moves possible without missing opportunities. There are many methods traders have used to decide where to cover deltas when gamma scalping: the daily standard deviation, a fixed percentage of the stock price, a fixed nominal value, covering at a certain time of day, “market feel.” No system appears to be absolutely better than another. This is where it gets personal. Finding what works for you, and what works for the individual stocks you trade, is the art of this science. Gamma, Theta, and Volatility Clearly, more volatile stocks are more profitable for gamma scalping, right? Well . . . maybe. Recall that the higher the implied volatility, the lower the gamma and the higher the theta of at-the-money (ATM) options. In many cases, the more volatile a stock, the higher the implied volatility (IV). That means that a volatile stock might have to move more for a trader to scalp enough stock to cover the higher theta. Let’s look at the gamma-theta relationship from another perspective. In this example, for 0.50 of theta, Harry could buy 2.80 gamma. This relationship is based on an assumed 25 percent implied volatility. If IV were 50 percent, theta for this 20 lot would be higher, and the gamma would be lower. At a volatility of 50, Harry could buy 1.40 gammas for 0.90 of theta. The gamma is more expensive from a theta perspective, but if the stock’s statistical volatility is significantly higher, it may be worth it. Gamma Hedging Knowing that the gamma and theta figures of Exhibit 13.1 are derived from a 25 percent volatility assumption offers a benchmark with which to gauge the potential profitability of gamma trading the options. If the stock’s standard deviation is below 25 percent, it will be difficult to make money being long gamma. If it is above 25 percent, the play becomes easier to trade. There is more scalping opportunity, there are more opportunities for big moves, and there are more likely to be gaps in either direction. The 25 percent volatility input not only determines the option’s theoretical value but also helps determine the ratio of gamma to theta. A 25 percent or higher realized volatility in this case does not guarantee the trade’s success or failure, however. Much of the success of the trade has to do with how well the trader scalps stock. Covering deltas too soon leads to reduced profitability. Covering too late can lead to missed opportunities. Trading stock well is also important to gamma sellers with the opposite trade: sell calls and buy stock delta neutral. In this example, a trader will sell 20 ATM calls and buy stock on a delta-neutral ratio. This is a bearish position in realized volatility. It is the opposite of the trade in the last example. Consider again that 25 percent IV is the benchmark by which to gauge potential profitability. Here, if the stock’s volatility is below 25, the chances of having a profitable trade are increased. Above 25 is a bit more challenging. In this simplified example, a different trader, Mary, plays the role of gamma seller. Over the same seven-day period as before, instead of buying calls, Mary sold a 20 lot. Exhibit 13.2 shows the analytics for the trade. For the purposes of this example, we assume that gamma remains constant and the trader is content trading odd lots of stock. EXHIBIT 13.2 Greeks for 20-lot delta-neutral short call. Day One This was one of the volatile days. The stock rallied from $40 to $42 early in the day and had fallen back down to $40 by the end of the day. Big moves like this are hard to trade as a short-gamma trader. As the stock rose to $42, the negative delta would have been increasing. That means losses were adding up at an increasing rate. The only way to have stopped the hemorrhaging of money as the stock continued to rise would have been to buy stock. Of course, if Mary buys stock and the stock then declines, she has a loser. Let’s assume the best-case scenario. When the stock reached $42 and she had a −560 delta, Mary correctly felt the market was overbought and would retrace. Sometimes, the best trades are the ones you don’t make. On this day, Mary traded no stock. When the stock reached $40 a share at the end of the day, she was back to being delta neutral. Theta makes her a winner today. Because of the way Mary handled her trade, the volatility of day one was not necessarily an impediment to it being profitable. Again, the assumption is that Mary made the right call not to negative scalp the stock. Mary could have decided to hedge her negative gamma when the stock reach $42 and the position delta was at −$560 by buying stock and then selling it at $40. There are a number of techniques for hedging deltas resulting from negative gamma. The objective of hedging deltas is to avoid losses from the stock trending in one direction and creating increasingly adverse deltas but not to overtrade stock and negative scalp. Day Two Recall that this day had a small dip and then recovered to close again at $40. It is more reasonable to assume that on this day there was no negative scalping. A $0.40 decline is a more typical move in a stock and nothing to be afraid of. The 112 delta created by negative gamma when the stock fell wouldn’t be perceived as a major concern by most traders in most situations. It is reasonable to assume Mary would take no action. Today, again, was a winner thanks to theta. Day Three Day three saw the stock price trending. It slowly drifted up $2. There would have been some judgment calls throughout this day. Again, delta-neutral trades are for active traders. Prepare to watch the market much of the day if implementing this kind of strategy. When the stock was at $41 a share, Mary decided to guard against further advances in stock price and hedged her delta. At that point, the position would have had a −2.80 delta. She bought 280 shares at $41. As the day progressed, the market proved Mary to be right. The stock rose to $42 giving the position a delta of −2.80 again. She covered her deltas at the end of the day by buying another 280 shares. Covering the negative deltas to get flat at $41 proved to be a smart move today. It curtailed an exponentially growing delta and let Mary take a smaller loss at $41 and get a fresh start. While the day was a loser, it would have been $280 worse if she had not purchased stock at $41 before the run-up to $42. This is evidenced by the fact that she made a $280 profit on the 280 shares of stock bought at $41, since the stock closed at $42. Day Four Day four offered a rather unpleasant surprise. This was the day that the stock gapped open $4 lower. This is the kind of day short-gamma traders dread. There is, of course, no right way to react to this situation. The stock can recover, heading higher; it can continue lower; or it can have a dead-cat bounce, remaining where it is after the fall. Staring at a quite contrary delta of 11.20, Mary was forced to take action by selling stock. But how much stock was the responsible amount to sell for a pure short-gamma trader not interested in trading direction? Selling 1,120 shares would bring the position back to being delta neutral, but the only way the trade would stay delta neutral would be if the stock stayed right where it was. Hedging is always a difficult call for short-gamma traders. Long-gamma traders are taking a profit on deltas with every stock trade that covers their deltas. Short-gamma traders are always taking a loss on delta. In this case, Mary decided to cover half her deltas by selling 560 shares. The other 560 deltas represent a loss, too; it’s just not locked in. Here, Mary made the conscious decision not to go home flat. On the one hand, she was accepting the risk of the stock continuing its decline. On the other hand, if she had covered the whole delta, she would have been accepting the risk of the stock moving in either direction. Mary felt the stock would regain some of its losses. She decided to lead the stock a little, going into the weekend with a positive delta bias. Days Five and Six Days five and six are the weekend. Day Seven This was the quiet day of the week, and a welcome respite. On this day, the stock rose just $0.25. The rise in price helped a bit. Mary was still long 560 deltas from Friday. Negative gamma took only a small bite out of her profit. The P&(L) can be broken down into the profit attributable to the starting delta of the trade, the estimated loss from gamma, and the gain from theta. Mary ends these seven days of trading worse off than she started. What went wrong? The bottom line is that she sold volatility on an asset that proved to be volatile. A $4 drop in price of a $42 dollar stock was a big move. This stock certainly moved at more than 25 percent volatility. Day four alone made this trade a losing proposition. Could Mary have done anything better? Yes. In a perfect world, she would not have covered her negative deltas on day 3 by buying 280 shares at $41 and another 280 at $42. Had she not, this wouldn’t have been such a bad week. With the stock ending at $38.25, she lost $1,050 on the 280 shares she bought at $42 ($3.75 times 280) and lost $770 on the 280 shares bought at $41 ($2.75 times 280). Then again, if the stock had continued higher, rising beyond $42, those would have been good buys. Mary can’t beat herself up too much for protecting herself in a way that made sense at the time. The stock’s $2 rally is more to blame than the fact that she hedged her deltas. That’s the risk of selling volatility: the stock may prove to be volatile. If the stock had not made such a move, she wouldn’t have faced the dilemma of whether or not to hedge. Conclusions The same stock during the same week was used in both examples. These two traders started out with equal and opposite positions. They might as well have made the trade with each other. And although in this case the vol buyer (Harry) had a pretty good week and the vol seller (Mary) had a not-so-good week, it’s important to notice that the dollar value of the vol buyer’s profit was not the same as the dollar value of the vol seller’s loss. Why? Because each trader hedged his or her position differently. Option trading is not a zero-sum game. Option-selling delta-neutral strategies work well in low-volatility environments. Small moves are acceptable. It’s the big moves that can blow you out of the water. Like long-gamma traders, short-gamma traders have many techniques for covering deltas when the stock moves. It is common to cover partial deltas, as Mary did on day four of the last example. Conversely, if a stock is expected to continue along its trajectory up or down, traders will sometimes overhedge by buying more deltas (stock) than they are short or selling more than they are long, in anticipation of continued price rises. Daily standard deviation derived from implied volatility is a common measure used by short-gamma players to calculate price points at which to enter hedges. Market feel and other indicators are also used by experienced traders when deciding when and how to hedge. Each trader must find what works best for him or her. Smileys and Frowns The trade examples in this chapter have all involved just two components: calls and stock. We will explore delta-neutral strategies in other chapters that involve more moving parts. Regardless of the specific makeup of the position, the P&(L) of each individual leg is not of concern. It is the profitability of the position as a whole that matters. For example, after a volatile move in a stock occurs, a positive-gamma trader like Harry doesn’t care whether the calls or the stock made the profit on the move. The trader would monitor the net delta that was produced—positive or negative—and cover accordingly. The process is the same for a negative-gamma trader. In either case, it is gamma and delta that need to be monitored closely. Gamma can make or break a trade. P&(L) diagrams are helpful tools that offer a visual representation of the effect of gamma on a position. Many option-trading software applications offer P&(L) graphing applications to study the payoff of a position with the days to expiration as an adjustable variable to study the same trade over time. P&(L) diagrams for these delta-neutral positions before the options’ expiration generally take one of two shapes: a smiley or a frown. The shape of the graph depends on whether the position gamma is positive or negative. Exhibit 13.3 shows a typical positive-gamma trade. EXHIBIT 13.3 P&(L) diagram for a positive-gamma delta-neutral position/l. This diagram is representative of the P&L of a delta-neutral positive-gamma trade calculated using the prices at which the trade was executed. With this type of trade, it is intuitive that when the stock price rises or falls, profits increase because of favorably changing deltas. This is represented by the graph’s smiley-face shape. The corners of the graph rise higher as the underlying moves away from the center of the graph. The graph is a two-dimensional snapshot showing that the higher or lower the underlying moves, the greater the profit. But there are other dimensions that are not shown here, such as time and IV. Exhibit 13.4 shows the effects of time on a typical long-gamma trade. EXHIBIT 13.4 The effect of time on P&(L). As time passes, the reduction in profit is reflected by the center point of the graph dipping farther into negative territory. That is the effect of time decay. The long options will have lost value at that future date with the stock still at the same price (all other factors held constant). Still, a move in either direction can lead to a profitable position. Ultimately, at expiration, the payoff takes on a rigid kinked shape. In the delta-neutral long call examples used in this chapter the position becomes net long stock if the calls are in-the-money at expiration or net short stock if they are out-of-the-money and only the short stock remains. Volatility, as well, would move the payoff line vertically. As IV increases, the options become worth more at each stock price, and as IV falls, they are worth less, assuming all other factors are held constant. A delta-neutral short-gamma play would have a P&(L) diagram quite the opposite of the smiley-faced long-gamma graph. Exhibit 13.5 shows what is called the short-gamma frown. EXHIBIT 13.5 Short-gamma frown. At first glance, this doesn’t look like a very good proposition. The highest point on the graph coincides with a profit of zero, and it only gets worse as the price of the underlying rises or falls. This is enough to make any trader frown. But again, this snapshot does not show time or volatility. Exhibit 13.6 shows the payout diagram as time passes. EXHIBIT 13.6 The effect of time on the short-gamma frown. A decrease in value of the options from time decay causes an increase in profitability. This profit potential pinnacles at the center (strike) price at expiration. Rising IV will cause a decline in profitability at each stock price point. Declining IV will raise the payout on the Y axis as profitability increases at each price point. Smileys and frowns are a mere graphical representation of the technique discussed in this chapter: buying and selling realized volatility. These P&(L) diagrams are limited, because they show the payout only of stock-price movement. The profitability of direction-indifferent and direction-neutral trading is also influenced by time and implied volatility. These actively traded strategies are best evaluated on a gamma-theta basis. Long-gamma traders strive each day to scalp enough to cover the day’s theta, while short-gamma traders hope to keep the loss due to adverse movement in the underlying lower than the daily profit from theta. The strategies in this chapter are the same ones traded in Chapter 12. The only difference is the philosophy. Ultimately, both types of volatility are being traded using these and other option strategies. Implied and realized volatility go hand in hand. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00025.html SCORE: 107.00 ================================================================================ CHAPTER 14 Studying Volatility Charts Implied and realized volatility are both important to option traders. But equally important is to understand how the two interact. This relationship is best studied by means of a volatility chart. Volatility charts are invaluable tools for volatility traders (and all option traders for that matter) in many ways. First, volatility charts show where implied volatility (IV) is now compared with where it’s been in the past. This helps a trader gauge whether IV is relatively high or relatively low. Vol charts do the same for realized volatility. The realized volatility line on the chart answers three questions: Have the past 30 days been more or less volatile for the stock than usual? What is a typical range for the stock’s volatility? How much volatility did the underlying historically experience in the past around specific recurring events? When IV lines and realized volatility lines are plotted on the same chart, the divergences and convergences of the two spell out the whole volatility story for those who know how to read it. Nine Volatility Chart Patterns Each individual stock and the options listed on it have their own unique realized and implied volatility characteristics. If we studied the vol charts of 1,000 stocks, we’d likely see around 1,000 different volatility patterns. The number of permutations of the relationship of realized to implied volatility is nearly infinite, but for the sake of discussion, we will categorize volatility charts into nine general patterns. 