International Securities Exchange

Alex JacobsonVice President, Education

www.iseoptions.com

Volatility And Its Importance To Options Traders

ISE EDUCATION WEBINAR

FEBRUARY 2006

For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before enteringinto any options strategy.

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation. A prospectus, which discusses the role of The Options Clearing Corporation, is also available, without charge, upon request at 1-888-OPTIONS or www.888options.com.

Any strategies discussed, including examples using actual securitiesprice data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.

www.iseoptions.com

» Free volatility data on all ISE listed options

» Updates on ISE broad market index products

» Updates on ISE sector options

» education@iseoptions.com

Long Stock

One Strategy: buy stock

Bullish Stock Investor

OPTIONS GIVE YOU OPTIONS

Call Volatility Spread

Some Bullish Option Choices

Many Strategies!

Split Strike Synthetic

Short Put Spread

Short Put Long Call SpreadLong Call

Fact

» All options strategies work» They each describe a specific set of expected

outcomes -- Price action --Volatility -- Time» No strategy works all the time

Options Myths

» 90% Expire Worthless {10 - 30 - 60}

» Sellers Smarter Than Buyers

» Zero Sum Game Between Buyer/Seller

» Raw Option Data Has Sentiment

Volatility Importance

» If you are right about direction but wrong about volatility, your trade may not make money

» If you are right about volatility but wrong about direction, your trade may not lose money

Option Pricing

To calculate an option’s theoretical value, you need:

» The Price of the underlying» The Strike Price of the option» The Time until the option expires» The Cost of Money (Interest Rates less dividends, if

any)» The Volatility

= Theoretical Value of the Option

Options Pricing

» Volatility is really the only unknown for short dated options

» Longer dated options also have interest rate uncertainty

The Reality of Pricing

Options Have Value For Two Core Reasons

1. The Time Value of MoneyFor Calls - The Cost of Carry Less

DividendsFor Puts - The Short Stock Rebate

Plus Dividends

2. The Probability of Price ChangeVolatility

Price Movements

Theoretical Values Change because Options Exist in a dynamic environment…

» Stock Prices Change» Time Goes By» Interest Rates are Adjusted» Volatility Increases and Decreases

Price Movements

» Volatility and price are generally inversely related

– Volatility generally goes up when prices decline

Price Movements

» If a stock moved 1% daily it would be a 16% volatility

» Daily % move X 16 is the annual volatility

» Why 16 ?

» All volatility is quoted is annual

Types of Volatility

» Historical Based on the PAST price action of the underlying instrument

» Implied Reverse engineered from the trading activity in the options

» Actual What you will experience over the life of your trade

» OOB/COB Be Careful (Especially on down days in puts)

» Mine Your expectation

Volatility Comparisons

» Historical vs. Implied

» Implied vs. Expected

» Implied vs. Actual

Expectations

» Options Buyers Volatility Expand

» Options Sellers Volatility Contract or Stay Constant

Some Comments On Volatility

» About as low as it’s been (in many stocks and indexes) for almost 30 years

» Is not right or wrong, but does represent a current consensus

» Is considered by some to be forward looking » Represents a lot more information than “just”

price distribution

Volatility And Hedging

» With volatility near 30 year lows hedging costs are also near 30 year lows

» Hedges involving buying options may feel inexpensive

» Hedges involving the selling of options may feel cheap to employ – premiums received provide little protection net of transaction costs

Why Volatility Is Low

» Flood of liquidity in options trading

» Dealer consolidation

» Lowered transaction costs

» Crash premium left market post-9/11

» Lack of downside gaps

» Stable market

Low Volatility

» Many major market events have come off of what was (in hindsight) a volatility low

» Volatility resources: www.iseoptions.com

Volatility’s Impact On Option Prices

» Volatility changes have an impact on options prices:

» ATM: Largest nominal change» OTM: Largest percentage change» ITM: Smallest nominal/percentage

Volatility

» QQQQ @ $37.98

Implied Volatility at about 16.50%

What if I changed it to 32% ?

Volatility

» 60 Day $35 Call 3.30 – 3.40 3.85

» 60 Day $38 Call 1.05 – 1.10 2.00

» 60 Day $41 Call .10 - .15 .90

Bullish Declining Volatility

» Trades that benefit from a price advance and a decline in volatility

» Put SellingDebit call spreadsOTM covered writes

ITM calls vs. ATM/OTM calls

Bearish Declining Volatility

» Trades that benefit from a price decline and a decline in volatility

– Selling calls– Debit put Spreads– ITM puts vs. ATM/OTM puts– ITM covered writes

Benefits Of Trading At ISE

» Largest equity options market

» First and proven all-electronic platform in the US

» Spreads traded as spreads

» Electronic buy/write capability

www.iseoptions.com

» Free volatility data on all ISE-listed options

» Updates on ISE broad market index products

» Updates on ISE sector index options

International Securities Exchange