FPA IL CAP Conference 2014 Trading Options: Advanced …...out” of stocks. At other times they...

Trading Options: Advanced ConceptsLessons Learned from 30 Years of

Investing and Options Trading

Russell Rhoads, CFA ,

Senior Instructor, The Options Institute at CBOE

FPA IL CAP Conference 2014

Copyright (c) 2014 CBOE. All Rights reserved

The Options Institute at CBOE

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Disclaimer & Disclosures

Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies are included with this presentation and may be obtained by contacting your broker, by calling 1-888-OPTIONS, or at www.theocc.com.

In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in this presentation. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Multiple leg strategies may involve multiple commission charges. Investors should consult their tax advisor about any potential tax consequences.

The information in this presentation, including examples using actual securities and price data, is strictly for illustrative and educational purposes only and is not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities or to provide investment advice.

Supporting documentation for any claims, comparisons, statistics, or other technical data, will be supplied upon request. Past performance is not a guarantee of future results. Annualized returns cited might be achieved only if the parameters described can be duplicated and there is no certainty of doing so. CBOE®, Chicago Board Options Exchange®, Execute Success® and VIX® are registered trademarks and The Options Institute is a service mark of Chicago Board Options Exchange, Incorporated (CBOE).

This presentation should not be construed as an endorsement or an indication by CBOE of the value of any non-CBOE product or service used or described in this presentation. CBOE is not affiliated with FPA of Illinois.

Copyright © 2014 CBOE. All rights reserved.

http://www.theocc.com/


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Session Outline

Volatility: The concept and three types

What it says about stock price moves

Probabilities of finishing and touching

Using volatility to set price targets

Income Generation: Helping clients develop realistic expectations

Portfolio Protection: The real cost, the psychology and ways to lower the cost


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Volatility – The Concept

Insurance Options

Asset Value Stock Price

Deductible Strike Price

Time Time

Interest Rates Int. Rates & Div.

Risk Volatility

= Premium = Premium

Options are like insurance.

Volatility corresponds to risk.


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Types of Volatility

Volatility means “movement,” but there are at least three ways to think of movement:

Historical volatility

Realized (or future) volatility

Implied volatility


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Historical Volatility

Stock price action in the past

High

Volatility

Low

Volatility

26

28

30

32

34

36

38

26

28

30

32

34

36

38


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Realized Volatility

Stock price action in the future(usually not the same as historical volatility)

Also called future volatility

Realized volatility is unknown today


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Implied Volatility

The volatility percentage that justifies the market price of an option

The volatility “in an option’s price”

Rising implied volatility means that the “market expects something to happen”


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??

XYZ stock 63.80

Strike Price 65.00

Days to Exp 45

Interest Rates 0.7%

Dividends -0-

Volatility 30.0%

Calculating an Option’s “Value”

Theoretical Value

of 65 Call

Where does a trader

get this number?


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XYZ stock 63.80

Strike Price 65.00

Days to Exp 45

Interest Rates 0.7%

Dividends -0-

Volatility ??

Calculating Implied Volatility

Market Price

of 65 Call

1.85

This is known.

This is unknown.


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Volatility Changes

#1 Stock price volatility: Investor emotions rise and fall with economic, corporate and world news. Sometimes investors “rush in or panic out” of stocks. At other times they have near-zero anxiety.

#2 Option implied volatility: As emotions rise and fall, the relative price that investors are willing to pay for options also rises and falls.

#1 and #2 do not always rise and fall together.

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SPX

H.V.&

I.V.

Volatility Changes


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The Bell Curve

From Statistics –

http://upload.wikimedia.org/wikipedia/commons/8/8c/Standard_deviation_diagram.svg

http://upload.wikimedia.org/wikipedia/commons/8/8c/Standard_deviation_diagram.svg


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Volatility – What it Means

Stated volatility is the annual standard deviation

68% of the time – in 1 year – the price will be

within 1 SD of today’s price


within 2 SDs of today’s price


within 3 SDs of today’s price


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Stated Volatility = Annual Std. Dev.

S&P 500 (SPX) 1900.00

Days to Exp 365

Implied Volatility 12%

Stock Price I.V. Days to Exp

Days per year

100.00 .12 365

365= 228.00


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Converting the 1-Year Std. Dev.