1 1. Realized Volatility Rises, Implied Volatility Rises The first volatility chart pattern is that in which both IV and realized volatility rise. In general, this kind of volatility chart can line up three ways: implied can rise more than realized volatility; realized can rise more than implied; or they can both rise by about the same amount. The chart below shows implied volatility rising at a faster rate than realized vol. The general theme in this case is that the stock’s price movement has been getting more volatile, and the option prices imply even higher volatility in the future. This specific type of volatility chart pattern is commonly seen in active stocks with a lot of news. Stocks du jour, like some Internet stocks during the tech bubble of the late 1990s, story stocks like Apple (AAPL) around the release of the iPhone in 2007, have rising volatilities, with the IV outpacing the realized volatility. Sometimes individual stocks and even broad market indexes and exchange-traded funds (ETFs) see this pattern, when the market is declining rapidly, like in the summer of 2011. A delta-neutral long-volatility position bought at the beginning of May, according to Exhibit 14.1 , would likely have produced a winner. IV took off, and there were sure to be plenty of opportunities to profit from gamma with realized volatility gaining strength through June and July. EXHIBIT 14.1 Realized volatility rises, implied volatility rises. Source : Chart courtesy of iVolatility.com Looking at the right side of the chart, in late July, with IV at around 50 percent and realized vol at around 35 percent, and without the benefit of knowing what the future will bring, it’s harder to make a call on how to trade the volatility. The IV signals that the market is pricing a higher future level of stock volatility into the options. If the market is right, gamma will be good to have. But is the price right? If realized volatility does indeed catch up to implied volatility—that is, if the lines converge at 50 or realized volatility rises above IV—a trader will have a good shot at covering theta. If it doesn’t, gamma will be very expensive in terms of theta, meaning it will be hard to cover the daily theta by scalping gamma intraday. The question is: why is IV so much higher than realized? If important news is expected to be released in the near future, it may be perfectly reasonable for the IV to be higher, even significantly higher, than the stock’s realized volatility. One big move in the stock can produce a nice profit, as long as theta doesn’t have time to work its mischief. But if there is no news in the pipeline, there may be some irrational exuberance—in the words of ex-Fed chairman Alan Greenspan—of option buyers rushing to acquire gamma that is overvalued in terms of theta. In fact, a lack of expectation of news could indicate a potential bearish volatility play: sell volatility with the intent of profiting from daily theta and a decline in IV. This type of play, however, is not for the fainthearted. No one can predict the future. But one thing you can be sure of with this trade: you’re in for a wild ride. The lines on this chart scream volatility. This means that negative-gamma traders had better be good and had better be right! In this situation, hedgers and speculators in the market are buying option volatility of 50 percent, while the stock is moving at 35 percent volatility. Traders putting on a delta-neutral volatility-selling strategy are taking the stance that this stock will not continue increasing in volatility as indicated by option prices; specifically, it will move at less than 50 percent volatility—hopefully a lot less. They are taking the stance that the market’s expectations are wrong. Instead of realized and implied volatility both trending higher, sometimes there is a sharp jump in one or the other. When this happens, it could be an indication of a specific event that has occurred (realized volatility) or news suddenly released of an expected event yet to come (implied volatility). A sharp temporary increase in IV is called a spike, because of its pointy shape on the chart. A one-day surge in realized volatility, on the other hand, is not so much a volatility spike as it is a realized volatility mesa. Realized volatility mesas are shown in Exhibit 14.2 . EXHIBIT 14.2 Volatility mesas. Source : Chart courtesy of iVolatility.com The patterns formed by the gray line in the circled areas of the chart shown below are the result of typical one-day surges in realized volatility. Here, the 30-day realized volatility rose by nearly 20 percentage points, from about 20 percent to about 40 percent, in one day. It remained around the 40 percent level for 30 days and then declined 20 points just as fast as it rose. Was this entire 30-day period unusually volatile? Not necessarily. Realized volatility is calculated by looking at price movements within a certain time frame, in this case, thirty business days. That means that a really big move on one day will remain in the calculation for the entire time. Thirty days after the unusually big move, the calculation for realized volatility will no longer contain that one-day price jump. Realized volatility can then drop significantly. 2. Realized Volatility Rises, Implied Volatility Remains Constant This chart pattern can develop from a few different market conditions. One scenario is a one-time unanticipated move in the underlying that is not expected to affect future volatility. Once the news is priced into the stock, there is no point in hedgers’ buying options for protection or speculators’ buying options for a leveraged bet. What has happened has happened. There are other conditions that can cause this type of pattern to materialize. In Exhibit 14.3 , the IV was trading around 25 for several months, while the realized volatility was lagging. With hindsight, it makes perfect sense that something had to give—either IV needed to fall to meet realized, or realized would rise to meet market expectations. Here, indeed, the latter materialized as realized volatility had a steady rise to and through the 25 level in May. Implied, however remained constant. EXHIBIT 14.3 Realized volatility rises, implied volatility remains constant. Source : Chart courtesy of iVolatility.com Traders who were long volatility going into the May realized-vol rise probably reaped some gamma benefits. But those who got in “too early,” buying in January or February, would have suffered too great of theta losses before gaining any significant profits from gamma. Time decay (theta) can inflict a slow, painful death on an option buyer. By studying this chart in hindsight, it is clear that options were priced too high for a gamma scalper to have a fighting chance of covering the daily theta before the rise in May. This wasn’t necessarily an easy vol-selling trade before the May realized-vol rise, either, depending on the trader’s timing. In early February, realized did in fact rise above implied, making the short volatility trade much less attractive. Traders who sold volatility just before the increase in realized volatility in May likely ended up losing on gamma and not enough theta profits to make up for it. There was no volatility crush like what is often seen following a one-day move leading to sharply higher realized volatility. IV simply remained pretty steady throughout the month of May and well into June. 3. Realized Volatility Rises, Implied Volatility Falls This chart pattern can manifest itself in different ways. In this scenario, the stock is becoming more volatile, and options are becoming cheaper. This may seem an unusual occurrence, but as we can see in Exhibit 14.4 , volatility sometimes plays out this way. This chart shows two different examples of realized vol rising while IV falls. EXHIBIT 14.4 Realized volatility rises, implied volatility falls. Source : Chart courtesy of iVolatility.com The first example, toward the left-hand side of the chart, shows realized volatility trending higher while IV is trending lower. Although fundamentals can often provide logical reasons for these volatility changes, sometimes they just can’t. Both implied and realized volatility are ultimately a function of the market. There is a normal oscillation to both of these figures. When there is no reason to be found for a volatility change, it might be an opportunity. The potential inefficiency of volatility pricing in the options market sometimes creates divergences such as this one that vol traders scour the market in search of. In this first example, after at least three months of IV’s trading marginally higher than realized volatility, the two lines converge and then cross. The point at which these lines meet is an indication that IV may be beginning to get cheap. First, it’s a potentially beneficial opportunity to buy a lower volatility than that at which the stock is actually moving. The gamma/theta ratio would be favorable to gamma scalpers in this case, because the lower cost of options compared with stock fluctuations could lead to gamma profits. Second, with IV at 35 at the first crossover on this chart, IV is dipping down into the lower part of its four-month range. One can make the case that it is getting cheaper from a historical IV standpoint. There is arguably an edge from the perspective of IV to realized volatility and IV to historical IV. This is an example of buying value in the context of volatility. Furthermore, if the actual stock volatility is rising, it’s reasonable to believe that IV may rise, too. In hindsight we see that this did indeed occur in Exhibit 14.4 , despite the fact that realized volatility declined. The example circled on the right-hand side of the chart shows IV declining sharply while realized volatility rises sharply. This is an example of the typical volatility crush as a result of an earnings report. This would probably have been a good trade for long volatility traders—even those buying at the top. A trader buying options delta neutral the day before earnings are announced in this example would likely lose about 10 points of vega but would have a good chance to more than make up for that loss on positive gamma. Realized volatility nearly doubled, from around 28 percent to about 53 percent, in a single day. 4. Realized Volatility Remains Constant, Implied Volatility Rises Exhibit 14.5 shows that the stock is moving at about the same volatility from the beginning of June to the end of July. But during that time, option premiums are rising to higher levels. This is an atypical chart pattern. If this was a period leading up to an anticipated event, like earnings, one would anticipate realized volatility falling as the market entered a wait-and-see mode. But, instead, statistical volatility stays the same. This chart pattern may indicate a potential volatility-selling opportunity. If there is no news or reason for IV to have risen, it may simply be high tide in the normal ebb and flow of volatility. EXHIBIT 14.5 Realized volatility remains constant, implied volatility rises. Source : Chart courtesy of iVolatility.com In this example, the historical volatility oscillates between 20 and 24 for nearly two months (the beginning of June through the end of July) as IV rises from 24 to over 30. The stock price is less volatile than option prices indicate. If there is no news to be dug up on the stock to lead one to believe there is a valid reason for the IV’s trading at such a level, this could be an opportunity to sell IV 5 to 10 points higher than the stock volatility. The goal here is to profit from theta or falling vega or both while not losing much on negative gamma. As time passes, if the stock continues to move at 20 to 23 vol, one would expect IV to fall and converge with realized volatility. 5. Realized Volatility Remains Constant, Implied Volatility Remains Constant This volatility chart pattern shown in Exhibit 14.6 is typical of a boring, run-of-the-mill stock with nothing happening in the news. But in this case, no news might be good news. EXHIBIT 14.6 Realized volatility remains constant, implied volatility remains constant. Source : Chart courtesy of iVolatility.com Again, the gray is realized volatility and the black line is IV. It’s common for IV to trade slightly above or below realized volatility for extended periods of time in certain assets. In this example, the IV has traded in the high teens from late January to late July. During that same time, realized volatility has been in the low teens. This is a prime environment for option sellers. From a gamma/theta standpoint, the odds favor short-volatility traders. The gamma/theta ratio provides an edge, setting the stage for theta profits to outweigh negative-gamma scalping. Selling calls and buying stock delta neutral would be a trade to look at in this situation. But even more basic strategies, such as time spreads and iron condors, are appropriate to consider. This vol-chart pattern, however, is no guarantee of success. When the stock oscillates, delta-neutral traders can negative scalp stock if they are not careful by buying high to cover short deltas and then selling low to cover long deltas. Time-spread and iron condor trades can fail if volatility increases and the increase results from the stock trending in one direction. The advantage of buying IV lower than realized, or selling it above, is statistical in nature. Traders should use a chart of the stock price in conjunction with the volatility chart to get a more complete picture of the stock’s price action. This also helps traders make more informed decisions about when to hedge. 6. Realized Volatility Remains Constant, Implied Volatility Falls Exhibit 14.7 shows two classic implied-realized convergences. From mid-September to early November, realized volatility stayed between 22 and 25. In mid-October the implied was around 33. Within the span of a few days, the implied vol collapsed to converge with the realized at about 22. EXHIBIT 14.7 Realized volatility remains constant, implied volatility falls. Source : Chart courtesy of iVolatility.com There can be many catalysts for such a drop in IV, but there is truly only one reason: arbitrage. Although it is common for a small difference between implied and realized volatility—1 to 3 points—to exist even for extended periods, bigger disparities, like the 7- to 10-point difference here cannot exist for that long without good reason. If, for example, IV always trades significantly above the realized volatility of a particular underlying, all rational market participants will sell options because they have a gamma/theta edge. This, in turn, forces options prices lower until volatility prices come into line and the arbitrage opportunity no longer exists. In Exhibit 14.7 , from mid-March to mid-May a similar convergence took place but over a longer period of time. These situations are often the result of a slow capitulation of market makers who are long volatility. The traders give up on the idea that they will be able to scalp enough gamma to cover theta and consequently lower their offers to advertise their lower prices. 7. Realized Volatility Falls, Implied Volatility Rises This setup shown in Exhibit 14.8 should now be etched into the souls of anyone who has been reading up to this point. It is, of course, the picture of the classic IV rush that is often seen in stocks around earnings time. The more uncertain the earnings, the more pronounced this divergence can be. EXHIBIT 14.8 Realized volatility falls, implied volatility rises. Source : Chart courtesy of iVolatility.com Another classic vol divergence in which IV rises and realized vol falls occurs in a drug or biotech company when a Food and Drug Administration (FDA) decision on one of the company’s new drugs is imminent. This is especially true of smaller firms without big portfolios of drugs. These divergences can produce a huge implied–realized disparity of, in some cases, literally hundreds of volatility points leading up to the announcement. Although rising IV accompanied by falling realized volatility can be one of the most predictable patterns in trading, it is ironically one of the most difficult to trade. When the anticipated news breaks, the stock can and often will make a big directional move, and in that case, IV can and likely will get crushed. Vega and gamma work against each other in these situations, as IV and realized volatility converge. Vol traders will likely gain on one vol and lose on the other, but it’s very difficult to predict which will have a more profound effect. Many traders simply avoid trading earnings events altogether in favor of less erratic opportunities. For most traders, there are easier ways to make money. 8. Realized Volatility Falls, Implied Volatility Remains Constant This volatility shift can be marked by a volatility convergence, divergence, or crossover. Exhibit 14.9 shows the realized volatility falling from around 30 percent to about 23 percent while IV hovers around 25. The crossover here occurs around the middle of February. EXHIBIT 14.9 Realized volatility falls, implied volatility remains constant. Source : Chart courtesy of iVolatility.com The relative size of this volatility change makes the interpretation of the chart difficult. The last half of September saw around a 15 percent decline in realized volatility. The middle of October saw a one-day jump in realized of about 15 points. Historical volatility has had several dynamic moves that were larger and more abrupt than the seven-point decline over this six-week period. This smaller move in realized volatility is not necessarily an indication of a volatility event. It could reflect some complacency in the market. It could indicate a slow period with less trading, or it could simply be a natural contraction in the ebb and flow of volatility causing the calculation of recent stock-price fluctuations to wane. What is important in this interpretation is how the options market is reacting to the change in the volatility of the stock—where the rubber hits the road. The market’s apparent assessment of future volatility is unchanged during this period. When IV rises or falls, vol traders must look to the underlying stock for a reason. The options market reacts to stock volatility, not the other way around. Finding fundamental or technical reasons for surges in volatility is easier than finding specific reasons for a decline in volatility. When volatility falls, it is usually the result of a lack of news, leading to less price action. In this example, probably nothing happened in the market. Consequently, the stock volatility drifted lower. But it fell below the lowest IV level seen for the six-month period leading up to the crossover. It was probably hard to take a confident stance in volatility immediately following the crossover. It is difficult to justify selling volatility when the implied is so cheap compared with its historic levels. And it can be hard to justify buying volatility when the options are priced above the stock volatility. The two-week period before the realized line moved beneath the implied line deserves closer study. With the IV four or five points lower than the realized volatility in late January, traders may have been tempted to buy volatility. In hindsight, this trade might have been profitable, but there was surely no guarantee of this. Success would have been greatly contingent on how the traders managed their deltas, and how well they adapted as realized volatility fell. During the first half of this period, the stock volatility remained above implied. For an experienced delta-neutral trader, scalping gamma was likely easy money. With the oscillations in stock price, the biggest gamma-scalping risk would have been to cover too soon and miss out on opportunities to take bigger profits. Using the one-day standard deviation based on IV (described in Chapter 3) might have produced early covering for long-gamma traders. Why? Because in late January, the standard deviation derived from IV was lower than the actual standard deviation of the stock being traded. In the latter half of the period being studied, the end of February on this chart, using the one-day standard deviation based on IV would have produced scalping that was too late. This would have led to many missed opportunities. Traders entering hedges at regular nominal intervals—every $0.50, for example—would probably have needed to decrease the interval as volatility ebbed. For instance, if in late January they were entering orders every $0.50, by late February they might have had to trade every $0.40. 9. Realized Volatility Falls, Implied Volatility Falls This final volatility-chart permutation incorporates a fall of both realized and IV. The chart in Exhibit 14.10 clearly represents the slow culmination of a highly volatile period. This setup often coincides with news of some scary event’s being resolved—a law suit settled, unpopular upper management leaving, rumors found to be false, a happy ending to political issues domestically or abroad, for example. After a sharp sell-off in IV, from 75 to 55, in late October, marking the end of a period of great uncertainty, the stock volatility began a steady decline, from the low 50s to below 25. IV fell as well, although it remained a bit higher for several months. EXHIBIT 14.10 Realized volatility falls, implied volatility falls. Source : Chart courtesy of iVolatility.com In some situations where an extended period of extreme volatility appears to be coming to an end, there can be some predictability in how IV will react. To be sure, no one knows what the future holds, but when volatility starts to wane because a specific issue that was causing gyrations in the stock price is resolved, it is common, and intuitive, for IV to fall with the stock volatility. This is another type of example of reversion to the mean. There is a potential problem if the high-volatility period lasted for an extended period of time. Sometimes, it’s hard to get a feel for what the mean volatility should be. Or sometimes, because of the event, the stock is fundamentally different—in the case of a spin-off, merger, or other corporate action, for example. When it is difficult or impossible to look back at a stock’s performance over the previous 6 to 12 months and appraise what the normal volatility should be, one can look to the volatility of other stocks in the same industry for some guidance. Stocks that are substitutable for one another typically trade at similar volatilities. From a realized volatility perspective, this is rather intuitive. When one stock within an industry rises or falls, others within the same industry tend to follow. They trade similarly and therefore experience similar volatility patterns. If the stock volatility among names within one industry tends to be similar, it follows that the IV should be, too. Regardless which of the nine patterns discussed here show up, or how the volatilities line up, there is one overriding observation that’s representative of all volatility charts: vol charts are simply graphical representations of realized and implied volatility that help traders better understand the two volatilities’ interaction. But the divergences and convergences in the examples in this chapter have profound meaning to the volatility trader. Combined with a comparison of current and past volatility (both realized and implied), they give traders insight into how cheap or expensive options are. Note 1 . The following examples use charts supplied by iVolatility.com . The gray line is the 30-day realized volatility, and the black line is the implied volatility. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html SCORE: 120.00 ================================================================================ CHAPTER 15 Straddles and Strangles Straddles and strangles are the quintessential volatility strategies. They are the purest ways to buy and sell realized and implied volatility. This chapter discusses straddles and strangles, how they work, when to use them, what to look out for, and the differences between the two. Long Straddle Definition : Buying one call and one put in the same option class, in the same expiration cycle, and with the same strike price. Linearly, the long straddle is the best of both worlds—long a call and a put. If the stock rises, the call enjoys the unlimited potential for profit while the put’s losses are decidedly limited. If the stock falls, the put’s profit potential is bound only by the stock’s falling to zero, while the call’s potential loss is finite. Directionally, this can be a win-win situation—as long as the stock moves enough for one option’s profit to cover the loss on the other. The risk, however, is that this may not happen. Holding two long options means a big penalty can be paid for stagnant stocks. The Basic Long Straddle The long straddle is an option strategy to use when a trader is looking for a big move in a stock but is uncertain which direction it will move. Technically, the Commodity Channel Index (CCI), Bollinger bands, or pennants are some examples of indicators which might signal the possibility of a breakout. Or fundamental data might call for a revaluation of the stock based on an impending catalyst. In either case, a long straddle, is a way for traders to position themselves for the expected move, without regard to direction. In this example, we’ll study a hypothetical $70 stock poised for a breakout. We’ll buy the one-month 70 straddle for 4.25. Exhibit 15.1 shows the payout of the straddle at expiration. EXHIBIT 15.1 At-expiration diagram for a long straddle. At expiration, with the stock at $70, neither the call nor the put is in-the-money. The straddle expires worthless, leaving a loss of 4.25 in its wake from erosion. If, however, the stock is above or below $70, either the call or the put will have at least some value. The farther the stock price moves from the strike price in either direction, the higher the net value of the options. Above $70, the call has value. If the underlying is at $74.25 at expiration, the put will expire worthless, but the call will be worth 4.25—the price initially paid for the straddle. Above this break-even price, the trade is a winner, and the higher, the better. Below $70, the put has value. If the underlying is at $65.75 at expiration, the call expires, and the put is worth 4.25. Below this breakeven, the straddle is a winner, and the lower, the better. Why It Works In this basic example, if the underlying is beyond either of the break-even points at expiration, the trade is a winner. The key to understanding this is the fact that at expiration, the loss on one option is limited—it can only fall to zero—but the profit potential on the other can be unlimited. In practice, most active traders will not hold a straddle until expiration. Even if the trade is not held to term, however, movement is still beneficial—in fact, it is more beneficial, because time decay will not have depleted all the extrinsic value of the options. Movement benefits the long straddle because of positive gamma. But movement is a race against the clock—a race against theta. Theta is the cost of trading the long straddle. Only pay it for as long as necessary. When the stock’s volatility appears poised to ebb, exit the trade. Exhibit 15.2 shows the P&(L) of the straddle both at expiration and at the time the trade was made. EXHIBIT 15.2 Long straddle P&(L) at initiation and expiration. Because this is a short-term at-the-money (ATM) straddle, we will assume for simplicity that it has a delta of zero. 1 When the trade is consummated, movement can only help, as indicated by the dotted line on the exhibit. This is the classic graphic representation of positive gamma—the smiley face. When the stock moves higher, the call gains value at an increasing rate while the put loses value at a decreasing rate. When the stock moves lower, the put gains at an increasing rate while the call loses at a decreasing rate. This is positive gamma. This still may not be an entirely fair representation of how profits are earned. The underlying is not required to move continuously in one direction for traders to reap gamma profits. As described in Chapter 13, traders can scalp gamma by buying and selling stock to offset long or short deltas created by movement in the underlying. When traders scalp gamma, they lock in profits as the stock price oscillates. The potential for gamma scalping is an important motivation for straddle buyers. Gamma scalping a straddle gives traders the chance to profit from a stock that has dynamic price swings. It should be second nature to volatility traders to understand that theta is the trade-off of gamma scalping. The Big V Gamma and theta are not alone in the straddle buyer’s thoughts. Vega is a major consideration for a straddle buyer, as well. In a straddle, there are two long options of the same strike, which means double the vega risk of a single-leg trade at that strike. With no short options in this spread, the implied-volatility exposure is concentrated. For example, if the call has a vega of 0.05, the put’s vega at that same strike will also be about 0.05. This means that buying one straddle gives the trader exposure of around 10 cents per implied volatility (IV) point. If IV rises by one point, the trader makes $10 per one-lot straddle, $20 for two points, and so on. If IV falls one point, the trader loses $10 per straddle, $20 for two points, and so on. Traders who want maximum positive exposure to volatility find it in long straddles. This strategy is a prime example of the marriage of implied and realized volatility. Traders who buy straddles because they are bullish on realized volatility will also have bullish positions in implied volatility—like it or not. With this in mind, traders must take care to buy gamma via a straddle that it is not too expensive in terms of the implied volatility. A winning gamma trade can quickly become a loser because of implied volatility. Likewise, traders buying straddles to speculate on an increase in implied volatility must take the theta risk of the trade very seriously. Time can eat away all a trade’s vega profits and more. Realized and implied exposure go hand in hand. The relationship between gamma and vega depends on, among other things, the time to expiration. Traders have some control over the amount of gamma relative to the amount of vega by choosing which expiration month to trade. The shorter the time until expiration, the higher the gammas and the lower the vegas of ATM options. Gamma traders may be better served by buying short-term contracts that coincide with the period of perceived high stock volatility. If the intent of the straddle is to profit from vega, the choice of the month to trade depends on which month’s volatility is perceived to be too high or too low. If, for example, the front-month IV looks low compared with historical IV, current and historical realized volatility, and the expected future volatility, but the back months’ IVs are higher and more in line with these other metrics, there would be no point in buying the back-month options. In this case, traders would need to buy the month that they think is cheap. Trading the Long Straddle Option trading is all about optimizing the statistical chances of success. A long-straddle trade makes the most sense if traders think they can make money on both implied volatility and gamma. Many traders make the mistake of buying a straddle just before earnings are announced because they anticipate a big move in the stock. Of course, stock-price action is only half the story. The option premium can be extraordinarily expensive just before earnings, because the stock move is priced into the options. This is buying after the rush and before the crush. Although some traders are successful specializing in trading earnings, this is a hard way to make money. Ideally, the best time to buy volatility is before the move is priced in—that is, before everyone else does. This is conceptually the same as buying a stock in anticipation of bullish news. Once news comes out, the stock rallies, and it is often too late to participate in profits. The goal is to get in at the beginning of the trend, not the end—the same goal as in trading volatility. As in analyzing a stock, fundamental and technical tools exist for analyzing volatility—namely, news and volatility charts. For fundamentals, buy the rumor, sell the news applies to the rush and crush of implied volatility. Previous chapters discussed fundamental events that affect volatility; be prepared to act fast when volatility-changing situations present themselves. With charts, the elementary concept of buy low, sell high is obvious, yet profound. Review Chapter 14 for guidance on reading volatility charts. With all trading, getting in is easy. It’s managing the position, deciding when to hedge and when to get out that is the tricky part. This is especially true with the long straddle. Straddles are intended to be actively managed. Instead of waiting for a big linear move to evolve over time, traders can take profits intermittently through gamma scalping. Furthermore, they hold the trade only as long as gamma scalping appears to be a promising opportunity. Legging Out There are many ways to exiting a straddle. In the right circumstances, legging out is the preferred method. Instead of buying and selling stock to lock in profits and maintain delta neutrality, traders can reduce their positions by selling off some of the calls or puts that are part of the straddle. In this technique, when the underlying rises, traders sell as many calls as needed to reduce the delta to zero. As the underlying falls, they sell enough puts to reduce their position to zero delta. As the stock oscillates, they whittle away at the position with each hedging transaction. This serves the dual purpose of taking profits and reducing risk. A trader, Susan, has been studying Acme Brokerage Co. (ABC). Susan has noticed that brokerage stocks have been fairly volatile in recent past. Exhibit 15.3 shows an analysis of Acme’s volatility over the past 30 days. EXHIBIT 15.3 Acme Brokerage Co. volatility. Stock Price Realized Volatility Front-Month Implied Volatility 30-day high $78.66 30-day high 47% 30-day high 55% 30-day low $66.94 30-day low 36% 30-day low 34% Current px $74.80 Current vol 36% Current vol 36% During this period, Acme stock ranged more than $11 in price. In this example, Acme’s volatility is a function of interest rate concerns and other macroeconomic issues affecting the brokerage industry as a whole. As the stock price begins to level off in the latter half of the 30-day period, realized volatility begins to ebb. The front month’s IV recedes toward recent lows as well. At this point, both realized and implied volatility converge at 36 percent. Although volatility is at its low for the past month, it is still relatively high for a brokerage stock under normal market conditions. Susan does not believe that the volatility plaguing this stock is over. She believes that an upcoming scheduled Federal Reserve Board announcement will lead to more volatility. She perceives this to be a volatility-buying opportunity. Effectively, she wants to buy volatility on the dip. Susan pays 5.75 for 20 July 75-strike straddles. Exhibit 15.4 shows the analytics of this trade with four weeks until expiration. EXHIBIT 15.4 Analytics for long 20 Acme Brokerage Co. 75-strike straddles. As with any trade, the risk is that the trader is wrong. The risk here is indicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an average of at least $207 a day just to break even against the time decay. And if IV continues to ebb down to a lower, more historically normal, level, she needs to scalp even more to make up for vega losses. Effectively, Susan wants both realized and implied volatility to rise. She paid 36 volatility for the straddle. She wants to be able to sell the options at a higher vol than 36. In the interim, she needs to cover her decay just to break even. But in this case, she thinks the stock will be volatile enough to cover decay and then some. If Acme moves at a volatility greater than 36, her chances of scalping profitably are more favorable than if it moves at less than 36 vol. The following is one possible scenario of what might have happened over two weeks after the trade was made. Week One During the first week, the stock’s volatility tapered off a bit more, but implied volatility stayed firm. After some oscillation, the realized volatility ended the week at 34 percent while IV remained at 36 percent. Susan was able to scalp stock reasonably well, although she still didn’t cover her seven days of theta. Her stock buys and sells netted a gain of $1,100. By the end of week one, the straddle was 5.10 bid. If she had sold the straddle at the market, she would have ended up losing $200. Susan decided to hold her position. Toward the end of week two, there would be the Federal Open Market Committee (FOMC) meeting. Week Two The beginning of the week saw IV rise as the event drew near. By the close on Tuesday, implied volatility for the straddle was 40 percent. But realized volatility continued its decline, which meant Susan was not able to scalp to cover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle was now 5.20 bid, 0.10 higher than it had been on previous Friday. The rising IV made up for most of the theta loss. At this point, Susan could have sold her straddle to scratch her trade. She would have lost $1,100 on the straddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the first week. Susan decided to wait and see what the Fed chairman had to say. By week’s end, the trade had proved to be profitable. After the FOMC meeting, the stock shot up more than $4 and just as quickly fell. It continued to bounce around a bit for the rest of the week. Susan was able to lock in $5,200 from stock scalps. After much gyration over this two-week period, the price of Acme stock incidentally returned to around the same price it had been at when Susan bought her straddle: $74.50. As might have been expected after the announcement, implied volatility softened. By Friday, IV had fallen to 30. Realized volatility was sharply higher as a result of the big moves during the week that were factored into the 30-day calculation. With seven more days of decay and a lower implied volatility, the straddle was 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the position. Her profit for week two was $2,000. What went into Susan’s decision to close her position? Susan had two objectives: to profit from a rise in implied volatility and to profit from a rise in realized volatility. The rise in IV did indeed occur, but not immediately. By Tuesday of the second week, vega profits were overshadowed by theta losses. Gamma was the saving grace with this trade. The bulk of the gain occurred in week two when the Fed announcement was made. Once that event passed, the prospects for covering theta looked less attractive. They were further dimmed by the sharp drop in implied volatility from 40 to 30. In this hypothetical scenario, the trade ended up profitable. This is not always the case. Here the profit was chiefly produced by one or two high-volatility days. Had the stock not been unusually volatile during this time, the trade would have been a certain loser. Even though implied volatility had risen four points by Tuesday of the second week, the trade did not yield a profit. The time decay of holding two options can make long straddles a tough strategy to trade. Short Straddle Definition : Selling one call and one put in the same option class, in the same expiration cycle, and with the same strike price. Just as buying a straddle is a pure way to buy volatility, selling a straddle is a way to short it. When a trader’s forecast calls for lower implied and realized volatility, a straddle generates the highest returns of all volatility-selling strategies. Of course, with high reward necessarily comes high risk. A short straddle is one of the riskiest positions to trade. Let’s look at a one-month 70-strike straddle sold at 4.25. The risk is easily represented graphically by means of a P&(L) diagram. Exhibit 15.5 shows the risk and reward of this short straddle. EXHIBIT 15.5 Short straddle P&(L) at initiation and expiration. If the straddle is held until expiration and the underlying is trading below the strike price, the short put is in-the-money (ITM). The lower the stock, the greater the loss on the +1.00 delta from the put. The trade as a whole will be a loser if the underlying is below the lower of the two break-even points—in this case $65.75. This point is found by subtracting the premium received from the strike. Before expiration, negative gamma adversely affects profits as the underlying falls. The lower the underlying is trading below the strike price, the greater the drain on P&(L) due to the positive delta of the short put. It is the same proposition if the underlying is above $70 at expiration. But in this case, it is the short call that would be in-the-money. The higher the underlying price, the more the −1.00 delta adversely impacts P&(L). If at expiration the underlying is above the higher breakeven, which in this case is $74.25 (the strike plus the premium), the trade is a loser. The higher the underlying, the worse off the trade. Before expiration, negative gamma creates negative deltas as the underlying climbs above the strike, eating away at the potential profit, which is the net premium received. The best-case scenario is that the underlying is right at $70 at the closing bell on expiration Friday. In this situation, neither option is ITM, meaning that the 4.25 premium is all profit. In reaping the maximum profit, both time and price play roles. If the position is closed before expiration, implied volatility enters into the picture as well. It’s important to note that just because neither option is ITM if the underlying is right at $70 at expiration, it doesn’t mean with certainty that neither option will be assigned. Sometimes options that are ATM or even out-of-the-money (OTM) get assigned. This can lead to a pleasant or unpleasant surprise the Monday morning following expiration. The risk of not knowing whether or not you will be assigned—that is, whether or not you have a position in the underlying security—is a risk to be avoided. It is the goal of every trader to remove unnecessary risk from the equation. Buying the call and the put for 0.05 or 0.10 to close the position is a small price to pay when one considers the possibility of waking up Monday morning to find a loss of hundreds of dollars per contract because a position you didn’t even know you owned had moved against you. Most traders avoid this risk, referred to as pin risk, by closing short options before expiration. The Risks with Short Straddles Looking at an at-expiration diagram or even analyzing the gamma/theta relationship of a short straddle may sometimes lead to a false sense of comfort. Sometimes it looks as if short straddles need a pretty big move to lose a lot of money. So why are they definitely among the riskiest strategies to trade? That is a matter of perspective. Option trading is about risk management. Dealing with a proverbial train wreck every once in a while is part of the game. But the big disasters can end one’s trading career in an instant. Because of its potential—albeit sometimes small potential—for a colossal blowup, the short straddle is, indeed, one of the riskiest positions one can trade. That said, it has a place in the arsenal of option strategies for speculative traders. Trading the Short Straddle A short straddle is a trade for highly speculative traders who think a security will trade within a defined range and that implied volatility is too high. While a long straddle needs to be actively traded, a short straddle needs to be actively monitored to guard against negative gamma. As adverse deltas get bigger because of stock price movement, traders have to be on alert, ready to neutralize directional risk by offsetting the delta with stock or by legging out of the options. To be sure, with a short straddle, every stock trade locks in a loss with the intent of stemming future losses. The ideal situation is that the straddle is held until expiration and expires with the underlying right at $70 with no negative-gamma scalping. Short-straddle traders must take a longer-term view of their positions than long-straddle traders. Often with short straddles, it is ultimately time that provides the payout. While long straddle traders would be inclined to watch gamma and theta very closely to see how much movement is required to cover each day’s erosion, short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game. There are some situations that are exceptions to this long-term focus. For example, when implied volatility gets to be extremely high for a particular option class relative to both the underlying stock’s volatility and the historical implied volatility, one may want to sell a straddle to profit from a fall in IV. This can lead to leveraged short-term profits if implied volatility does, indeed, decline. Because of the fact that there are two short options involved, these straddles administer a concentrated dose of negative vega. For those willing to bet big on a decline in implied volatility, a short straddle is an eager croupier. These trades are delta neutral and double the vega of a single-leg trade. But they’re double the gamma, too. As with the long straddle, realized and implied volatility levels are both important to watch. Short-Straddle Example For this example, a trader, John, has been watching Federal XYZ Corp. (XYZ) for a year. During the 12 months that John has followed XYZ, its front-month implied volatility has typically traded at around 20 percent, and its realized volatility has fluctuated between 15 and 20 percent. The past 30 days, however, have been a bit more volatile. Exhibit 15.6 shows XYZ’s recent volatility. EXHIBIT 15.6 XYZ volatility. Stock Price Realized Volatility Front-Month Implied Volatility 30-day high $111.71 30-day high 26% 30-day high 30% 30-day low $102.05 30-day low 21% 30-day low 24% Current px $104.75 Current vol 22% Current vol 26% The stock volatility has begun to ease, trading now at a 22 volatility compared with the 30-day high of 26, but still not down to the usual 15-to-20 range. The stock, in this scenario, has traded in a channel. It currently lies in the lower half of its recent range. Although the current front-month implied volatility is in the lower half of its 30-day range, it’s historically high compared with the 20 percent level that John has been used to seeing, and it’s still four points above the realized volatility. John believes that the conditions that led to the recent surge in volatility are no longer present. His forecast is for the stock volatility to continue to ease and for implied volatility to continue its downtrend as well and revert to its long-term mean over the next week or two. John sells 10 September 105 straddles at 5.40. Exhibit 15.7 shows the greeks for this trade. EXHIBIT 15.7 Greeks for short XYZ straddle. The goal here is for implied volatility to fall to around 20. If it does, John makes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will outpace gamma losses. The following is a two-week examination of one possible outcome for John’s trade. Week One The first week in this example was a profitable one, but it came with challenges. John paid for his winnings with a few sleepless nights. On the Monday following his entry into the trade, the stock rose to $106. While John collected a weekend’s worth of time decay, the $1.25 jump in stock price ate into some of those profits and naturally made him uneasy about the future. At this point, John was sitting on a profit, but his position delta began to grow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75 stock, a move of $1.25—or just over 1 percent—is not out of the ordinary, but it put John on his guard. He decided to wait and see what happened before hedging. The following day, the rally continued. The stock was at $107.30 by noon. His delta was around −3. In the face of an increasingly negative delta, John weighed his alternatives: He could buy back some of his calls to offset his delta, which would have the added benefit of reducing his gamma as well. He could buy stock to flatten out. Lastly, he could simply do nothing and wait. John felt the stock was overbought and might retrace. He also still believed volatility would fall. He decided to be patient and enter a stop order to buy all of his deltas at $107.50 in case the stock continued trending up. The XYZ shares closed at $107.45 that day. This time inaction proved to be the best action. The stock did retrace. Week one ended with Federal XYZ back down around $105.50. The IV of the straddle was at 23. The straddle finished up week one offered at $4.10. Week Two The future was looking bright at the start of week two until Wednesday. Wednesday morning saw XYZ gap open to $109. When you have a short straddle, a $3.50 gap move in the underlying tends to instantly give you a sinking feeling in the pit of your stomach. But the damage was truly not that bad. The offer in the straddle was 4.75, so the position was still a winner if John bought it back at this point. Gamma/delta hurt. Theta helped. A characteristic that enters into this trade is volatility’s changing as a result of movement in the stock price. Despite the fact that the stock gapped $3.50 higher, implied volatility fell by 1 percent, to 22. This volatility reaction to the underlying’s rise in price is very common in many equity and index options. John decided to close the trade. Nobody ever went broke taking a profit. The trade in this example was profitable. Of course, this will not always be the case. Sometimes short straddles will be losers—sometimes big ones. Big moves and rising implied volatility can be perilous to short straddles and their writers. If the XYZ stock in the previous example had gapped up to $115—which is not an unreasonable possibility—John’s trade would have been ugly. Synthetic Straddles Straddles are the pet strategy of certain professional traders who specialize in trading volatility. In fact, in the mind of many of these traders, a straddle is all there is. Any single-legged trade can be turned into a straddle synthetically simply by adding stock. Chapter 6 discussed put-call parity and showed that, for all intents and purposes, a put is a call and a call is a put. For the most part, the greeks of the options in the put-call pair are essentially the same. The delta is the only real difference. And, of course, that can be easily corrected. As a matter of perspective, one can make the case that buying two calls is essentially the same as buying a call and a put, once stock enters into the equation. Take a non-dividend-paying stock trading at $40 a share. With 60 days until expiration, a 25 volatility, and a 4 percent interest rate, the greeks of the 40-strike calls and puts of the straddle are as follows: Essentially, the same position can be created by buying one leg of the spread synthetically. For example, in addition to buying one 40 call, another 40 call can be purchased along with shorting 100 shares of stock to create a 40 put synthetically. Combined, the long call and the synthetic long put (long call plus short stock) creates a synthetic straddle. A long synthetic straddle could have similarly been constructed with a long put and a long synthetic call (long put plus long stock). Furthermore, a short synthetic straddle could be created by selling an option with its synthetic pair. Notice the similarities between the greeks of the two positions. The synthetic straddle functions about the same as a conventional straddle. Because the delta and gamma are nearly the same, the up-and-down risk is nearly the same. Time and volatility likewise affect the two trades about the same. The only real difference is that the synthetic straddle might require a bit more cash up front, because it requires buying or shorting the stock. In practice, straddles will typically be traded in accounts with retail portfolio margining or professional margin requirements (which can be similar to retail portfolio margining). So the cost of the long stock or margin for short stock is comparatively small. Long Strangle Definition : Buying one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typical long strangles involve an OTM call and an OTM put. A strangle in which an ITM call and an ITM put are purchased is called a long guts strangle. A long strangle is similar to a long straddle in many ways. They both require buying a call and a put on the same class in the same expiration month. They are both buying volatility. There are, however, some functional differences. These differences stem from the fact that the options have different strike prices. Because there is distance between the strike prices, from an at-expiration perspective, the underlying must move more for the trade to show a profit. Exhibit 15.8 illustrates the payout of options as part of a long strangle on a $70 stock. The graph is much like that of Exhibit 15.1 , which shows the payout of a long straddle. But the net cost here is only 1.00, compared with 4.25 for the straddle with the same time and volatility inputs. The cost is lower because this trade consists of OTM options instead of ATM options. The breakdown is as follows: EXHIBIT 15.8 Long strangle at-expiration diagram. The underlying has a bit farther to go by expiration for the trade to have value. If the underlying is above $75 at expiration, the call is ITM and has value. If the underlying is below $65 at expiration, the put is ITM and has value. If the underlying is between the two strike prices at expiration both options expire and the 1.00 premium is lost. An important difference between a straddle and a strangle is that if a strangle is held until expiration, its break-even points are farther apart than those of a comparable straddle. The 70-strike straddle in Exhibit 15.1 had a lower breakeven of $65.75 and an upper break-even of $74.25. The comparable strangle in this example has break-even prices of $64 and $76. But what if the strangle is not held until expiration? Then the trade’s greeks must be analyzed. Intuitively, two OTM options (or ITM ones, for that matter) will have lower gamma, theta, and vega than two comparable ATM options. This has a two-handed implication when comparing straddles and strangles. On the one hand, from a realized volatility perspective, lower gamma means the underlying must move more than it would have to for a straddle to produce the same dollar gain per spread, even intraday. But on the other hand, lower theta means the underlying doesn’t have to move as much to cover decay. A lower nominal profit but a higher percentage profit is generally reaped by strangles as compared with straddles. A long strangle composed of two OTM options will also give positive exposure to implied volatility but, again, not as much as an ATM straddle would. Positive vega really kicks in when the underlying is close to one of the strike prices. This is important when anticipating changes in the stock price and in IV. Say a trader expects implied volatility to rise as a result of higher stock volatility. As the stock rises or falls, the strangle will move toward the price point that offers the highest vega (the strike). With a straddle, the stock will be moving away from the point with the highest vega. If the stock doesn’t move as anticipated, the lower theta and vega of the strangle compared with the ATM straddle have a less adverse effect on P&L. Long-Strangle Example Let’s return to Susan, who earlier in this chapter bought a straddle on Acme Brokerage Co. (ABC). Acme currently trades at $74.80 a share with current realized volatility at 36 percent. The stock’s volatility range for the past month was between 36 and 47. The implied volatility of the four-week options is 36 percent. The range over the past month for the IV of the front month has been between 34 and 55. As in the long-straddle example earlier in this chapter, there is a great deal of uncertainty in brokerage stocks revolving around interest rates, credit-default problems, and other economic issues. An FOMC meeting is expected in about one week’s time about whose possible actions analysts’ estimates vary greatly, from a cut of 50 basis points to no cut at all. Add a pending earnings release to the docket, and Susan thinks Acme may move quite a bit. In this case, however, instead of buying the 75-strike straddle, Susan pays 2.35 for 20 one-month 70–80 strangles. Exhibit 15.9 compares the greeks of the long ATM straddle with those of the long strangle. EXHIBIT 15.9 Long straddle versus long strangle. The cost of the strangle, at 2.35, is about 40 percent of the cost of the straddle. Of course, with two long options in each trade, both have positive gamma and vega and negative theta, but the exposure to each metric is less with the strangle. Assuming the same stock-price action, a strangle would enjoy profits from movement and losses from lack of movement that were similar to those of a straddle—just nominally less extreme. For example, if Acme stock rallies $5, from $74.80 to $79.80, the gamma of the 75 straddle will grow the delta favorably, generating a gain of 1.50, or about 25 percent. The 70–80 strangle will make 1.15 from the curvature of the delta–almost a 50 percent gain. With the straddle and especially the strangle, there is one more detail to factor in when considering potential P&L: IV changes due to stock price movement. IV is likely to fall as the stock rallies and rise as the stock declines. The profits of both the long straddle and the long strangle would likely be adversely affected by IV changes as the stock rose toward $79.80. And because the stock would be moving away from the straddle strike and toward one of the strangle strikes, the vegas would tend to become more similar for the two trades. The straddle in this example would have a vega of 2.66, while the strangle’s vega would be 2.67 with the underlying at $79.80 per share. Short Strangle Definition : Selling one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typically, an OTM call and an OTM put are sold. A strangle in which an ITM call and an ITM put are sold is called a short guts strangle. A short strangle is a volatility-selling strategy, like the short straddle. But with the short strangle, the strikes are farther apart, leaving more room for error. With these types