S&P 500 (SPX) 1900.00

Days to Exp 60

Implied Volatility 12%

Stock Price I.V. Days to Exp

Days per year

100.00 .12 60

365= 92.45


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Converting the 1-Year Std. Dev.

SPX 1,900; Days 60; Stated Vol 12%; 1 SD 92.00

68% of the time – in 60 days – SPX will be

between 1,808 and 1,992

± 1 SD (1,900 – 92) (1,900 + 92)

95% between 1,716 and 2,084

± 2 SDs (1,900 – 184) (1,900 + 184)

99% between 1,624 and 2,176

± 3 SDs (1,900 – 276) (1,900 + 276)

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1 S.D. – Quick & Dirty – The Straddle

-8

-6

-4

-2

0

2

4

6

8

10

90 95 100 105 110

Buy 1 100 Call @ 3.35 & Buy 1 100 Put @ 3.30


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Underlying Price 35 60 123

Strike Price 35 60 125

Days to Exp. 35 28 51

Int Rate/Div Yld 1.2/0 1.2/0 2.0/4.0

Volatility 35% 50% 43%

1 Std Dev 3.79 8.31 19.77

Call Price 1.53 3.34 6.80

Put Price 1.49 3.28 9.13

Straddle 3.02 6.62 15.93

Straddle / S.D. ? ? ?


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The at-the-money straddle price is 80% of 1 SD.

This is based on implied volatility, which is determined

by the supply and demand in the market.

This calculation of SD is “what the market thinks.”


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The Bell Curve

What the bell curve tells you –

68.2% of the time, a stock should land between

up and down 1 SD at expiration

95% of the time, a stock should land between

up and down 2 SD at expiration

Conclusion: Options with strike prices 1 SD out of the

money expire worthless 84% of the time. But

how much do they increase in price 16% of the

time?


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The Bell Curve

What the bell curve does not tell you –

What path does the stock take between now and expiration?

How often is a standard deviation level violated?

What happens once a standard deviation is violated?


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Probabilities

(probabilities of “finishing”)

1 Close between up 1 SD and down 1 SD at exp 68%



(probabilities of “touching”)

4 Touch up or down 0.5 SD prior to expiration 99%




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Probabilities



8 Touch both up and down 0.25 SD prior to exp 36%

9 Touch both up and down 0.50 SD prior to exp 14%

10 Close beyond 1.0 SD after touching 1.0 SD 58%


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Using the Probabilities

Probabilities #4 & #8, imply:

If the underlying touches 0.25 SD, then there

is a 64% chance the underlying will continue to

0.50 SD in the same direction without reversing

to touch the 0.25 SD in the opposite direction.

Therefore, there is a statistical advantage to following the

trend when the underlying touches 0.25 SD.

(At the least, this is a decision point.)


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Using the Probabilities

If you are bullish on a stock…..

Wait for it to rise 0.25 SD, then buy it.

You then have a 64% chance it will continue rising.

If you buy a stock…..

Down 0.25 SD is a logical level for a stop-loss.

There is a 64% chance it continue falling.

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“Sell options to generate income.”

Covered calls

Cash-secured puts

The hard question:

If the market is efficient, why does selling options “increase income”?

ANSWER: Selling options does not “beat the market.” It allocates part of the return to realized cash income instead of capital gains.

Income Generation

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CBOE created indexes to track option-selling strategies

BXM: Own an S&P 500 Portfolio and

Sell 30-day at-the-money SPX Calls

BXY: Own an S&P 500 Portfolio and

Sell 30-day 2% out-of-the-money SPX Calls

PUT: Hold T-Bills equal to the S&P 500 Index and

Sell 30-day at-the-money SPX Puts

Income Generation

CBOE OPTIONS INSTITUTE 29

CBOE S&P 500 BuyWrite Index

$100 Invested in BXM and SPXTR

June 30, 1988 – July 31, 2014

0

200

400

600

800

1000

1200

1400

1988 1991 1994 1997 2000 2003 2006 2009 2012

S&P 500 Total

Return (SPXTR)

CBOE S&P 500

BuyWrite Index (BXM)

Data Source: Bloomberg


CBOE S&P 500 2% OTM BuyWrite Index

$100 Invested in BXY and SPXTR

June 30, 1988 – July 31, 2014

0

200

400

600

800

1000

1200

1400

1600

1988 1991 1994 1997 2000 2003 2006 2009 2012

S&P 500 Total

Return (SPXTR)