of strategies, movement is the enemy. Wiggle room is the important difference between the short-strangle and short-straddle strategies. Of course, the trade-off for a higher chance of success is lower option premium. Exhibit 15.10 shows the at-expiration diagram of a short strangle sold at 1.00, using the same options as in the diagram for the long strangle. EXHIBIT 15.10 Short strangle at-expiration diagram. Note that if the underlying is between the two strike prices, the maximum gain of 1.00 is harvested. With the stock below $65 at expiration, the short put is ITM, with a +1.00 delta. If the stock price is below the lower breakeven of $64 (the put strike minus the premium), the trade is a loser. The lower the stock, the bigger the loss. If the underlying is above $75, the short call is ITM, with a −1.00 delta. If the stock is above the upper breakeven of $76 (the call strike plus the premium), the trade is a loser. The higher the stock, the bigger the loss. Intuitively, the signs of the greeks of this strangle should be similar to those of a short straddle—negative gamma and vega, positive theta. That means that increased realized volatility hurts. Rising IV hurts. And time heals all wounds—unless, of course, the wounds caused by gamma are greater than the net premium received. This brings us to an important philosophical perspective that emphasizes the differences between long straddles and strangles and their short counterparts. Losses from rising vega are temporary; the time value of all options will be zero at expiration. But gamma losses can be permanent and profound. These short strategies have limited profit potential and unlimited loss potential. Although short-term profits (or losses) can result from IV changes, the real goal here is to capture theta. Short-Strangle Example Let’s revisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this example, with an implied volatility of 26 percent and a stock volatility of 22. Both implied and realized volatility are higher than has been typical during the past twelve months. John wants to sell volatility. In this example, he believes the stock price will remain in a fairly tight range, causing realized volatility to revert to its normal level, in this case between 15 and 20 percent. He does everything possible to ensure success. This includes scanning the news headlines on XYZ and its financials for a reason not to sell volatility. Playing devil’s advocate with oneself can uncover unforeseen yet valid reasons to avoid making bad trades. John also notes the recent price range, which has been between $111.71 and $102.05 over the past month. Once John commits to an outlook on the stock, he wants to set himself up for maximum gain if he’s right and, for that matter, to maximize his chances of being right. In this case, he decides to sell a strangle to give himself as much margin for error as possible. He sells 10 three-week 100–110 strangles at 1.80. Exhibit 15.11 compares the greeks of this strangle with those of the 105 straddle. EXHIBIT 15.11 Short straddle vs. short strangle. As expected, the strangle’s greeks are comparable to the straddle’s but of less magnitude. If John’s intention were to capture a drop in IV, he’d be better off selling the bigger vega of the straddle. Here, though, he wants to see the premium at zero at expiration, so the strangle serves his purposes better. What he is most concerned about are the breakevens—in this case, 98.20 and 111.8. The straddle has closer break-even points, of $99.60 and $110.40. Despite the fact that in this case, John is not really trading the greeks or IV per se, they still play an important role in his trade. First, he can use theta to plan the best strangle to trade. In this case, he sells the three-week strangle because it has the highest theta of the available months. The second month strangle has a −0.71 theta, and the third month has a −0.58 theta. With strangles, because the options are OTM, this disparity in theta among the tradable months may not always be the case. But for this trade, if he is still bearish on realized volatility after expiration, John can sell the next month when these options expire. Certainly, he will monitor his risk by watching delta and gamma. These are his best measures of directional exposure. He will consider implied volatility in the decision-making process, too. An implied volatility significantly higher than the realized volatility can be a red flag that the market expects something to happen, but there’s a bigger payoff if there is no significant volatility. An IV significantly lower than the realized can indicate the risk of selling options too cheaply: the premium received is not high enough, based on how much the stock has been moving. Ideally, the IV should be above the realized volatility by between 2 and 20 percent, perhaps more for highly speculative traders. Limiting Risk The trouble with short straddles and strangles is that every once in a while the stock unexpectedly reacts violently, moving by three or more standard deviations. This occurs when there is a takeover, an extreme political event, a legal action, or some other extraordinary incident. These events can be guarded against by buying farther OTM options for protection. Essentially, instead of selling a straddle or a strangle, one sells an iron butterfly or iron condor. Then, when disaster strikes, it’s not a complete catastrophe. How Cheap Is Too Cheap? At some point, the absolute premium simply is not worth the risk of the trade. For example, it would be unwise to sell a two-month 45–55 strangle for 0.10 no matter what the realized volatility was. With the knowledge that there is always a chance for a big move, it’s hard to justify risking dollars to make a dime. Note 1 . This depends on interest, dividends, and time to expiration. The delta will likely not be exactly zero. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html SCORE: 56.00 ================================================================================ CHAPTER 16 Ratio Spreads and Complex Spreads The purpose of spreading is to reduce risk. Buying one contract and selling another can reduce some or all of a trade’s risks, as measured by the greeks, compared with simply holding an outright option. But creative traders have the ability to exercise great control over their greeks risk. They can practically eliminate risk in some greeks, while retaining risks in just the desired greeks. To do so, traders may have to use more complex, and less conventional spreads. These spreads often involve buying or selling options in quantities other than one-to-one ratios. Ratio Spreads The simplest versions of these strategies used by retail traders, institutional traders, proprietary traders, and others are referred to as ratio spreads . In ratio spreads, options are bought and sold in quantities based on a ratio. For example, a 1:3 spread is when one option is bought (or sold) and three are sold (or bought)—a ratio of one to three. This kind of ratio spread would be called a “one-by-three.” However, some option positions can get a lot more complicated. Market makers and other professional traders manage a complex inventory of long and short options. These types of strategies go way beyond simple at-expiration diagrams. This chapter will discuss the two most common types of ratio spreads—backspreads and ratio vertical spreads—and also the delta-neutral position management of market makers and other professional traders. Backspreads Definition : An option strategy consisting of more long options than short options having the same expiration month. Typically, the trader is long calls (or puts) in one series of options and short a fewer number of calls (or puts) in another series with the same expiration month in the same option class. Some traders, such as market makers, refer generically to any delta-neutral long-gamma position as a backspread. Shades of Gray In its simplest form, trading a backspread is trading a one-by-two call or put spread and holding it until expiration in hopes that the underlying stock’s price will make a big move, particularly in the more favorable direction. But holding a backspread to expiration as described has its challenges. Let’s look at a hypothetical example of a backspread held to term and its at-expiration diagram. With the stock at $71 and one month until March expiration: In this example, there is a credit of 3.20 from the sale of the 70 call and a debit of 1.10 for each of the two 75 calls. This yields a total net credit of 1.00 (3.20 − 1.10 − 1.10). Let’s consider how this trade performs if it is held until expiration. If the stock falls below $70 at expiration, all the calls expire and the 1.00 credit is all profit. If the stock is between $70 and $75 at expiration, the 70 call is in-the-money (ITM) and the −1.00 delta starts racking up losses above the breakeven of $71 (the strike plus the credit). At $75 a share this trade suffers its maximum potential loss of $4. If the stock is above $75 at expiration, the 75 calls are ITM. The net delta of +1.00, resulting from the +2.00 deltas of the 75 calls along with the −1.00 delta of the 70 call, makes money as the stock rises. To the upside, the trade is profitable once the stock is at a high enough price for the gain on the two 75 calls to make up for the loss on the 70 call. In this case, the breakeven is $79 (the $4 maximum potential loss plus the strike price of 75). While it’s good to understand this at-expiration view of this trade, this diagram is a bit misleading. What does the trader of this spread want to have happen? If the trader is bearish, he could find a better way to trade his view than this, which limits his gains to 1.00—he could buy a put. If the trader believes the stock will make a volatile move in either direction, the backspread offers a decidedly limited opportunity to the downside. A straddle or strangle might be a better choice. And if the trader is bullish, he would have to be very bullish for this trade to make sense. The underlying needs to rise above $79 just to break even. If instead he just bought 2 of the 75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the breakeven would be $77.20 instead of $79, and profits at expiration would rack up twice as fast above the breakeven, since the trader is net long two calls instead of one. Why would a trader ever choose to trade a backspread? EXHIBIT 16.1 Backspread at expiration. The backspread is a complex spread that can be fully appreciated only when one has a thorough knowledge of options. Instead of waiting patiently until expiration, an experienced backspreader is more likely to gamma scalp intermittent opportunities. This requires trading a large enough position to make scalping worthwhile. It also requires appropriate margining (either professional-level margin requirements or retail portfolio margining). For example, this 1:2 contract backspread has a delta of −0.02 and a gamma of +0.05. Fewer than 10 deltas could be scalped if the stock moves up and down by one point. It becomes a more practical trade as the position size increases. Of course, more practical doesn’t necessarily guarantee it will be more profitable. The market must cooperate! Backspread Example Let’s say a 20:40 contract backspread is traded. ( Note : In trader lingo this is still called a one-by-two; it is just traded 20 times.) The spread price is still 1.00 credit per contract; in this case, that’s $2,000. But with this type of trade, the spread price is not the best measure of risk or reward, as it is with some other kinds of spreads. Risk and reward are best measured by delta, gamma, theta, and vega. Exhibit 16.2 shows this trade’s greeks. EXHIBIT 16.2 Greeks for 20:40 backspread with the underlying at $71. Backspreads are volatility plays. This spread has a +1.07 vega with the stock at $71. It is, therefore, a bullish implied volatility (IV) play. The IV of the long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much as with any other volatility trade, traders would compare current implied volatility with realized volatility and the implied volatility of recent past and consider any catalysts that might affect stock volatility. The objective is to buy an IV that is lower than the expected future stock volatility, based on all available data. The focus of traders of this backspread is not the dollar credit earned. They are more interested in buying a 30 volatility—that’s the focus. But the 75 calls’ IV is not the only volatility figure to consider. The short options, the 70s, have implied volatility of 32 percent. Because of their lower strike, the IV is naturally higher for the 70 calls. This is vertical skew and is described in Chapter 3. The phenomenon of lower strikes in the same option class and with the same expiration month having higher IV is very common, although it is not always the case. Backspreads usually involve trading vertical skew. In this spread, traders are buying a 30 volatility and selling a 32 volatility. In trading the skew, the traders are capturing two volatility points of what some traders would call edge by buying the lower volatility and selling the higher. Based on the greeks in Exhibit 16.2 , the goal of this trade appears fairly straightforward: to profit from gamma scalping and rising IV. But, sadly, what appears to be straightforward is not. Exhibit 16.3 shows the greeks of this trade at various underlying stock prices. EXHIBIT 16.3 70–75 backspread greeks at various stock prices. Notice how the greeks change with the stock price. As the stock price moves lower through the short strike, the 70 strike calls become the more relevant options, outweighing the influence of the 75s. Gamma and vega become negative, and theta becomes positive. If the stock price falls low enough, this backspread becomes a very different position than it was with the stock price at $71. Instead of profiting from higher implied and realized volatility, the spread needs a lower level of both to profit. This has important implications. First, gamma traders must approach the backspread a little differently than they would most spreads. The backspread traders must keep in mind the dynamic greeks of the position. With a trade like a long straddle, in which there are no short options, traders scalping gamma simply buy to cover short deltas as the stock falls and sell to cover long deltas as the stock rises. The only risks are that the stock may not move enough to cover theta or that the traders may cover deltas too soon to maximize profits. With the backspread, the changing gamma adds one more element of risk. In this example, buying stock to flatten out delta as the stock falls can sometimes be a premature move. Traders who buy stock may end up with more long deltas than they bargained for if the stock falls into negative-gamma territory. Exhibit 16.3 shows that with the stock at $68, the delta for this trade is −2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the stock subsequently falls to $62 a share, instead of being short 1.46 deltas, as the figure indicates, they will be long 1.04 because of the 250 shares they bought. These long deltas start to hurt as the stock continues lower. Backspreaders must therefore anticipate stock movements to avoid overhedging. The traders in this example may decide to lean short if the stock shows signs of weakness. Leaning short means that if the delta is −2.50 at $68 a share, the traders may decide to underhedge by buying just 100 or 200 shares. If the stock continues to fall and negative gamma kicks in, this gives the traders some cushion to the downside. The short delta of the position moves closer to being flat as the stock falls. Because there is a long strike and a short strike in this delta-neutral position, trading ratio spreads is like trading a long and a short volatility position at the same time. Trading backspreads is not an exact science. The stock has just as good a chance of rising as it does of falling, and if it does rise and the traders have underhedged at $68, they will not participate in all the gains they would have if they had fully hedged by buying 250 shares of stock. If trading were easy, everyone would do it! Backspreaders must also be conscious of the volatility of each leg of the spread. There is an inherent advantage in this example to buying the lower volatility of the 75 calls and selling the higher volatility of the 70 calls. But there is also implied risk. Equity prices and IV tend to have an inverse relationship. When stock prices fall—especially if the drop happens quickly—IV will often rise. When stock prices rise, IV often falls. In this backspread example, as the stock price falls to or through the short strike, vega becomes negative in the face of a potentially rising IV. As the stock price rises into positive vega turf, there is the risk of IV’s declining. A dynamic volatility forecast should be part of a backspread-trading plan. One of the volatility questions traders face in this example is whether the two-point volatility skew between the two strike prices is enough to compensate for the potential adverse vega move as the stock price changes. Put backspreads have the opposite skew/volatility issues. Buying two lower-strike puts against one higher-strike put means the skew is the other direction—buying the higher IV and selling the lower. The put backspread would have long gamma/vega to the downside and short gamma/vega to the upside. But if the vega firms up as the stock falls into positive-vega territory, it would be in the trader’s favor. As the stock rises, leading to negative vega, there is the potential for vega profits if IV indeed falls. There are a lot of things to consider when trading a backspread. A good trader needs to think about them all before putting on the trade. Ratio Vertical Spreads Definition : An option strategy consisting of more short options than long options having the same expiration month. Typically, the trader is short calls (or puts) in one series of options and long a fewer number of calls (or puts) in another series in the same expiration month on the same option class. A ratio vertical spread, like a backspread, involves options struck at two different prices—one long strike and one short. That means that it is a volatility strategy that may be long or short gamma or vega depending on where the underlying price is at the time. The ratio vertical spread is effectively the opposite of a backspread. Let’s study a ratio vertical using the same options as those used in the backspread example. With the stock at $71 and one month until March expiration: In this case, we are buying one ITM call and selling two OTM calls. The relationship of the stock price to the strike price is not relevant to whether this spread is considered a ratio vertical spread. Certainly, all these options could be ITM or OTM at the time the trade is initiated. It is also not important whether the trade is done for a debit or a credit. If the stock price, time to expiration, volatility, or number of contracts in the ratio were different, this