CBOE S&P 500 2% OTM

BuyWrite Index (BXY)



CBOE S&P 500 PutWrite Index

$100 Invested in PUT and SPXTR

June 30, 1988 – July 31, 2014

0

200

400

600

800

1000

1200

1400

1600

1988 1991 1994 1997 2000 2003 2006 2009 2012

S&P 500 Total

Return (SPXTR)

CBOE S&P 500

PutWrite Index (PUT)


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Stock Price 100.00

Days to Exp 90

Volatility 20%

1 Std Dev ≈ 10 (100 x .18 x √90 ÷ √365)

½ SD OOM Call

105.00 Strike 2.05 (8.2% ROR)

½ SD OOM Put

95.00 Strike 1.85 (7.4% ROR)

Income Generation – Example 1

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Stock Price 100.00

Days to Exp 90

Volatility 24%

1 Std Dev ≈ 12 (100 x .24 x √90 ÷ √365)

½ SD OOM Call

106.00 Strike 2.50 (10.0% ROR)

½ SD OOM Put

94.00 Strike 2.25 (9.0% ROR)


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Stock Price 100.00

Days to Exp 90

Volatility 28%

1 Std Dev ≈ 14 (100 x .28 x √90 ÷ √365)

½ SD OOM Call

107.00 Strike 2.90 (11.6% ROR)

½ SD OOM Put

93.00 Strike 2.55 (10.2% ROR)


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Implied Volatility Est ROR Call Est ROR Put

20% 8.2% 7.4%

24% 10.0% 9.0%

28% 11.6% 10.2%

Conclusion? Many people look for high volatility, because it “makes more money.”

But these stocks have the same probability of moving twice as much.

Stock picking is an art, not a science.

Income Generation – Summary

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Your client has a $1,800,000 portfolio that

closely follows the SPX now at 2,000

You are worried about a 15% market decline in

the next 3-4 months.

You want to limit downside risk and keep the

upside.

Protecting a Diversified Portfolio

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Determine # of SPX contracts:

Portfolio $Value to be Hedged

Notional Value of Index Contract (Strike x $100)

$1,800,000

2,000 x $100

Buy 9 SPX Dec 2000 Puts @ $60.00 ($6,000/Contract)

= ??


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SPX @ 2,000

Buy____ SPX ________ Puts @ ______

Cost = __________________________9 x 60 x $100 = $54,000

3.0% of portfolio value

1 SPX Put protects $200,000

9 Dec 2000

Strike price is at the money

60.00

$1,800,000 Portfolio



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How the Protection Works

Assume SPX at 1,700 (down 15%)

Market is down 15% so portfolio is down 15%

$1,746,000 stock portfolio now $1,484,000

With SPX @ 1,700 2000 Puts @ __________

Value of puts = __________________________

Total Portfolio = __________________________

300.00 each

300.00 x 9 x $100 = $270,000

1,484,000 + 270,000 = 1,754,000

Market down 15%. You are down 3%

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Imp. Vol. 4-mo ATM Put 4-mo 5% OOM Put12% 2.7% 0.9%16% 3.7% 1.4%20% 4.6% 2.4%24% 5.5% 3.2%48% 11.0% 8.3%

The cost of ATM protection rises linearly with rising implied volatility.

The cost of OOM protection rises exponentially with rising implied volatility.

The “Real Cost” of Protection


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Unwilling to Pay for Puts?

Sell equity calls to pay for index puts

• Sell near-the-money calls on stocks that you are willing to sell now.

• Sell out-of-the-money calls on stocks that you are willing to sell if price rises.

• Sell calls on part of a stock position if you want

to “lighten up” or diversify.


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Summary

Volatility Historical, Implied, RealizedProbabilities rule!

Income Realistic expectations are key

The goal is to get cash income (not to beat the market)

Protection The cost is related to the level of implied volatility


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Trading Options: Advanced Concepts

THANK YOU FOR ATTENDING!

Visit us at: www.cboe.com

[email protected]

mailto:[email protected]

FPA IL CAP Conference 2014 Trading Options: Advanced …...out” of stocks. At other times they...

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Transcript of FPA IL CAP Conference 2014 Trading Options: Advanced …...out” of stocks. At other times they...