could just as easily been a credit ratio vertical. Exhibit 16.4 illustrates the payout of this strategy if both legs of the 1:2 contract are still open at expiration. EXHIBIT 16.4 Short ratio spread at expiration. This strategy is a mirror image of the backspread discussed previously in this chapter. With limited risk to the downside, the maximum loss to the trade is the initial debit of 1 if the stock is below $70 at expiration and all the calls expire. There is a maximum profit potential of 4 if the stock is at the short strike at expiration. There is unlimited loss potential, since a short net delta is created on the upside, as one short 75 call is covered by the long 70 call, and one is naked. The breakevens are at $71 and $79. Low Volatility With the stock at $71, gamma and vega are both negative. Just as the backspread was a long volatility play at this underlying price, this ratio vertical is a short-vol play here. As in trading a short straddle, the name of the game is low volatility—meaning both implied and realized. This strategy may require some gamma hedging. But as with other short volatility delta-neutral trades, the fewer the negative scalps, the greater the potential profit. Delta covering should be implemented in situations where it looks as if the stock will trend deep into negative-gamma territory. Murphy’s Law of trading dictates that delta covering will likely be wrong at least as often as it is right. Ratio Vertical Example Let’s examine a trade of 20 contracts by 40 contracts. Exhibit 16.5 shows the greeks for this ratio vertical. EXHIBIT 16.5 Short ratio vertical spread greeks. Before we get down to the nitty-gritty of the mechanics and management of this trade—the how—let’s first look at the motivations for putting the trade on—the why. For the cost of 1.00 per spread, this trader gets a leveraged position if the stock rises moderately. The profits max out with the stock at the short-strike target price—$75—at expiration. Another possible profit engine is IV. Because of negative vega, there is the chance of taking a quick profit if IV falls in the interim. But short-term losses are possible, too. IV can rise, or negative gamma can hurt the trader. Ultimately, having naked calls makes this trade not very bullish. A big move north can really hurt. Basically, this is a delta-neutral-type short-volatility play that wins the most if the stock is at $75 at expiration. One would think about making this trade if the mechanics fit the forecast. If this trader were a more bullish than indicated by the profit and loss diagram, a more-balanced bull call spread would be a better strategy, eliminating the unlimited upside risk. If upside risk were acceptable, this trader could get more aggressive by trading the spread one-by-three. That would result in a credit of 0.05 per spread. There would then be no ultimate risk below $70 but rather a 0.05 gain. With double the naked calls, however, there would be double punishment if the stock rallied strongly beyond the upside breakeven. Ultimately, mastering options is not about mastering specific strategies. It’s about having a thorough enough understanding of the instrument to be flexible enough to tailor a position around a forecast. It’s about minimizing the unwanted risks and optimizing exposure to the intended risks. Still, there always exists a trade-off in that where there is the potential for profit, there is the possibility of loss—you can always be wrong. Recalling the at-expiration diagram and examining the greeks, the best-case scenario is intuitive: the stock at $75 at expiration. The biggest theta would be right at that strike. But that strike price is also the center of the biggest negative gamma. It is important to guard against upward movement into negative delta territory, as well as movement lower where the position has a slightly positive delta. Exhibit 16.6 shows what happens to the greeks of this trade as the stock price moves. EXHIBIT 16.6 Ratio vertical spread at various prices for the underlying. As the stock begins to rise from $71 a share, negative deltas grow fast in the short term. Careful trend monitoring is necessary to guard against a rally. The key, however, is not in knowing what will happen but in skillfully hedging against the unknown. The talented option trader is a disciplined risk manager, not a clairvoyant. One of the risks that the trader willingly accepted when placing this trade was short gamma. But when the stock moves and deltas are created, decisions have to be made. Did the catalyst(s)—if any—that contributed to the rise in stock price change the outlook for volatility? If not, the decision is simply whether or not to hedge by buying stock. However, if it appears that volatility is on the rise, it is not just a delta decision. A trader may consider buying some of the short options back to reduce volatility exposure. In this example, if the stock rises and it’s feared that volatility may increase, a good choice may be to buy back some of the short 75-strike calls. This has the advantage of reducing delta (buy enough deltas to flatten out) and reducing gamma and vega. Of course, the downside to this strategy is that in purchasing the calls, a loss is likely to be locked in. Unless a lot of time has passed or implied volatility has dropped sharply, the calls will probably be bought at a higher price than they were sold. If the stock makes a violent move upward, a loss will be incurred. Whether this loss is locked in by closing all or part of the position, the account will still be down in value. The decision to buy the calls back at a loss is based on looking forward. Nothing good can come of looking back. How Market Makers Manage Delta-Neutral Positions While market makers are not position traders per se, they are expert position managers. For the most part, market makers make their living by buying the bid and selling the offer. In general, they don’t act; they react. Most of their trades are initiated by taking the other side of what other people want to do and then managing the risk of the positions they accumulate. The business of a market maker is much like that of a casino. A casino takes the other side of people’s bets and, in the long run, has a statistical (theoretical) edge. For market makers, because theoretical value resides in the middle of the bid and the ask, these accommodating trades lead to a theoretical profit—that is, the market maker buys below theoretical value and sells above. Actual profit—cold, hard cash you can take to the bank—is, however, dependent on sound management of the positions that are accumulated. My career as a market maker was on the floor of the Chicago Board Options Exchange (CBOE) from 1998 to 2005. Because, over all, the trades I made had a theoretical edge, I hoped to trade as many contracts as possible on my markets without getting too long or too short in any option series or any of my greeks. As a result of reacting to order flow, market makers can accumulate a large number of open option series for each class they trade, resulting in a single position. For example, Exhibit 16.7 shows a position I had in Ford Motor Co. (F) options as a market maker. EXHIBIT 16.7 Market-maker position in Ford Motor Co. options. With all the open strikes, this position is seemingly complex. There is not a specific name for this type of “spread.” The position was accumulated over a long period of time by initiating trades via other traders selling options to me at prices I wanted to buy them—my bid—and buying options from me at prices I wanted to sell them—my offer. Upon making an option trade, I needed to hedge directional risk immediately. I usually did so by offsetting my option trades by taking the opposite delta position in the stock—especially on big-delta trades. Through this process of providing liquidity to the market, I built up option-centric risk. To manage this risk I needed to watch my other greeks. To be sure, trying to draw a P&L diagram of this position would be a fruitless endeavor. Exhibit 16.8 shows the risk of this trade in its most distilled form. EXHIBIT 16.8 Analytics for market-maker position in Ford Motor Co. (stock at $15.72). Delta +1,075 Gamma −10,191 Theta +1,708 Vega +7,171 Rho −33,137 The +1,075 delta shows comparatively small directional risk relative to the −10,191 gamma. Much of the daily task of position management would be to carefully guard against movement by delta hedging when necessary to earn the $1,708 per day theta. Much of the negative gamma/positive theta comes from the combined 1,006 short January 15 calls and puts. (Note that because this position is traded delta neutral, the net long or short options at each strike is what matters, not whether the options are calls or puts. Remember that in delta-neutral trading, a put is a call, and a call is a put.) The positive vega stems from the fact that the position is long 1,927 January 2003 20-strike options. Although this position has a lot going on, it can be broken down many ways. Having long LEAPS options and short front-month options gives this position the feel of a time spread. One way to think of where most of the gamma risk is coming from is to bear in mind that the 15 strike is synthetically short 503 straddles (1,006 options ÷ two). But this position overall is not like a straddle. There are more strikes involved—a lot more. There is more short gamma to the downside if the price of Ford falls toward $12.50. To the upside, the 17.50 strike is long a combined total of 439 options. Looking at just the 15 and 17.50 strikes, we can see something that looks more like a ratio spread: 1,006:439. If the stock were at $17.50, the gamma would be around +5,000. With the stock at $15.72, there is realized volatility risk of F rallying, but with gamma changing from negative to positive as the stock rallies, the risk of movement decreases quickly. The 20 strike is short 871 options which brings the position back to negative-gamma territory. Having alternating long and short strikes, sometimes called a butterflied position, is a handy way for market makers to reduce risk. A position is perfectly butterflied if it has alternating long and short strikes with the same number of contracts. Through Your Longs to Your Shorts With market-maker-type positions consisting of many strikes, the greatest profit is gained if the underlying security moves through the longs to the shorts. This provides kind of a win-win scenario for greeks traders. In this situation, traders get the benefit of long gamma as the stock moves higher or lower through the long strike. They also reap the benefits of theta when the stock sits at the short strike. Trading Flat Most market makers like to trade flat—that is, profit from the bid-ask spread and strive to lower exposure to direction, time, volatility, and interest as much as possible. But market makers are at the mercy of customer orders, or paper, as it’s known in the industry. If someone sells, say, the March 75 calls to a market maker at the bid, the best-case scenario is that moments later someone else buys the same number of the same calls—the March 75s, in this case—from that same market maker at the offer. This is locking in a profit. Unfortunately, this scenario seldom plays out this way. In my seven years as a market maker, I can count on one hand the number of times the option gods smiled upon me in such a way as to allow me to immediately scalp an option. Sometimes, the same option will not trade again for a week or longer. Very low-volume options trade “by appointment only.” A market maker trading illiquid options may hold the position until it expires, having no chance to get out at a reasonable price, often taking a loss on the trade. More typically, if a market maker buys an option, he must sell a different option to lessen the overall position risk. The skills these traders master are to lower bids and offers on options when they are long gamma and/or vega and to raise bids and offers on options when they are short gamma and/or vega. This raising and lowering of markets is done to manage risk. Effectively, this is your standard high school economics supply-and-demand curves in living color. When the market demands (buys) all the options that are supplied (offered) at a certain price, the price rises. When the market supplies (sells) all the options demanded (bid) at a price level, the price falls. The catalyst of supply and demand is the market maker and his risk tolerance. But instead of the supply and demand for individual options, it is supply and demand for gamma, theta, and vega. This is trading option greeks. Hedging the Risk Delta is the easiest risk for floor traders to eliminate quickly. It becomes second nature for veteran floor traders to immediately hedge nearly every trade with the underlying. Remember, these liquidity providers are in the business of buying option bids and selling option offers, not speculating on direction. The next hurdle is to trade out of the option-centric risk. This means that if the market maker is long gamma, he needs to sell options; if he’s short gamma, he needs to buy some. Same with theta and vega. Market makers move their bids and offers to avoid being saddled with too much gamma, theta, and vega risk. Experienced floor traders are good at managing option risk by not biting off more than they can chew. They strive to never buy or sell more options than they can spread off by selling or buying other options. This breed of trader specializes in trading the spread and managing risk, not in predicting the future. They’re market makers, not market takers. Trading Skew There are some trading strategies for which market makers have a natural propensity that stems from their daily activity of maintaining their positions. While money managers who manage equity funds get to know the fundamentals of the stocks they trade very well, options market makers know the volatility of the option classes they trade. When they adjust their markets in reacting to order flow, it’s, mechanically, implied volatility that they are raising or lowering to change theoretical values. They watch this figure very carefully and trade its subtle changes. A characteristic of options that many market makers and some other active professional traders observe and trade is the volatility skew. Savvy traders watch the implied volatility of the strikes above the at-the-money (ATM)—referred to as calls , for simplicity—compared with the strikes below the ATM, referred to as puts . In most stocks, there typically exists a “normal” volatility skew inherent to options on that stock. When this skew gets out of line, there may be an opportunity. Say for a particular option class, the call that is 10 percent OTM typically trades about four volatility points lower than the put that is 10 percent OTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher, say, nine points above where the calls are offered—for instance, the puts are bid at 32 volatility bid while the calls are offered at 23 vol—a trader can speculate on the skew reverting back to its normal relationship by selling the puts, buying the calls, and hedging the delta by selling the right amount of stock. This position—long a call, short a put with a different strike, and short stock on a delta-neutral ratio—is called a risk reversal. The motive for risk reversals is to capture vega as the skew realigns itself. But there are many risk factors that require careful attention. First, as in other positions consisting of both long and short strikes, the gamma, theta, and vega of the position will vary from positive to negative depending on the price of the underlying. Risk-reversal traders must be prepared to trade long gamma (and battle time decay) when the stock rallies closer to the long-call strike and trade short gamma (and assume the risk of possible increased realized volatility) when the stock moves closer to the short-put strike. As for vega, being short implied volatility on the downside and long on the upside is inherently a potentially bad position whichever way the stock moves. Why? As equities decline in price, the implied volatility of their options tends to rise. But the downside is where the risk reversal has its short vega. Furthermore, as equities rally, their IV tends to fall. That means the long vega of the upside hurts as well. When Delta Neutral Isn’t Direction Indifferent Many dynamic-volatility option positions, such as the risk reversal, have vega risk from potential IV changes resulting from the stock’s moving. This is indirectly a directional risk. While having a delta-neutral position hedges against the rather straightforward directional risk of the position delta, this hidden risk of stock movement is left unhedged. In some circumstances, a delta-lean can help abate some of the vega risk of stock-price movement. Say an option position has fairly flat greeks at the current stock price. Say that given the way this particular position is set up, if the stock rises, the position is still fairly flat, but if the stock falls, short lower-strike options will lead to negative gamma and vega. One way to partially hedge this position is to lean short deltas—that is, instead of maintaining a totally flat delta, have a slightly short delta. That way, if the stock falls, the trade profits some on the short stock to partially offset some of the anticipated vega losses. The trade-off of this hedge is that if the stock rises, the trade loses on the short delta. Delta leans are more of an art than a science and should be used as a hedge only by experienced vol traders. They should be one part of a well-orchestrated plan to trade the delta, gamma, theta, and vega of a position. And, to be sure, a delta lean should be entered into a model for simulation purposes before executing the trade to study the up-and-down risk of the position. If the lean reduces the overall risk of the position, it should be implemented. But if it creates a situation where there is an anticipated loss if the stock moves in either direction and there is little hope of profiting from the other greeks, the lean is not the answer—closing the position is. Managing Multiple-Class Risk Most traders hold option positions in more than one option class. As an aside, I recommend doing so, capital and experience permitting. In my experience, having positions in multiple classes psychologically allows for a certain level of detachment from each individual position. Most traders can make better decisions if they don’t have all their eggs in one basket. But holding a portfolio of option positions requires one more layer of risk management. The trader is concerned about the delta, gamma, theta, vega, and rho not only of each individual option class but also of the portfolio as a whole. The trader’s portfolio is actually one big position with a lot of moving parts. To keep it running like a well-oiled machine requires monitoring and maintaining each part to make sure they are working together. To have the individual trades work in harmony with one another, it is important to keep a well-balanced series of strategies. Option trading requires diversification, just like conventional linear stock trading or investing. Diversification of the option portfolio is easily measured by studying the portfolio greeks. By looking at the net greeks of the portfolio, the trader can get some idea of exposure to overall risk in terms of delta, gamma, theta, vega, and rho. ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00029.html SCORE: 24.00 ================================================================================ 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! ================================================================================ SOURCE: eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00031.html SCORE: 40.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:30 SCORE: 15.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:31 SCORE: 0.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:33 SCORE: 0.00 ================================================================================ 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 WeeklysSM 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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:34 SCORE: 20.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:46 SCORE: 0.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:47 SCORE: 15.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:48 SCORE: 10.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:54 SCORE: 5.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:55 SCORE: 22.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:86 SCORE: 0.00 ================================================================================ Vega Over the past decade or so, computers have revolutionized option trading. Options traded through an online broker are filled faster than you can say, “Oops! I meant to click on puts.” Now trading is facilitated almost entirely online by professional and retail traders alike. Market and trading information is disseminated worldwide in subseconds, making markets all the more efficient. And the tools now available to the common retail trader are very powerful as well. Many online brokers and other web sites offer high-powered tools like screeners, which allow traders to sift through thousands of options to find those that fit certain parameters. Using a screener to find ATM calls on same-priced stocks—say, stocks trading at $40 a share—can yield a result worth talking about here. One $40 stock can have a 40-strike call trading at around 0.50, while a different $40 stock can have a 40 call with the same time to expiration trading at more like 2.00. Why? The model doesn’t know the name of the company, what industry it’s in, or what its price-to-earnings ratio is. It is a mathematical equation with six inputs. If five of the inputs—the stock price, strike price, time to expiration, interest rate, and dividends—are identical for two different options but they’re trading at different prices, the difference must be the sixth variable, which is volatility. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:87 SCORE: 16.00 ================================================================================ Implied Volatility (IV) and Vega The volatility component of option values is called implied volatility (IV). (For more on implied volatility and how it relates to vega, see Chapter 3.) IV is a percentage, although in practice the percent sign is often omitted. This is the value entered into a pricing model, in conjunction with the other variables, that returns the option’s theoretical value. The higher the volatility input, the higher the theoretical value, holding all other variables constant. The IV level can change and often does—sometimes dramatically. When IV rises or falls, option prices rise and fall in line with it. But by how much? The relationship between changes in IV and changes in an option’s value is measured by the option’s vega. Vega is the rate of change of an option’s theoretical value relative to a change in implied volatility . Specifically, if the IV rises or declines by one percentage point, the theoretical value of the option rises or declines by the amount of the option’s vega, respectively. For example, if a call with a theoretical value of 1.82 has a vega of 0.06 and IV rises one percentage point from, say, 17 percent to 18 percent, the new theoretical value of the call will be 1.88—it would rise by 0.06, the amount of the vega. If, conversely, the IV declines 1 percentage point, from 17 percent to 16 percent, the call value will drop to 1.76—that is, it would decline by the vega. A put with the same expiration month and the same strike on the same underlying will have the same vega value as its corresponding call. In this example, raising or lowering IV by one percentage point would cause the corresponding put value to rise or decline by $0.06, just like the call. An increase in IV and the consequent increase in option value helps the P&(L) of long option positions and hurts short option positions. Buying a call or a put establishes a long vega position. For short options, the opposite is true. Rising IV adversely affects P&(L), whereas falling IV helps. Shorting a call or put establishes a short vega position. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:88 SCORE: 4.00 ================================================================================ The Effect of Moneyness on Vega Like the other greeks, vega is a snapshot that is a function of multiple facets of determinants influencing option value. The stock price’s relationship to the strike price is a major determining factor of an option’s vega. IV affects only the time value portion of an option. Because ATM options have the greatest amount of time value, they will naturally have higher vegas. ITM and OTM options have lower vega values than those of the ATM options. Exhibit 2.13 shows an example of 186-day options on AT&T Inc. (T), their time value, and the corresponding vegas. EXHIBIT 2.13 AT&T theos and vegas (T at $30, 186 days to Expry, 20% IV). Note that the 30-strike calls and puts have the highest time values. This strike boasts the highest vega value, at 0.085. The lower the time premium, the lower the vega—therefore, the less incremental IV changes affect the option. Since higher-priced stocks have higher time premium (in absolute terms, not necessarily in percentage terms) they will have higher vega. Incidentally, if this were a $300 stock instead of a $30 stock, the 186-day ATMs would have a 0.850 vega, if all other model inputs remain the same. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:177 SCORE: 4.00 ================================================================================ to be more risk than usual of future volatility. The question remains: Is the higher premium worth the risk? The answer to this question is subjective. Part of the answer is based on Stacie’s assessment of future volatility. Is the market right? The other part is based on Stacie’s risk tolerance. Is she willing to endure the greater price swings associated with the potentially higher volatility? This can mean getting whipsawed, which is exiting a position after reaching a stop-loss point only to see the market reverse itself. The would-be profitable trade is closed for a loss. Higher volatility can also mean a higher likelihood of getting assigned and acquiring an unwanted long stock position. Cash-Secured Puts There are some situations where higher implied volatility may be a beneficial trade-off. What if Stacie’s motivation for shorting puts was different? What if she would like to own the stock, just not at the current market price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her trading account to secure the purchase of 1,000 shares of Johnson & Johnson if she gets assigned. The $63,250 is the $65 per share she will pay for the stock if she gets assigned, minus the 1.75 premium she received for the put × $100 × 10 contracts. Because the cash required to potentially purchase the stock is secured by cash sitting ready in the account, this is called a cash-secured put. Her effective purchase price if assigned is $63.25—the same as her breakeven at expiration. The idea with this trade is that if Johnson & Johnson is anywhere under $65 per share at expiration, she will buy the stock effectively at $63.25. If assigned, the time premium of the put allows her to buy the stock at a discount compared with where it is priced when the trade is established, $64. The higher the time premium—or the higher the implied volatility—the bigger the discount. This discount, however, is contingent on the stock not moving too much. If it is above $65 at expiration she won’t get assigned and therefore can only profit a maximum of 1.75 per contract. If the stock is below $63.25 at expiration, the time premium no longer represents a discount, in fact, the trade becomes a loser. In a way, Stacie is still selling volatility. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:178 SCORE: 14.00 ================================================================================ Covered Call The problem with selling a naked call is that it has unlimited exposure to upside risk. Because of this, many traders simply avoid trading naked calls. A more common, and some would argue safer, method of selling calls is to sell them covered. A covered call is when calls are sold and stock is purchased on a share- for-share basis to cover the unlimited upside risk of the call. For each call that is sold, 100 shares of the underlying security are bought. Because of the addition of stock to this strategy, covered calls are traded with a different motivation than naked calls. There are clearly many similarities between these two strategies. The main goal for both is to harvest the premium of the call. The theta for the call is the same with or without the stock component. The gamma and vega for the two strategies are the same as well. The only difference is the stock. When stock is added to an option position, the net delta of the position is the only thing affected. Stock has a delta of one, and all its other greeks are zero. The pivotal point for both positions is the strike price. That’s the point the trader wants the stock to be above or below at expiration. With the naked call, the maximum payout is reaped if the stock is below the strike at expiration, and there is unlimited risk above the strike. With the covered call, the maximum payout is reaped if the stock is above the strike at expiration. If the stock is below the strike at expiration, the risk is substantial—the stock can potentially go to zero. Putting It on There are a few important considerations with the covered call, both when putting on, or entering, the position and when taking off, or exiting, the trade. The risk/reward implications of implied volatility are important in the trade-planning process. Do I want to get paid more to assume more potential risk? More speculative traders like the higher premiums. More conservative (investment-oriented) covered-call sellers like the low implied risk of low-IV calls. Ultimately, a main focus of a covered call is the option ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:179 SCORE: 0.00 ================================================================================ premium. How fast can it go to zero without the movement hurting me? To determine this, the trader must study both theta and delta. The first step in the process is determining which month and strike call to sell. In this example, Harley-Davidson Motor Company (HOG) is trading at about $69 per share. A trader, Bill, is neutral to slightly bullish on Harley- Davidson over the next three months. Exhibit 5.7 shows a selection of available call options for Harley-Davidson with corresponding deltas and thetas. EXHIBIT 5.7 Harley-Davidson calls. In this example, the May 70 calls have 85 days until expiration and are 2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80 premium would represent a 4 percent profit over this 85-day period (2.80 ÷ 69). That’s an annualized return of about 17 percent ([0.04 / 85)] × 365). Bill considers his alternatives. He can sell the April (57-day) 70 calls at 2.20 or the March (22-day) 70 calls at 0.85. Since there is a different number of days until expiration, Bill needs to compare the trades on an apples-to-apples basis. For this, he will look at theta and implied volatility. Presumably, the March call has a theta advantage over the longer-term choices. The March 70 has a theta of 0.032, while the April 70’s theta is 0.026 and the May 70’s is 0.022. Based on his assessment of theta, Bill would have the inclination to sell the March. If he wants exposure for 90 days, when the March 70 call expires, he can roll into the April 70 call and then the May 70 call (more on this in subsequent chapters). This way Bill can continue to capitalize on the nonlinear rate of decay through May. Next, Bill studies the IV term structure for the Harley-Davidson ATMs and finds the March has about a 19.2 percent IV, the April has a 23.3 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:271 SCORE: 12.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:281 SCORE: 8.00 ================================================================================ Condor A condor is a four-legged option strategy that enables a trader to capitalize on volatility—increased or decreased. Traders can trade long or short iron condors. Long Condor Long one call (put) with strike A; short one call (put) with a higher strike, B; short one call (put) at strike C, which is higher than B; and long one call (put) at strike D, which is higher than C. The distance between strike price A and B is equal to the distance between strike C and strike D. The options are all on the same security, in the same expiration cycle, and either all calls or all puts. Long Condor Example Buy 1 XYZ November 70 call (A) Sell 1 XYZ November 75 call (B) Sell 1 XYZ November 90 call (C) Buy 1 XYZ November 95 call (D) Short Condor Short one call (put) with strike A; long one call (put) with a higher strike, B; long one call (put) with a strike, C, that is higher than B; and short one call (put) with a strike, D, that is higher than C. The options must be on the same security, in the same expiration cycle, and either all calls or all puts. The differences in strike price between the vertical spread of strike prices A and B and the strike prices of the vertical spread of strikes C and D are equal. Short Condor Example Sell 1 XYZ November 70 call (A) Buy 1 XYZ November 75 call (B) Buy 1 XYZ November 90 call (C) Sell 1 XYZ November 95 call (D) ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:282 SCORE: 32.00 ================================================================================ Iron Condor An iron condor is similar to a condor, but with a mix of both calls and puts. Essentially, the condor and iron condor are synthetically the same. Short Iron Condor Long one put with strike A; short one put with a higher strike, B; short one call with an even higher strike, C; and long one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put credit spread has the same distance between the strike prices as the call credit spread. Short Iron Condor Example Buy 1 XYZ November 70 put (A) Sell 1 XYZ November 75 put (B) Sell 1 XYZ November 90 call (C) Buy 1 XYZ November 95 call (D) Long Iron Condor Short one put with strike A; long one put with a higher strike, B; long one call with an even higher strike, C; and short one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put debit spread (strikes A and B) has the same distance between the strike prices as the call debit spread (strikes C and D). Long Iron Condor Example Sell 1 XYZ November 70 put (A) Buy 1 XYZ November 75 put (B) Buy 1 XYZ November 90 call (C) Sell 1 XYZ November 95 call (D) ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:283 SCORE: 8.00 ================================================================================ Butterflies Butterflies are wing spreads similar to condors, but there are only three strikes involved in the trade—not four. Long Butterfly Long one call (put) with strike A; short two calls (puts) with a higher strike, B; and long one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The difference in price between strikes A and B equals that between strikes B and C. Long Butterfly Example Buy 1 XYZ December 50 call (A) Sell 2 XYZ December 60 call (B) Buy 1 XYZ December 70 call (C) Short Butterfly Short one call (put) with strike A; long two calls (puts) with a higher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike A and strike B has the same distance between the strike prices of the vertical spread made up of the options with strike B and strike C. Short Butterfly Example Sell 1 XYZ December 50 call Buy 2 XYZ December 60 call Sell 1 XYZ December 70 call ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:291 SCORE: 5.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:292 SCORE: 13.00 ================================================================================ Greeks and Wing Spreads Much of this chapter has been spent on how wing spreads perform if held until expiration, and little has been said of option greeks and their role in wing spreads. Greeks do come into play with butterflies and condors but not necessarily the same way they do with other types of option trades. The vegas on these types of spreads are smaller than they are on many other types of strategies. For a typical nonprofessional trader, it’s hard to trade implied volatility with condors or butterflies. The collective commissions on the four legs, as well as margin and capital considerations, put these out of reach for active trading. Professional traders and retail traders subject to portfolio margining are better equipped for volatility trading with these spreads. The true strength of wing spreads, however, is in looking at them as break-even analysis trades much like vertical spreads. The trade is a winner if it is on the correct side of the break-even price. Wing spreads, however, are a combination of two vertical spreads, so there are two break-even prices. One of the verticals is guaranteed to be a winner. The stock can be either higher or lower at expiration—not both. In some cases, both verticals can be winners. Consider an iron condor. Instead of reaping one premium from selling one OTM call credit spread, iron condor sellers double dip by additionally selling an OTM put credit spread. They collect a double credit, but only one of the credit spreads can be a loser at expiration. The trader, however, does have to worry about both directions independently. There are two ways for greeks and volatility analysis to help traders trade wing spreads. One of them involves using delta and theta as tools to trade a directional spread. The other uses implied volatility in strike selection decisions. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:293 SCORE: 0.00 ================================================================================ Directional Butterflies Trading a butterfly can be an excellent way to establish a low-cost, relatively low-risk directional trade when a trader has a specific price target in mind. For example, a trader, Ross, has been studying Walgreen Co. (WAG) and believes it will rise from its current level of $33.50 to $36 per share over the next month. Ross buys a butterfly consisting of all OTM January calls with 31 days until expiration. He executes the following legs: As a directional trade alternative, Ross could have bought just the January 35 call for 1.15. As a cheaper alternative, he could have also bought the 35– 36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only a dime. The benefit of lower cost, however, comes with trade-offs. Exhibit 10.5 compares the bull call spread with a bullish butterfly. EXHIBIT 10.5 Bull call spread vs. bull butterfly (Walgreen Co. at $33.50). ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:305 SCORE: 24.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:306 SCORE: 0.00 ================================================================================ In this example, February is 59 days from expiration. Exhibit 10.10 shows the analytics for this trade with CRM at $104.32. EXHIBIT 10.10 Salesforce.com condor ( Salesforce.com at $104.32). As expected with the underlying centered between the two middle strikes, delta and gamma are about flat. As Salesforce.com moves higher or lower, though, gamma and, consequently, delta will change. As the stock moves closer to either of the long strikes, gamma will become more positive, causing the delta to change favorably for Joe. Theta, however, is working against him with Salesforce.com at $104.32, costing $150 a day. In this instance, movement is good. Joe benefits from increased realized volatility. The best-case scenario would be if Salesforce.com moves through either of the long strikes to, or through, either of the short strikes. The prime objective in this example, though, is to profit from a rise in IV. The position has a positive vega. The position makes or loses $400 with every point change in implied volatility. Because of the proportion of theta risk to vega risk, this should be a short-term play. If Joe were looking for a small rise in IV, say five points, the move would have to happen within 13 calendar days, given the vega and theta figures. The vega gain on a rise of five vol points would be $2,000, and the theta loss over 13 calendar days would be $1,950. If there were stock movement associated with the IV increase, that delta/gamma gain would offset some of the havoc that theta wreaked on the option premiums. However, if Joe traded a strategy like a condor as a vol play, he would likely expect a bigger ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:337 SCORE: 15.00 ================================================================================ 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. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:338 SCORE: 3.00 ================================================================================ 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? ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:432 SCORE: 4.00 ================================================================================ EXHIBIT 15.4 Analytics for long 20 Acme Brokerage Co. 75-strike straddles. As with any trade, the risk is that the trader is wrong. The risk here is indicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an average of at least $207 a day just to break even against the time decay. And if IV continues to ebb down to a lower, more historically normal, level, she needs to scalp even more to make up for vega losses. Effectively, Susan wants both realized and implied volatility to rise. She paid 36 volatility for the straddle. She wants to be able to sell the options at a higher vol than 36. In the interim, she needs to cover her decay just to break even. But in this case, she thinks the stock will be volatile enough to cover decay and then some. If Acme moves at a volatility greater than 36, her chances of scalping profitably are more favorable than if it moves at less than 36 vol. The following is one possible scenario of what might have happened over two weeks after the trade was made. Week One During the first week, the stock’s volatility tapered off a bit more, but implied volatility stayed firm. After some oscillation, the realized volatility ended the week at 34 percent while IV remained at 36 percent. Susan was able to scalp stock reasonably well, although she still didn’t cover her seven days of theta. Her stock buys and sells netted a gain of $1,100. By the end of week one, the straddle was 5.10 bid. If she had sold the straddle at the market, she would have ended up losing $200. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:433 SCORE: 12.00 ================================================================================ Susan decided to hold her position. Toward the end of week two, there would be the Federal Open Market Committee (FOMC) meeting. Week Two The beginning of the week saw IV rise as the event drew near. By the close on Tuesday, implied volatility for the straddle was 40 percent. But realized volatility continued its decline, which meant Susan was not able to scalp to cover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle was now 5.20 bid, 0.10 higher than it had been on previous Friday. The rising IV made up for most of the theta loss. At this point, Susan could have sold her straddle to scratch her trade. She would have lost $1,100 on the straddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the first week. Susan decided to wait and see what the Fed chairman had to say. By week’s end, the trade had proved to be profitable. After the FOMC meeting, the stock shot up more than $4 and just as quickly fell. It continued to bounce around a bit for the rest of the week. Susan was able to lock in $5,200 from stock scalps. After much gyration over this two-week period, the price of Acme stock incidentally returned to around the same price it had been at when Susan bought her straddle: $74.50. As might have been expected after the announcement, implied volatility softened. By Friday, IV had fallen to 30. Realized volatility was sharply higher as a result of the big moves during the week that were factored into the 30-day calculation. With seven more days of decay and a lower implied volatility, the straddle was 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the position. Her profit for week two was $2,000. What went into Susan’s decision to close her position? Susan had two objectives: to profit from a rise in implied volatility and to profit from a rise ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:434 SCORE: 4.00 ================================================================================ in realized volatility. The rise in IV did indeed occur, but not immediately. By Tuesday of the second week, vega profits were overshadowed by theta losses. Gamma was the saving grace with this trade. The bulk of the gain occurred in week two when the Fed announcement was made. Once that event passed, the prospects for covering theta looked less attractive. They were further dimmed by the sharp drop in implied volatility from 40 to 30. In this hypothetical scenario, the trade ended up profitable. This is not always the case. Here the profit was chiefly produced by one or two high- volatility days. Had the stock not been unusually volatile during this time, the trade would have been a certain loser. Even though implied volatility had risen four points by Tuesday of the second week, the trade did not yield a profit. The time decay of holding two options can make long straddles a tough strategy to trade. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:437 SCORE: 0.00 ================================================================================ The Risks with Short Straddles Looking at an at-expiration diagram or even analyzing the gamma/theta relationship of a short straddle may sometimes lead to a false sense of comfort. Sometimes it looks as if short straddles need a pretty big move to lose a lot of money. So why are they definitely among the riskiest strategies to trade? That is a matter of perspective. Option trading is about risk management. Dealing with a proverbial train wreck every once in a while is part of the game. But the big disasters can end one’s trading career in an instant. Because of its potential—albeit sometimes small potential—for a colossal blowup, the short straddle is, indeed, one of the riskiest positions one can trade. That said, it has a place in the arsenal of option strategies for speculative traders. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:438 SCORE: 12.00 ================================================================================ Trading the Short Straddle A short straddle is a trade for highly speculative traders who think a security will trade within a defined range and that implied volatility is too high. While a long straddle needs to be actively traded, a short straddle needs to be actively monitored to guard against negative gamma. As adverse deltas get bigger because of stock price movement, traders have to be on alert, ready to neutralize directional risk by offsetting the delta with stock or by legging out of the options. To be sure, with a short straddle, every stock trade locks in a loss with the intent of stemming future losses. The ideal situation is that the straddle is held until expiration and expires with the underlying right at $70 with no negative-gamma scalping. Short-straddle traders must take a longer-term view of their positions than long-straddle traders. Often with short straddles, it is ultimately time that provides the payout. While long straddle traders would be inclined to watch gamma and theta very closely to see how much movement is required to cover each day’s erosion, short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game. There are some situations that are exceptions to this long-term focus. For example, when implied volatility gets to be extremely high for a particular option class relative to both the underlying stock’s volatility and the historical implied volatility, one may want to sell a straddle to profit from a fall in IV. This can lead to leveraged short-term profits if implied volatility does, indeed, decline. Because of the fact that there are two short options involved, these straddles administer a concentrated dose of negative vega. For those willing to bet big on a decline in implied volatility, a short straddle is an eager croupier. These trades are delta neutral and double the vega of a single-leg trade. But they’re double the gamma, too. As with the long straddle, realized and implied volatility levels are both important to watch. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:439 SCORE: 4.00 ================================================================================ Short-Straddle Example For this example, a trader, John, has been watching Federal XYZ Corp. (XYZ) for a year. During the 12 months that John has followed XYZ, its front-month implied volatility has typically traded at around 20 percent, and its realized volatility has fluctuated between 15 and 20 percent. The past 30 days, however, have been a bit more volatile. Exhibit 15.6 shows XYZ’s recent volatility. EXHIBIT 15.6 XYZ volatility. Stock Price Realized VolatilityFront-Month Implied Volatility 30-day high $111.7130-day high 26%30-day high 30% 30-day low $102.0530-day low 21%30-day low 24% Current px $104.75Current vol 22%Current vol 26% The stock volatility has begun to ease, trading now at a 22 volatility compared with the 30-day high of 26, but still not down to the usual 15-to- 20 range. The stock, in this scenario, has traded in a channel. It currently lies in the lower half of its recent range. Although the current front-month implied volatility is in the lower half of its 30-day range, it’s historically high compared with the 20 percent level that John has been used to seeing, and it’s still four points above the realized volatility. John believes that the conditions that led to the recent surge in volatility are no longer present. His forecast is for the stock volatility to continue to ease and for implied volatility to continue its downtrend as well and revert to its long-term mean over the next week or two. John sells 10 September 105 straddles at 5.40. Exhibit 15.7 shows the greeks for this trade. EXHIBIT 15.7 Greeks for short XYZ straddle. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:459 SCORE: 0.00 ================================================================================ for the loss on the 70 call. In this case, the breakeven is $79 (the $4 maximum potential loss plus the strike price of 75). While it’s good to understand this at-expiration view of this trade, this diagram is a bit misleading. What does the trader of this spread want to have happen? If the trader is bearish, he could find a better way to trade his view than this, which limits his gains to 1.00—he could buy a put. If the trader believes the stock will make a volatile move in either direction, the backspread offers a decidedly limited opportunity to the downside. A straddle or strangle might be a better choice. And if the trader is bullish, he would have to be very bullish for this trade to make sense. The underlying needs to rise above $79 just to break even. If instead he just bought 2 of the 75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the breakeven would be $77.20 instead of $79, and profits at expiration would rack up twice as fast above the breakeven, since the trader is net long two calls instead of one. Why would a trader ever choose to trade a backspread? EXHIBIT 16.1 Backspread at expiration. The backspread is a complex spread that can be fully appreciated only when one has a thorough knowledge of options. Instead of waiting patiently until expiration, an experienced backspreader is more likely to gamma scalp intermittent opportunities. This requires trading a large enough position to make scalping worthwhile. It also requires appropriate margining (either professional-level margin requirements or retail portfolio margining). For ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:460 SCORE: 12.00 ================================================================================ example, this 1:2 contract backspread has a delta of −0.02 and a gamma of +0.05. Fewer than 10 deltas could be scalped if the stock moves up and down by one point. It becomes a more practical trade as the position size increases. Of course, more practical doesn’t necessarily guarantee it will be more profitable. The market must cooperate! Backspread Example Let’s say a 20:40 contract backspread is traded. (Note : In trader lingo this is still called a one-by-two; it is just traded 20 times.) The spread price is still 1.00 credit per contract; in this case, that’s $2,000. But with this type of trade, the spread price is not the best measure of risk or reward, as it is with some other kinds of spreads. Risk and reward are best measured by delta, gamma, theta, and vega. Exhibit 16.2 shows this trade’s greeks. EXHIBIT 16.2 Greeks for 20:40 backspread with the underlying at $71. Backspreads are volatility plays. This spread has a +1.07 vega with the stock at $71. It is, therefore, a bullish implied volatility (IV) play. The IV of the long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much as with any other volatility trade, traders would compare current implied volatility with realized volatility and the implied volatility of recent past and consider any catalysts that might affect stock volatility. The objective is to buy an IV that is lower than the expected future stock volatility, based on all available data. The focus of traders of this backspread is not the dollar credit earned. They are more interested in buying a 30 volatility—that’s the focus. But the 75 calls’ IV is not the only volatility figure to consider. The short options, the 70s, have implied volatility of 32 percent. Because of their ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:461 SCORE: 0.00 ================================================================================ lower strike, the IV is naturally higher for the 70 calls. This is vertical skew and is described in Chapter 3. The phenomenon of lower strikes in the same option class and with the same expiration month having higher IV is very common, although it is not always the case. Backspreads usually involve trading vertical skew. In this spread, traders are buying a 30 volatility and selling a 32 volatility. In trading the skew, the traders are capturing two volatility points of what some traders would call edge by buying the lower volatility and selling the higher. Based on the greeks in Exhibit 16.2 , the goal of this trade appears fairly straightforward: to profit from gamma scalping and rising IV. But, sadly, what appears to be straightforward is not. Exhibit 16.3 shows the greeks of this trade at various underlying stock prices. EXHIBIT 16.3 70–75 backspread greeks at various stock prices. Notice how the greeks change with the stock price. As the stock price moves lower through the short strike, the 70 strike calls become the more relevant options, outweighing the influence of the 75s. Gamma and vega become negative, and theta becomes positive. If the stock price falls low enough, this backspread becomes a very different position than it was with the stock price at $71. Instead of profiting from higher implied and realized volatility, the spread needs a lower level of both to profit. This has important implications. First, gamma traders must approach the backspread a little differently than they would most spreads. The backspread traders must keep in mind the dynamic greeks of the position. With a trade like a long straddle, in which there are no short options, traders scalping gamma simply buy to cover short deltas as the stock falls and sell to cover long deltas as the stock rises. The only risks are that the stock may not move enough to cover theta or that the traders may cover deltas too soon to maximize profits. ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:497 SCORE: 7.00 ================================================================================ 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 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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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:499 SCORE: 0.00 ================================================================================ 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 ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:502 SCORE: 29.00 ================================================================================ 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? 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